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Submitted by SUDAM CHARAN BEHERA (11MI92R01) Under the Supervision of


Department of Mining Engineering Indian Institute of Technology Kharagpur


1. Outline of the work done during the last one year:

I joined the Department of Mining Engineering, Indian Institute of Technology, Kharagpur as an institute research scholar on December 29, 2011 under the supervision of Prof. A. Bhattacharjee and Prof. B.S.Shastry. My broad area of research is Development of a

Decision Support System for a Mining Project. 1.1 Course work:

During the last one year, I have completed seven subjects of my course work as recommended by the DSC members. The completed course works are listed below. S.N. 1 2 3 4 5 6 7 Subject Name English for Technical Writing Society, Science and technology Computational Geomechanics Numerical Method for Subsurface Environment Financial Engineering Simulation of Mining Systems Project Management IM60059 MI60016 BM60061 3-0-0 3-0-0 3-0-0 3 3 3 A B C Subject code HS63002 HS51637 MI60004 MI60002 L-T-P 2-2-0 3-0-0 3-1-0 3-1-0 Credit 4 3 4 4 Grade C B C C

1.2 Technical assistantship:

I assisted Prof. B.S.Sastry and Prof. Biswajit Samant for conducting Mine Environmental lab for B.Tech students during the autumn semester 2012.

I also assisted Prof. K.Pathak and Prof. S.K. Pal in Mining Machinery lab for B.Tech students during the spring semester 2011-2012


The mining industry has experienced so many ups and downs in recent times due to volatilities in the market, mineral commodity prices, exchange rates, and interest rates. Due to change in world order different sets of paradigms have been set to bring forth new challenges in mining world. Mining sustainability, which stresses to maintain the Triple Bottom Line (TBL) has become the central point in the mining industry after the various deliberations on sustainable development in the different world forums since 1st UN conference on sustainable development in 1992 at Rio de janeiro and Rio+10 at Johannesburg in 2002 and Rio+20 at Rio de janeiro in 2012(wikipedia). The mining industry has moved to an uncertain zone since the crackdown of the Bretton Wood agreement in 1971 and end of the gold standard era (1944 to 1971). It is a landmark system for monetary and exchange rate management established at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire in 1944(Wikipedia.2011). The rapid fluctuations in stock market around the globe, political instabilities in different countries, rising consciousness of environmental bodies, NGOs and local bodies in socio-economic and environmental issues etc have drastically changed the mindsets of mine planners and decision makers to give due attention towards the overall uncertainties and risks that play important role in determining the mining project value. Different techniques have been developed over time by various researchers for the valuation of the mining project. The most popular Discounted Cash Flow (DCF) method of project evaluation i.e. Net Present Value (NPV) has been widely used for the valuation of mining companies across the globe because it has following advantages: a. Very simple to calculate b. Easy to understand But it suffers from following limitations: (Brennan & Schwartz, 1985; Martinez, 2009; Yeo &Qiu, 2003;)

a. Neglects time varying nature of mineral commodity prices and managerial flexibility in response to price variations. b. It is static and deterministic in approach. c. It assumes that companies follow a predetermined plan irrespective of future developments. d. It uses a single risk-adjusted discount rate for calculation of present values incorporating all types of risks which is incorrect. e. Ignores upside potential of the investment. f. Underestimates the value of the project. The DCF evaluation method used for the mining project gives the project value by considering a fixed set of input parameters like discount rate and cash flows (Martinez, 2009). The important question here is whether it gives true value for the project in an uncertain and volatile environment, the answer is no because it doesnt consider uncertainty and flexibility in calculation of mining projects worth. The DCF technique considers only fixed and deterministic values of all the input parameters for the project value calculation which is quite wrong as input parameters like commodity price, interest rates, exchange rates etc are stochastic and dynamic in a project changing the future cash flows over the whole project life (DelCastillo,2012;Martinez,2009). There is an urgent need for an effective evaluation system which can address the issues of uncertainty and flexibility in a mining project. Real option method of evaluation of project gives an efficient and viable tool in the hands of decision makers/managers to adopt different set of options in uncertain scenarios in order to increase the worth of the project because what is most important at the end of the day for any mining project is survival, growth and profitability. Real option is a dynamic, stochastic, and flexible technique which can take most of the advantages in the uncertain and unpredictable environment than what DCF technique fails to do because of its static and deterministic properties. 3.0 PROBLEM STATEMENT The mining industry is facing different sort of issues like sustainability, risk and uncertainty, safety management system, and strategic decision making in the period of highly volatile and turbulent market scenario. The conventional method of project evaluation doesnt provide sufficient and accurate

