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Acct2114 : Real Options Analysis Assessment Answers

Question:

Given current economic conditions, BHP's risk management department believes that the price of iron ore has an equal probability going up by 20%, and going down by 20% every year for the next three years. After three years, economic conditions will have stabilised so that the price of iron ore will remain constant for the remaining life of the mine. They have also estimated BHP's cost of capital to be 10%.

1.Draw a decision tree to summarise the dilemma faced by BHP.

2. Calculate the NPV of continuing to operate the mine by working your way backwards through the tree and taking into account the option to abandon.

3.Based on your answer in (2), what should BHP do with the iron ore mine?

Answer:

BHP Mining Ltd (BHP) currently operates an iron ore mine and has commissioned CG to determine whether to continue operating the mine or to abandon it. The price of iron ore is currently $80 per ton, with the mine producing 50,000 tons of iron ore per year and costing $5 million per year to operate. In its current state, the mine has enough iron ore to continue operating for 50 years. Shutting the mine down would require BHP to bringing the land up to environmental standards, which is expected to cost $10 million. Reopening the mine once it is shut down would be an impossibility given current environmental standards. 

1.Decision tree

As on today

 

Cost= $5 million per year

 

Revenue per tonne= $80 per ton

Production per year= 50000 tons

To abandon

  

Cost of shutting down= $10 million

  

To continue

  

If prices increase

 

If prices decrease

Increase in prices by 20% for three years and then stable

 

Decrease in prices by 20% for three years and then stable

2.Computation of NPV

NPV if prices goes up by 20% YoY

       
        
 

Year

Discounting factor @10%

Price /ton

Revenue

Cost

Net inflow

Present Value

 

0

1.00

80

-

-

-

-

 

1

0.91

96

4.80

5.00

(0.20)

(0.18)

 

2

0.83

115

5.76

5.00

0.76

0.63

 

3

0.75

138

6.91

5.00

1.91

1.43

 

4

0.68

166

8.29

5.00

3.29

22.40

       

24.28

NPV if prices decreased by 20% YoY

       
        
 

Year

Discounting factor @10%

Price per tonne

Revenue

Cost

Net inflow

Present Value

 

0

1.00

80

-

-

-

-

 

1

0.91

64

3.20

5.00

(1.80)

(1.64)

 

2

0.83

51

2.56

5.00

(2.44)

(2.03)

 

3

0.75

41

2.05

5.00

(2.95)

(2.21)

 

4

0.68

33

1.64

5.00

(3.36)

(22.86)

       

(28.74)

NPV of the project is continued- 50% of 24.28 (+) 50% of -28.74 = (2.23)

Since there are equal chances of an increase or decrease in prices, we are taking an equal probability of the same.

NPV if project is discontinued

       
       
 

Year

Discounting factor @10%

Price per tonne

Revenue

Cost

Net inflow

Present Value

 

0

1.00

 

-

10

(10.00)

(10.00)

       

(10.00)

3. The project should be continued as on today. After year 1, it can be checked whether prices have increased or decreased. If increased, continue, else take a decision then. Hence, from the computation it is clear that the continuation of the project depends entirely on the prices.

Introducation:

Finance is a system that involves the exchange of funds between the borrowers and the lenders and investors. It operates at various levels from firms to global to national levels. Thus, there are many complexities involved in it related to markets, institutions, etc. An introduction to finance will provide a basic idea of how the finance sector in general works in India.In the finance system, credit, money, and finance are used as a medium for various exchanges. So, they work as a known value for which the services and goods are exchanged.
Thus, in modern systems, banks financial instruments, financial markets, and services are included. Also, this system allows for the funds invested, allocated, and moved within a smooth process.

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