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.
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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
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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

Develop: CapEX (years 2 to 5) Bid & Win Explore (years 0 to 2) Year 2 Walk away This is Flexibility on System. Why?
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Close mine

Produce Metal (from year 5 until closure)

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 Mines life Future prices of zinc and copper Quantity of ore Costs Operation expenses Capital Expenditures
Massachusetts Institute of Technology Engineering System Analysis for Design

Uncertainty treatment Deterministic Stochastic process (Lattice, Years 0 to 2)

Probability distributions Monte Carlo simulation

Richard de Neufville Michael Benouaich Slide 10 of 23

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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
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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

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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
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Results: Base Case No Flexibility

Crystal Ball Student EditionForecast: Not for Commercial Use

NPV (base case)

457

10,000 Trials
.046

Frequency Chart

.034

342.7

.023

228.5

.011 Mean = $556.85 Mean = $550 $684.28

114.2

.000 ($1,092.85)

M
$4,238.52

0 $6,015.64

$2,461.40

Massachusetts Institute of Technology Engineering System Analysis for Design

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Simulation Results: Flexibility to Abandon

Crystal Ball Student Edition Forecast: Not for Commercial Use

NPV (base case)

457

10,000 Trials
.046

Frequency Chart

.034

342.7

.023

228.5

.011 Mean = $556.85 Mean = $819 $684.28 $2,461.40 $4,238.52 Certainty is 75.61% from $0.00 to $6,015.64

114.2

.000 ($1,092.85)

0 $6,015.64

Massachusetts Institute of Technology Engineering System Analysis for Design

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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
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Valuation: Flexibility to Abandon

Value of flexibility to abandon: $819 - $550 = $269 million

Massachusetts Institute of Technology Engineering System Analysis for Design

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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

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Simulation Results: Early Development

Crystal Ball Student Edition Forecast: Not for Commercial Use

NPV (early development)

457

10,000 Trials
.046

Frequency Chart

.034

342.7

.023

228.5

.011 Mean = $574.92 Mean = $567 $658.32 $2,477.25 $4,296.18

114.2

.000 ($1,160.61)

0 $6,115.11

Massachusetts Institute of Technology Engineering System Analysis for Design

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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!
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Simulation Results: Both Flexibilities

Crystal Ball Student Edition Forecast: Not for Commercial Use

NPV (early development) Frequency Chart

459

10,000 Trials
.046

.034

344.2

.023

229.5

.011 Mean = $566.91 Mean = $836 $770.71 $2,489.21 $4,207.72 Certainty is 76.09% from $0.00 to $5,926.22

114.7

.000 ($947.79)

0 $5,926.22

Massachusetts Institute of Technology Engineering System Analysis for Design

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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
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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
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