Decision tree/real options analysis Price of commodity now is $55 per ton You pr

Question

Decision tree/real options analysis

Price of commodity now is $55 per ton

You produce 80,000 tons per year

$5,000,000 per year to operating costs

Can operate for 88 years before closing down

Shutting down requires you to spend $5,000,000 or transfer mine ownership without cost and gain $2,000,000 in year 1 only

Equal probability of price going up 25%, staying same price same price or going down 30% every year for next 3 years. After 3 years price remains constant for remaining life.

Cost of capital is 15%

Create a decision tree to summarise dilemma then calculate the NPV of continuing to operate the mine taking into account the probability of each outcome, the abandonment option and the cost of capital.

Explanation / Answer

Cost Scenario Probability Revenue Profit Expected Profit NPV @ 15% Expected Profit Produce 8000 tons 5000000 Price Increase by 25% 33.33% 5500000 500000 -526614 $4,845,597 ($4,834,360) Price No Change 33.33% 4400000 -600000 ($3,999,982) DT Price down by 30% 33.33% 3520000 -1480000 ($15,350,145) Shutting down 5000000 100% -5000000 -5000000 -5000000 -5000000 Trf Mine Ownership NIL 100% 2000000 2000000 2000000 2000000 2000000 Computation of NPV Price Increase by 25% Price No Change Price down by 30% 1 500000 -600000 -1480000 2 625000 -600000 -1924000 3 781250 -600000 -2501200 4 781250 -600000 -2501200 5 781250 -600000 -2501200 6 781250 -600000 -2501200 7 781250 -600000 -2501200 8 781250 -600000 -2501200 9 781250 -600000 -2501200 10 781250 -600000 -2501200 11 781250 -600000 -2501200 12 781250 -600000 -2501200 13 781250 -600000 -2501200 14 781250 -600000 -2501200 15 781250 -600000 -2501200 16 781250 -600000 -2501200 17 781250 -600000 -2501200 18 781250 -600000 -2501200 19 781250 -600000 -2501200 20 781250 -600000 -2501200 21 781250 -600000 -2501200 22 781250 -600000 -2501200 23 781250 -600000 -2501200 24 781250 -600000 -2501200 25 781250 -600000 -2501200 26 781250 -600000 -2501200 27 781250 -600000 -2501200 28 781250 -600000 -2501200 29 781250 -600000 -2501200 30 781250 -600000 -2501200 31 781250 -600000 -2501200 32 781250 -600000 -2501200 33 781250 -600000 -2501200 34 781250 -600000 -2501200 35 781250 -600000 -2501200 36 781250 -600000 -2501200 37 781250 -600000 -2501200 38 781250 -600000 -2501200 39 781250 -600000 -2501200 40 781250 -600000 -2501200 41 781250 -600000 -2501200 42 781250 -600000 -2501200 43 781250 -600000 -2501200 44 781250 -600000 -2501200 45 781250 -600000 -2501200 46 781250 -600000 -2501200 47 781250 -600000 -2501200 48 781250 -600000 -2501200 49 781250 -600000 -2501200 50 781250 -600000 -2501200 51 781250 -600000 -2501200 52 781250 -600000 -2501200 53 781250 -600000 -2501200 54 781250 -600000 -2501200 55 781250 -600000 -2501200 56 781250 -600000 -2501200 57 781250 -600000 -2501200 58 781250 -600000 -2501200 59 781250 -600000 -2501200 60 781250 -600000 -2501200 61 781250 -600000 -2501200 62 781250 -600000 -2501200 63 781250 -600000 -2501200 64 781250 -600000 -2501200 65 781250 -600000 -2501200 66 781250 -600000 -2501200 67 781250 -600000 -2501200 68 781250 -600000 -2501200 69 781250 -600000 -2501200 70 781250 -600000 -2501200 71 781250 -600000 -2501200 72 781250 -600000 -2501200 73 781250 -600000 -2501200 74 781250 -600000 -2501200 75 781250 -600000 -2501200 76 781250 -600000 -2501200 77 781250 -600000 -2501200 78 781250 -600000 -2501200 79 781250 -600000 -2501200 80 781250 -600000 -2501200 81 781250 -600000 -2501200 82 781250 -600000 -2501200 83 781250 -600000 -2501200 84 781250 -600000 -2501200 85 781250 -600000 -2501200 86 781250 -600000 -2501200 87 781250 -600000 -2501200 88 781250 -600000 -2501200 PV $4,845,597 ($3,999,982) ($15,350,145)

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