estimation of future cash flows. The discounted cash flow method uses a single time and risk adjusted discount rate for the calculation of present values of future cash flows. It is static in approach as production sticks to the designed plan regardless of changes in future markets. The managerial flexibility, a dynamic concept that mine planners/mine managers can react in response to the emerging, volatile and uncertainty situation is lacking in the traditional valuation approach. It underestimates the project value as it doesnt consider flexibility and uncertainty in the estimation of project value. This approach provides no idea regarding future course of action if anything what is assumed in the approach has gone wrong. Many mining companies have suffered heavy losses and some of them have closed their operation in midway when the market tumbles to a level beyond anybodys imagination. This is the grave situation where real option can provide impetus and clear guidelines regarding what to do and what not to do.

4.0 OBJECTIVES OF THE RESEARCH The main objective of the research work is to find a strategy to tackle the issues of mining project evaluation under uncertainty and risk and sustainable development and provide a decision tool to optimize the worth of the project and increase the competitiveness in the mining sector. The main focus areas of the present work are the following: 1. Identify, classify, and analyze various types of risk in the mining project. 2. Quantification of total risk by value at risk (VaR) technique. 3. Design, develop and implement an objective, comprehensive decision support system real option analysis with Monte Carlo simulation for the evaluation of mining project.

5.0 SCOPE OF WORK The scope of work consists of the followings: Literature survey of the theoretical, empirical and analytical analysis of the real option research specific to mining projects. Visit to mines for the collection of mines data. Compilation of data for various sources of uncertainties and risks. Development of risk methodology for various uncertainties in a mining project. Estimation of historical volatilities of commodity price. Calculation of real option value based on Monte Carlo simulation. Preparation of thesis.


6.1 HISTORICAL OVERVIEW During last 30 years a large number of literatures has been published using real option valuation methods for the evaluation of different types of projects basically in the mining sector. Stewart Myers (1977) coined the term Real Options in his work Determinants of Corporate Borrowing which draws attention of the management personnel of various organizations. According to Myers (1977), any mining company captures the right after making final investment decision. This right entitles the company to buy or sell a real (physical) asset or investment plan in the future looking into the positive or negative scenarios. The project value will be equal to the net present value plus real option value in the highly uncertain scenarios. Real options evolve from financial options. Its original intention was to deal with future uncertainties of project implementation (Zheng & Zhang, 2011). The concept of real option has generated tremendous excitement in recent years. Amaram & Kulatilaka (1999) has applied real option theory to the evaluation of physical assets (investments) helping managers in strategic decision making.

The literature survey of last thirty years brings out three important approaches in real option research, namely theoretical, managerial and empirical. Theoretical (Dixit &Pindyck, 1994; Trigeorgis, 1997) and managerial (Amaram &Kulatilaka, 2000; Luehrman, 1998) work on real option strategy which considers firm or organization as a monolithic actor while empirical work by Folta,1998; Miller & Reuer, 1998 tends to see the investment decisions are not integrated within organizational activities. Brennan and Schwartz (1985) have adopted the modern option pricing techniques to evaluate natural resource investments which provided great impetus for further research in mining projects. Dixit (1989) analyzes the effects of uncertainty on the magnitude of hysteresis in the models with entry and exit. Dixit and Pindyck (1996) present a detailed overview of this early literature and constitute an excellent introduction to the techniques of dynamic programming and contingent claims analysis, which are widely applicable in the area of real options and investment under uncertainty. Trigeorgis (2005) has introduced real option basics. He has divided Real Options into eight categories according to the difference in flexibility it has provided. The 1990s provided a huge number of publications in real option application in diverse fields which includes managing R&D projects (Pennings, 1998), natural resources investment (Trigeorgis, 1990), real estate (Williams, 1993), energy (Kulatilaka, 1993, and Pindyck, 1993), aerospace industry (Sick, 1999), banking (Panayi and Trigeorgis, 1998), technology adoption (Grenadier and Weiss, 1997), merger policy (Mason and Weeds, 2002) and biotechnology sector (Ottoo, 1998, and Woerner, 2001). Management from around the globe has effectively applied, managed and structured uncertainty in various capital budgeting decisions by applying an options analysis to their evaluations of the project (Amram and Kulatilaka (1999); Copeland and Antikarov (2003); Dixit and Pindyck (1994); Luenberger (1998); Park (2006); and Trigeorgis (1996)). Kelly(1998) used the binomial option model for the evaluation of a gold mine. Cortazar and Casassus (1998) evaluated a Copper mine applying expand options in their empirical work and demonstrated that the value of expansion options was 8 to 98 percent of the total project value. Moel and Tufano(2002)

