Transcript Option Approach to Capital Investment and Engineering

Valuation with Simulation
of Flexibility “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
Definition; “on” and “in” flexibility
Class focuses on design features that enable
systems to evolve easily (e.g., more floors to
garage). This is flexibility “in” system.
We can also discuss flexibility to abandon a
project, to delay its opening. Such flexibilities
have nothing to do with design. This kind of
flexibility is known in finance as a “real option”.
More about those important flexibilities later in
course. This is flexibility “on” a system.
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 2 of 23
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 3 of 23
Antamina Project Description
 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 4 of 23
Antamina Auction Process
 Government Required:
–Bidding on 2-stage process
–Companies must bid for right to explore and
must decide on development in 2 years
–Big penalty for not developing (why?)
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 5 of 23
Antamina Mine Time Line
 Step 1: explore geology, topography for
access
 Step 2: decide to develop and spend 3
years on building facilities before getting
profits in Year 6
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 6 of 23
Project Time Line
Close
mine
Develop: CapEX
(years 2 to 5)
Produce Metal (from
year 5 until closure)
Bid &
Win
Explore
(years 0 to 2)
Year 2
Walk away
This is Flexibility “on” System. Why?
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 7 of 23
Antamina Mine Flexibilities
• “on” Flexibility
–Winning Company has flexibility to abandon
mine in 2 years
• “in” Flexibility
–Designers can create flexibility “in” system
–Ex: create port during exploration period, to
provide flexibility to expedite development to 2
years (from 3) – and thus advance revenue
stream by 1 year and increase NPV
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 8 of 23
Antamina Mine Simulation
 System Model: NPV depends on:
–ore quality, quantity
–cost of mining
–value of metals (mostly copper, zinc and “moly”)
 Distributions for Key parameters
–Estimated: Technical Cost Models (of mine ops)
–Assumed: Market data (historical data)
–Guessed: Expert Judgment on ore quality
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 9 of 23
Sources of Uncertainty
Revenues
 Mine’s life
 Future prices
of zinc and copper
 Quantity of ore
Uncertainty treatment
 Deterministic
 Stochastic process
(Lattice, Years 0 to 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 10 of 23
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 (this is assumption M&T
made – a bit of a stretch…)
 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 11 of 23
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 12 of 23
Antamina Mine Valuation
 Assumed operators could “lock in” price for
metal by long-term contracts over life of mine
–Probably not possible. Necessary assumption to
for financial analysis to get life-time NPV of mine
 Value of “on” Option = EV(all positive NPV) –
EV(project without option to abandon)
 Value of “in” Option = further improvements
in NPV due to flexibility provided
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 13 of 23
Results: Base Case – No Flexibility
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 14 of 23
Simulation Results: Flexibility 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 15 of 23
What “rule for exercising flexibility”?
What Rule Useful for Antamina?
Rule for exercising flexibility defines time,
conditions for choosing to exercise
flexibility
In this case:
• Only 1 time available;
• Condition obvious: get out if expect losses
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 16 of 23
Valuation: Flexibility to Abandon
Value of flexibility to abandon:
$819 - $550 = $269 million
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 17 of 23
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 flexibility?
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 18 of 23
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 19 of 23
Valuation: Flexibility of Early Development
Early Development Flexibility (alone):
$567 - $550 = $17 million
Would easily justify several million $
spent early on design work
This flexibility would in fact be compounded
with the flexibility to abandon
Generally not additive!
Massachusetts Institute of Technology
Engineering System Analysis for Design
Richard de Neufville
©
Michael Benouaich Slide 20 of 23
Simulation Results: Both Flexibilities
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 21 of 23
Valuation: Both Flexibilities Together
Value of both Flexibilities together:
$ 836- $550 = $286 million
Incremental Value of Early
Development Flexibility:
$ 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 22 of 23
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 23 of 23