Transcript Option Approach to Capital Investment and Engineering

Valuation with Simulation
of Options “on” and “in” a System
Capital Investment and
Engineering Flexibility
in the development of
the Antamina mine (Peru)
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 1 of 16
Note
This presentation is based on the case
developed by Peter Tufano and Alberto Moel
from the Harvard Business School.
It contains simplifications. The figures appearing
here differ from those presented by Tufano and
Moel. They reflect the assumptions of the
authors of this presentation about the treatment
of uncertainty and the cash flows projection.
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 2 of 16
Project Description: Antamina
 State-owned copper and zinc mine in Peru,
~480km (300miles) north of Lima
 Privatization in 1996: call for bids. Small upfront
payment + promise to develop
 Little reliable geological information
 Geological study to take two years, start after
the bidding, be available before construction
 Proceed with development if survey suggested
the mine could be developed economically
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 3 of 16
Project Time Line
Develop: CapX
(years 2-5)
Produce Metal
(year 5-closure)
Bid &
Win
Explore
(years 0-2)
Close
mine
Year 2
Walk away
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 4 of 16
Sources of Uncertainty
Revenues
 Mine’s life
 Future prices
of zinc and copper
 Quantity of ore
Uncertainty treatment
 Deterministic
 Stochastic process
(Lattice, Years 0-2)
Costs
 Operation expenses
 Capital Expenditures
 Probability distributions
Monte Carlo simulation
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 5 of 16
Monte Carlo Simulation
1. Probability
values for
significant
factors
2. Random
selection of
factors
according
to their pdf
3. Determine
NPV for each
combination
4. Repeat
process and
obtain NPV
distribution
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 6 of 16
Sources of Uncertainty
 Price and quantity uncertainty prevails only
during the first two years
 Price risk is assumed to be eliminated in year
2 by entering forward contracts to sell the
output of the mine
 All other sources of uncertainty are modeled
in the Monte Carlo simulation after year 2
Simulation result: Realization of expected NPV
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 7 of 16
Results: Base Case – No Options
Crystal Ball Student EditionForecast:
Not for Commercial Use
10,000 Trials
NPV (base case)
Frequency Chart
.046
457
.034
342.7
.023
228.5
.011
114.2
.000
($1,092.85)
Mean
= $556.85
Mean
= $550
$684.28
Massachusetts Institute of Technology
Engineering System Analysis for Design
M
$2,461.40
0
$4,238.52
$6,015.64
Richard de Neufville
©
Michael Benouaich Slide 8 of 16
Simulation Results: Option to Abandon
Crystal Ball Student EditionForecast:
Not for Commercial Use
10,000 Trials
NPV (base case)
Frequency Chart
.046
457
.034
342.7
.023
228.5
.011
114.2
.000
($1,092.85)
Mean
= $556.85
Mean
= $819
0
$684.28
$2,461.40
$4,238.52
Certainty is 75.61% from $0.00 to $6,015.64
Massachusetts Institute of Technology
Engineering System Analysis for Design
$6,015.64
Richard de Neufville
©
Michael Benouaich Slide 9 of 16
Valuation: Option to Abandon
Option to abandon:
$819 - $550 = $269 million
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 10 of 16
Engineering Flexibility
 Add flexibility, add value?
 Starting engineering study earlier and faster would
allow you to shorten construction to two years and
ramp up production faster
What would you pay for this option?
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 11 of 16
Simulation Results: Early Development
Crystal Ball Student Edition
Forecast:
Not for Commercial Use
10,000 Trials
NPV (early development)
Frequency Chart
.046
457
.034
342.7
.023
228.5
.011
114.2
.000
($1,160.61)
Mean
= $574.92
Mean
= $567
$658.32
Massachusetts Institute of Technology
Engineering System Analysis for Design
$2,477.25
0
$4,296.18
$6,115.11
Richard de Neufville
©
Michael Benouaich Slide 12 of 16
Valuation: Option for Early Development
Early Development Option (alone):
$567 - $550 = $17 million
Would easily justify several million $
spent early on design work
This real option would in fact be
compounded with the option to abandon
Generally not additive!
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 13 of 16
Simulation Results: Both Options
Crystal Ball Student Edition
Forecast:
Not for Commercial Use
10,000 Trials
NPV (early development)
Frequency Chart
.046
459
.034
344.2
.023
229.5
.011
114.7
.000
($947.79)
Mean
= $566.91
Mean
= $836
0
$770.71
$2,489.21
$4,207.72
Certainty is 76.09% from $0.00 to $5,926.22
Massachusetts Institute of Technology
Engineering System Analysis for Design
$5,926.22
Richard de Neufville
©
Michael Benouaich Slide 14 of 16
Valuation: Both Options Together
Value of both Options together:
$ 836- $550 = $286 million
Incremental Value of Early
Development Option :
$ 836- $819 = $17 million
Appears additive, but actually a difference.
In this case rounded out and insignificant
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 15 of 16
References
 Tufano, P., Moel, A., (1997) “Bidding for Antamina”,
Harvard Business School Case number 9-297-054,
Rev. Sept. 15.
 Tufano, P., Moel, A., (2000) “Bidding for the Antamina
Mine – Valuation and Incentives in a Real Option
Context”, in “Project Flexibility, Agency, and
Competition,” edited by Brennan, M. and Trigeorgis, L.,
Oxford University Press
 Hertz, D. (1979) “Risk Analysis in Capital Investment”,
Harvard Business Review September-October, pp.
169-180
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 16 of 16