Reference no: EM132199555
Assignment - NPV and real option valuation
Proposed project: Alchemy Mines is considering an investment in the rights to a palladium mine.
Initial investment - The owner of the mine will sell the rights to Alchemy Mines at a cost of $1,000,000 payable immediately. Purchase of the rights entitles Alchemy Mines to all mining rights provided mining commences within one year and continues without interruption until the entire deposit is recovered and the land restored in compliance with regulatory requirements. If mining does not commence in one year, the title to the mine reverts to the seller.
Expected operating variables - The firm has made the following assumptions regarding operating cash flows for the mine:
Recoverable palladium: 10,000 ounces
Current market price of palladium: $1081.10 per ounce
Expected price of palladium in one year: $1040.90 per ounce
Expected fixed costs of mining and refining: $7,500,000
Expected variable costs of mining and refining: $136.25 per ounce
Cost to restore the land and remediate environmental damage: $500,000
No taxes are paid on profits from the project
If the firm mines the palladium, all cash in- and out-flows from mining and selling the palladium will occur on the day the mining commences because:
The firm is required by the local government to deposit in escrow at commencement of mining, all funds necessary to pay the costs of mining, refining and restoration; and
The firm will pre-sell all the recovered palladium with payment to be made by the purchaser on the day mining commences.
As a result, for net present valuation purposes, all cash flows for the project occur either at time 0 (the initial payment for the rights) or (at most) 1 year later (all other expected cash inflows and outflows for the project).
Additional Information:
The firm estimates additional economic variables as follows:
Risk free interest rate equals 2.5%
Expected market return: 12.2%
Beta for palladium mining and smelting: 0.535
Standard deviation of annual returns on palladium prices: 26.91%
1. Use net present value analysis to determine whether the firm should accept the proposed Alchemy Mines project.
a. Determine the amount and timing of all expected cash flows for the proposed project.
b. Determine the appropriate discount rate (using CAPM).
c. Calculate NPV.
d. Indicate whether Alchemy Mines should accept the project based on it NPV and explain.
2. Use option pricing analysis to determine whether Alchemy Mines should accept the proposed palladium mine project.
a. Determine whether the project cash flows have the characteristics of a put option or a call option.
b. Find the implicit "strike price," that is, the expected spot palladium price at which the firm will elect to commence mining and processing rather than just walk away from the project. (Remember that for an option, the option premium is a sunk cost and does not affect the decision to exercise.)
c. Calculate the option value of the mine using the Black-Scholes options pricing model.
Note: You can calculate the option value for a single ounce of palladium using per ounce price and costs, then multiply that by the total amount of palladium to get the total option value of the mine. Alternatively, you can calculate the option value using the total price of palladium and the total costs.
d. Compare the option value of the mine to the cost to acquire rights to the mine to determine whether to accept the project.
e. Indicate whether Alchemy Mines should accept the project and explain.