demonstrated the options of opening and closing with the help of a huge database of 285 developed gold mines in North America operated during the period 1988-1997. Colwell et al. (2002) applied the Brennan and Schwartz real option model (1985) for evaluation of gold mines in Australia. Mayer and Kazakidis (2007) used Monte Carlo simulation approach for value different types of real options like abandonment option, sequence option etc. From the literature survey, it is cleared that application timing of option is very important to get the appropriate Real Option value. 6.2 RISK AND UNCERTAINTY IN THE MINING INDUSTRY The ISO 31000(2009)/ISO Guide 73:2002 defines risk as the effect of uncertainty on objectives. Uncertainties indicate events which may or may not happen and caused by ambiguity or a lack of information (Wikipedia). Risk is the probability of the uncertain future events. Identification of risk is limited by the certainty or uncertainty of the risk. The difference between risk and uncertainty is that risk can be represented by random variable which has probability distribution and uncertainty cant. Risk can be categorized into three groups: known-knowns, known-unknowns and unknown-unknowns. Known-known- It is a risk which is known to everybody involving little uncertainty. Known-unknowns-It is a risk which exists in our knowledge but not sure about its effects. This type of risk can be identified and managed. Unknown-unknowns-This is a type of risk which is difficult to identify and manage but requires extensive planning. Mining project risks can be broadly classified into six categories. Business risk Technical or operational (geological and engineering) risk Regulatory and legal risk Country risk

Market volatility risk Environmental risk Business risks: Business risk is the most important risks to be considered for any mining project before taking into consideration of any other aspects. This type of risk is generally of two types: Systematic risk (External) and unsystematic risk Internal). Systematic risk which is called undiversified risk or market risk depends upon macro-economic parameters like inflation, interest rate, exchange rate, money supply etc. Unsystematic risk which is called diversified risk or unique risk depends upon the firm specific factors like labour strike, arrival of new competitor, introduction of new product etc. Business risks

Systematic Risk

Unsystematic Risk

Economic Natural

Political Human



Systematic risks or external risks are influenced by the events outside of the organization. These types of risks are come into the limelight due to three factors: i. Economic Factors: These are the most important causes of systematic risks. Natural Factors: Political Factors

ii. iii.

Business risks in a mining project can be classified into ten categories (According to Ernst & Young, a global accounting firm, 2012-13 annual report). These are the followings:

1. 2. 3. 4. 5. 6.

Resource Nationalism Skill Shortage Infrastructure Access Cost Inflation Capital Project Execution Maintaining a Social license to operate 7. Currency and Price Volatility 8. Capital Management Access 9. Sharing the Benefits 10. Fraud and Corruption Technical and operational risk (geological and engineering risk) i. Geological risk is attributed to the uncertainties in the geological condition of the deposit like grade, continuity, volume According to Hebblewhite (2010), mining project risks can be divided into three levels: Level 1: Day-to-day operational risks Level 2: Specific site or mining condition related risks Level 3: core risks associated with mining method or system ii. Production risk covers extraction parameters and processing parameters Legal and Regulatory risk: it covers changes in the regulatory system. Country risk Country risk can be divided into four classes: i. ii. Social risk: It covers wealth distribution among people, level of poverty, percentage of literacy, labour policy of government etc. Political risk: It covers stability of the government, policies of the government relating to external trade, foreign investment, tax regime, environment and mineral conservation. Geographical risk: It covers natural climatic conditions and infrastructure development.




Economic risk: It covers stability of domestic currency, foreign exchange restrictions etc.

Market volatility risk or economic risk: It is resulted from commodity price variations, market share variance, supply and demand variance, Environmental risk: It covers Environmental and land use impacts, accident and health hazards and Economic-political-social-psychological impacts. 6.3 REAL OPTIONS AS A STRATAGIC DECISION MAKING TOOL According to Martinez (2010), real option analysis is a valuation and strategic decision making tool that uses financial option pricing theory to real assets like plants, machineries, buildings, any projects etc. In general option is a derivative instrument which derives its value from its underlying instrument. Option is nothing but right not the obligation to carry out transactions at a predetermined price on or before a particular time period. Real options which is applicable to tangible assets such as mining projects is right but not the obligation to invest in a predetermined investment till the opportunity disappears. Options are generally of two types: financial options and real options .These options can be divided into two categories namely call option and put option. A call/put option provides the right to buy/sell a share of stock. These call/put options are two types: American options and European options (Hull, 1958). Comparison between financial option on a stock and real option on a mining project (Luehrman, 2009) Financial option Current value of stock Strike/exercise price

