Real Options.

Case of Nord Gold

Nord Gold is the international gold-mining company, which specializes on the
emerging markets. Nord Gold was founded in 2007 as the gold-mining subdivision
of the company Severstal, engaged in mineral and steel industry. In the
beginning of 2012, Nord Gold separated from Severstal and became public. In
January 2013, Nord Gold put into operation a new gold mine called Bissa, which is
located in Burkina Faso. At this time the company has nine operating gold mines
and five development projects, located in Russia (Zun-Kholba, Aprelkovo,
Berezitoviy, Irokinda, Uryakh, Gross, Prognoz), Kazakhstan (Suzdal), Burkina
Faso (Taparko, Bissa, Bouly), Guinea (Lefa) and French Guinea (Montagne DOr).
In this paper the Nord Gold project on gold mine Bissa start on the territory of
Burkina Faso, which is the first asset built by the company, is analyzed. Nord Gold
investments on this project are equal to 250 mln. USD, whereas the costs on the
gold mine Bissa are about 600-700 USD per ounce. According to the analysts
estimation in 2013, this gold mine will permit the company to increase production
by 13%. However, this project involves some uncertainties such as risk of political
destabilization in Burkina Faso, the potential reserves of the gold mine and the
dynamics of gold price. As the solution to these uncertainties, we suggest the
following real options, depending on the circumstances: to delay the project, to
expand the project or to abandon the project.
At the first stage the projects NPV was calculated. In order to calculate NPV,
several
assumptions
were
implemented:
changes
in
Capex,
Depreciation&Amortization and Net Working Capital are equal to zero, whereas
WACC is equal to the return on equity (Re), that is the project is financed by
equity. As the return on equity index there were used the industry average return
on equity for the companies (emerging marlets), mining precious metals. The
World Bank forecast of gold price and the production output in ounce on the mine
Bissa were used for calculation of the projects revenue. According to Nord Gold
estimation, the peak production output of Bissa gold mine is 200 000 ounce per
year, thereby in 2013 the company planned to produce 100 000 ounce. In the paper
we assume that the peak production output would be gained by steady pace (annual
increase by 200 000 ounce) during five years, beginning from 2014, hereafter, the
production output would stay permanent at the level of the peak production. As the
companys costs on the Bissa gold mine are about 600-700 USD per ounce, we use
the average value (650 USD) and suppose that the costs increase by the annual
average inflation in the USA during the last 10 years 2,42%. Further, there were
calculated free cash flow to the firm and the projects NPV, which presents the
sum of the discounted free cash flows and equals 45, 8 mln. USD.
Hereafter, there were considered the realization opportunities of three options.
1

Option to delay
In order to prevent the risks of political destabilization uprising in the region, let
consider the option to delay the project. Let assume that the probabilities of
political destabilization uprising equal to 2% in 2013. In case of revolution Nord
Gold has an opportunity to delay a project up to the stabilization of political
situation in the country. However, we assume that if the company does not decide
to delay the project, then all its assets will be destroyed during collisions or
plundered by the marauders. This assumption is made in order to minimize the
decision tree. To add to it, upon occurrence of revolution Nord Gold does not hold
information concerning the projects future, when the company abandons to
exercise the option to delay. This means that Nord Gold has a choice in this
uncertain situation.
Option to expand
The mines Bissa resources include both proved and possible reserves. Let make
the assumption that by the 2016 year, during production field development, the
company will overestimate the mines reserve up to 4,9 mln. oz. with 20%
probability and therefore invest in the project additional 150 mln.USD. If this
event occurs in 2016, then the realization of the option to expand permits Nord
Gold to increase the mining up to 400 000 ounce per year and prolong the project
to 2027 year, which changes the projects FCF and PVs.
Option to abandon
In case of the sharp gold price fall, Nord Gold could realize the option to abandon
the project. Let assume that the gold price will fall in 2019 with the 1% probability,
the company will fall below the break-even point, and the prices will never recover
in subsequent years. In case of negative outcome, the company could stop the
mining production and sell the equipment at net book value. This option gives the
company a chance to avoid negative FCF in unfavorable years.

DTA Method
This method is based on the calculation of PV with the decision tree usage, where
the calculations are being made from the end of the tree to its beginning. The
following formula is used:

Next, the option value is calculated as the difference between PVDTA and PV
without option.
2

Option to delay
The first option is connected with the uncertainty concerning political revolution.
We assume that in the first period this uncertainty could be held with the
probability of 2%. In the case of revolution realization, Nord Gold could use the
option to delay the project and save its assets. If Nord Gold decides not to exercise
the option to delay, then we assume that the company does not have an opportunity
to continue operations in the circumstances. Moreover, during estimation of this
option, it is assumed that in the case of revolution absence, the operation of the
company is developing according the decision tree, however, without opportunity
to exercise options in the second and third periods.
According to the calculations, the value of the option to abandon is equal to 4,92
million dollars.

Option to expand
In the second period Nord Gold could find out larger amount of gold in the ore
during further exploration (the probability of this case is 20%). Accordingly, in this
case the company is offered to exercise the option to expand the project, which will
give an opportunity to increase gold mining and profits. Moreover, if in the first
period Nord Gold finds itself in the case of the political revolution, then the
company has a right to exercise the option to delay the project and then continue its
performance according to scenario.
In this case the value of the option to expand is 80,65 million dollars.

Option to abandon
Finally, in the third period Nord Gold deals with the uncertainty concerning the
gold price dynamics (the probability of price drop is 1%). In the case of price gold
decrease the company has an opportunity to exercise the option to abandon the
project as we consider a one-time drop of price (the price will never rise again).
When calculating the value of the option to delay, the options to expand and to
delay are either taken into account. The offered options for the first and second
periods would be realized by Nord Gold in case of getting in the corresponding
nodes as Vioption>Vi.
On the whole, the option value to delay the project in the third period is equal to
81,16 million dollars.
3

Black-Scholes-Merton
We have calculated this approach only for the option to abandon. In this
methodology were employed several variables:
V Cash flow from the realization the option
K This is the strike. 2 types $180 mln if the option to delay was accepted
and $80 mln if the same option hasnt accepted.
Volatility This indicator was taken from LSE (of own shares).
Risk free rate US treasury rate (T-bills, 20 years)
T time to solution (T=3)
Results:
1) C = 40 298 718,83
2) C = 12 352 119,72