Documente Academic
Documente Profesional
Documente Cultură
Jason Hall
UQ Business School, The University of Queensland
St Lucia Queensland Australia 4072
j.hall@business.uq.edu.au
Ph: 61 7 3346 9421
UQ Business School
High earnings
stream
Expected
earnings
= Probability of
high earnings x
High earnings
stream
+ (1- Probability of
high earnings) x
Low earnings
stream
Present value of
expected earnings
Expected value
= Probability of high
earnings x Value
contingent upon the
high earnings state
+ (1 Probability of
high earnings) x
Value contingent
upon the low
earnings state
Present value of
expected future value
Low earnings
stream
Value, contingent
upon the low
earnings state
management faces a continuous expansioncontraction decision. Large mine expansions or shutdowns are merely extreme examples of this
continuous production decision.
Consideration of real options valuation is
especially important for the high-volatility mining
sector. The volatility associated with value drivers
such as commodity prices, exchange rates and costs,
dictates that management require the ability to alter
investment plans in response to these drivers. Hence,
the value of the firms abandonment option is likely
to be greater than average. Furthermore, the
heightened volatility of revenue streams and margin
growth means that their growth options also have
above-average value, given that investment policy is
expected to change in response to feedback regarding
the firms growth prospects.
For projects which contain no embedded options,
the valuation arrived at using a binomial tree is, in
theory, exactly the same as which would be arrived at
by discounted expected cash flows at the riskadjusted cost of capital. Any difference between
these two valuations results from an inconsistency in
the inputs to valuation. This could result from the
volatility of cash flows implicitly incorporated into
the binomial tree being different to the volatility
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UQ Business School
Exhibit 2 Potential future coal prices over a ten-year period and associated cash flow estimates
Constrained price
0
50.00
1
56.37
44.35
2
63.56
50.00
39.33
3
71.67
56.37
44.35
34.88
4
80.80
63.56
50.00
39.33
30.94
5
6
7
8
9
10
91.11 100.00 100.00 100.00 100.00 100.00
71.67 80.80 91.11 100.00 100.00 100.00
56.37 63.56 71.67 80.80 91.11 100.00
44.35 50.00 56.37 63.56 71.67 80.80
34.88 39.33 44.35 50.00 56.37 63.56
30.00 30.94 34.88 39.33 44.35 50.00
30.00 30.00 30.94 34.88 39.33
30.00 30.00 30.00 30.94
30.00 30.00 30.00
30.00 30.00
30.00
50.54
51.12
51.75
52.44
53.35
54.15
55.23
56.18
57.42
58.53
1
53
3
2
84
27
-18
3
118
53
3
-37
4
156
84
27
-18
-53
5
199
118
53
3
-37
-57
6
237
156
84
27
-18
-53
-57
7
237
199
118
53
3
-37
-57
-57
8
237
237
156
84
27
-18
-53
-57
-57
9
237
237
199
118
53
3
-37
-57
-57
-57
10
237
237
237
156
84
27
-18
-53
-57
-57
-57
28.86
31.31
33.97
36.85
40.66
44.03
48.58
52.55
57.76
62.43
Expected FCFF
0
27
DCF =
(1 + r )
t =1
FCFFt
t
where:
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p V10,63.56 + (1 p ) V10,50.00
1 + rf
0.47 84 + 0.53 27
1.06
= $104m
= 53 +
where:
V9,56.37 = value in year 9 in the case where coal price
is $56.37 per tonne;
V10,63.56 = value in year 10 in the case where coal
price rises to $63.56 per tonne; and
V10,50.00 = value in year 10 in the case where coal
price falls to $50.00per tonne; and
= the risk-free rate of interest.
rf
You will note that I have discounted at the riskfree rate of interest, rather than the risk-adjusted cost
of capital. This is the correct valuation approach,
provided the probabilities used in estimating
expected future values are risk-neutral probabilities.
One of the contributions made by Black, Scholes and
Merton in their work on option pricing is to establish
that discounting of risk-neutral expected payoffs at
the risk-free rate provides the same present value of
real-world expected cash flows, discounted at the
risk-adjusted cost of capital.
The reason why risk-neutral valuation is useful in
binomial option pricing is that risk-neutral
probabilities can be assumed to be constant
throughout the life of the project and at different parts
of the binomial tree, under the assumption that the
risk-free rate is constant. In contrast, the actual risk of
a project can vary substantially over time, and in
different parts of the binomial tree. The variability of
returns on investment will be considerably higher for
a project which is close to financial distress,
compared to a project which is highly profitable. The
assumption typically made in DCF valuation that
discount rates are constant over time and in all states
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Exhibit 3 Potential future discounted cash flow and real options valuations over a ten-year period
Discounted cash flow
valuation
Real options
valuation
0
199
1
414
31
2
594
193
-116
3
757
350
23
-216
4
888
491
158
-100
-270
5
967
606
278
16
-177
-277
6
963
681
373
119
-78
-211
-252
7
850
699
431
196
10
-130
-200
-210
8
670
632
440
237
75
-52
-140
-162
-163
9
460
460
382
229
104
6
-72
-110
-112
-112
10
237
237
237
156
84
27
-18
-53
-57
-57
-57
0
252
1
437
117
2
603
233
21
3
759
365
89
0
4
888
496
184
9
0
5
967
607
286
62
0
0
6
963
681
374
134
0
0
0
7
850
699
431
198
38
0
0
0
8
670
632
440
237
80
0
0
0
0
9
460
460
382
229
104
15
0
0
0
0
10
237
237
237
156
84
27
0
0
0
0
0
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Exhibit 4 Discounted cash flow and real options valuations including the option to expand in year 5
Real options
valuation
0
253
1
439
2
607
3
768
4
908
5
1013
6
1165
845
7
843
714
458
8
9
10
434 Expansion
434
option
300 exercised - out
84 of reserves
117
233
21
365
89
0
496
184
9
0
607
286
62
0
0
681
374
134
0
0
0
699
431
198
38
0
0
0
632
440
237
80
0
0
0
0
460
382
229
104
15
0
0
0
0
237
237
156
84
27
0
0
0
0
0
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References
UQ Business School