A New Era of Risk and Uncertainty Analysis in Project Valuation (The 25th Pan Pacific Congress of Appraisers, Valuers, and Counselors, Sept 2010, Bali)

August 26, 2010 • Tell FriendsPrinter Friendly

This paper had been presented in the 25th Pan Pacific Congress of Real Estate Appraisers, Valuers, and Counselors (Session: Mining Asset/Extractive Industries Valuation).
Please see their website (www.ppc2010Bali.com)


SUMMARY OF PAPER

The era of high uncertain of commodity price requires the economic reassessment of many mining projects. The primary valuation challenge confronting mining appraiser is to recognize the uncertainty during the project life and the impact these uncertainties on the project cash flow uncertainty.

Conventional mining project valuation uses an approach called net present value (NPV) analysis based on static discounted cash flow (DCF) method.
This involves forecasting the cash flows associated with a given mine plan, discounting those cash flows to the present using a risk-adjusted discount rate (RADR), and then summing the resultant discounted values.

The mining industry for the most part uses the DCF valuation method to estimate asset values because it is simple and straight away. However this method is too generalized and could be misleading especially for valuing mining project.

There are some assumptions behind the DCF valuation method, i.e.:

1. Expected future cash flows from the project are taken as “given”. They are assumed to be certain to happen
2. Project risk does not change throughout its life
3. The project is a “now or never” opportunity. Once the project is undertaken, it will not be affected by any future managerial decision.

Since the last two decades, valuation professionals have been actively investigating how to improve Discounted Cash Flow (DCF) valuation methods by better representing mining industry complexities in their cash flow models.

They look for the valuation methods that able to:

1. compute and value non linear cash flow pay offs that accrue to project owner
2. asses the impact of the uncertain variables on the project value and risk
3. recognize managerial flexibility to intervene the project in facing either an adverse or a favorable condition

Real Options (RO) is considered as a modern valuation methods that able to accommodate the above conditions. This method had been introduced to the mining industry as an alternative to the DCF valuation methods.

This paper will use two valuation approaches (DCF and RO) to assess the impact of the uncertainty of the commodity price on the projects value and risk. The difference in their approach to adjusting project cash flow for risk gives the different results of the project value.

An analysis on one Coal Mine Project illustrates how valuation methods affect the uncertainty, characteristics, and value of project cash flow streams when both discounted cash flow (DCF) and real options (RO) methods are used to calculate net present value (NPV) for project cash flow.

A comparison is made between the DCF and RO risk adjustments applied to each cash flow stream to show how each method deals with the effects on value of the differences in uncertainty of project cash flows.

In this paper, we also examine the applicability of Real Options in valuing this coal project having operating flexibility options.

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