Real option on mining projects Present value of expected cash flows Total investment cost

Time to expiration Risk free interest rate

Time period until opportunity disappears Risk free interest rate

According to Trigeorgis (2005), real options can be placed in eight groups. 1. 2. 3. 4. 5. 6. 7. 8. defer Staging (compound) Expand Contract Temporary shut down Abandon Switching Growth

According to Amram and Kulatilaka (1999), real options are of seven types. 1. 2. 3. 4. 5. 6. 7. Timing Growth Staging (compound) Exit Flexibility Operating Learning

Defer option provides the option holder or buyer to wait until the uncertainty disappears. Broadly Real Options can be grouped into three categories (Wikipedia) a. Options relating to project size. b. Options relating to project life and timing. c. Options relating to project operation. a. Options relating to project size can be of three types: option to expand, option to contract and option to expand or contract (switching option).


When management is of the view that company is operating in a high growth environment, then option to expand can be applied. That is equivalent to call option. If it feels that the company is entering in a low growth environment, then option to contract can be applied. This is like a put option. b. Options relating to project life and timing can be of three types: option to initiation or defer, option to abandon, and sequencing options. c. Options relating to project operation can be of three types: output mix (product flexibility), input mix (process flexibility) and operating scale options or intensity options. Valuation approach for the Real options: Real Options can be evaluated by three types of approaches: Partial Differential Equations : Closed form Solutions using BlackScholes Model, Analytical Approximations Numerical Methods (e.g. Finite Difference Method) Binomial option pricing model Monte Carlo Simulation. According to Sheng Baozhu et al. (2010), Real Option models can be divided into two categories: Discrete time models and Continuous time models. Discrete time models are binomial option pricing model developed by Cox, Ross, and Rubinstein (1974). Continuous time model are famous BlackScholes model and Monte Carlo simulation Black-Scholes Model for Real Options: Black-Scholes model was developed by Fisher Black, Robert Merton and Myron Scholes in 1973 for which they got Nobel prize in 1997.

According to the Black-Scholes Model, the price or pay-off of a Real Option at maturity in a risk neutral world has a closed form solution. C=SN(d1)-X exp-r(T-t) N(d2) Where C: price of real options S: the present value of the future cash flows X: total investment T-t: length of time the decision to be deferred r: risk-free rate of return N(x): cumulative probability distribution function for standard normal distribution d 1: ln(S/X)+(r+2/2)(T-t)/ )1/2 d 2 = d 1-(T-t)1/2


The methodology consists of followings: 1. 2. 3. 4. 5. 6. 7. Development of base case net present value (NPV) Identification, analysis and documentation of uncertainties and risks. Estimation of project volatilities from uncertain parameters. Identification of opportunities in response to different uncertainties. Make a synergy between uncertainties and opportunities Determination of real option value True value of the project= Base case NPV + Real Option value

Development of Base case NPV: It is the primary input to the real option analysis. This is calculated considering risk-adjusted rate of return and discounting the future cash flows. Base case NPV= Future cash flows/ (1+R)^t Initial Investment R is the hurdle rate


Identification, Analysis and Documentation of Risks and Uncertainties i. ii. Identifying important sources of uncertainties and risks by adopting different qualitative and quantitative techniques. Developing relative impact on the project value.

Estimation of Project Volatilities: There are five techniques used in estimation of volatility in real option approach: 1. 2. 3. 4. 5. Historical volatility of underlying asset i.e mining project Historical volatility of the compatible assets Historical volatility of traded assets(companys stock price) Historical volatility of the industrial group index Monte Carlo Simulation

Opportunities: Wait for future market movements and when news is good then apply option to expand and option to growth. Combine uncertainties and opportunities and get the real option value. True project value will be the summation of base case NPV and Real Option value.

7.1 Case study of a copper project in India:

A Mining company is planning to invest in a copper project in India. It requires a thorough evaluation of the project as the international market for mineral commodities is volatile and involves different uncertainties from various sources. In this volatile and uncertain environment, real option is the best evaluation method for quantifying true project value


. Real option analysis requires following project data: 1. 2. 3. 4.


Mine life Lease period Operating costs/tonne Current market price of copper

5. Copper price volatility(% in yearly terms) 6. Risk-free interest rate 7. Risk adjusted interest rate 8. Initial project investment 9. Mine closure costs 10. Mine lease cost for delay

8.0 Future Work Future work will be Collection of copper mines project data. Collection of historical copper price data for last20 years (1990-2010). Estimation of price volatility by time series analysis. Identification of risk in a project. Analysis of effect of risk on project value. Study the effect of various real options on project value Preparation of thesis.


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