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Modern Asset Pricing — A Valuable Real Option Complement to Discounted Cash Flow Modelling of Mining Projects

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Author P Guj and R Garzon

Description

For resources projects with healthy net present value (NPV) and low cash flow volatility, conventional discounted cash flow (DCF) analysis will continue to provide the dominant investment decision-making criteria. However, DCF analysis can be biased because it often applies a single risk-adjusted discount rate (RADR) to compare the value of projects with different risk characteristics. Many of the difficulties with DCF modelling arise from analysts’ inability to determine appropriate risk discounts and to estimate expected spot prices inputs for the commodities produced over the life of the project. Modern asset pricing (MAP) is a very valuable complement to DCF analysis in addressing some of these issues. Most papers dealing with MAP, however, while academically rigorous, tend not to be explicit in terms of practical application of this methodology in routine project evaluation. This paper has the objective of reviewing the MAP methodology and of demystifying its complexity, by providing a simple but realistic step-by-step evaluation of a mining project, comparing its DCF and MAP NPV values. The paper concludes that MAP provides a minimum, risk-adjusted ‘floor’ value, thus representing a valuable complement to any DCF valuation.


FORMAL
CITATION:
Guj, P and Garzon, R, 2007.
Modern
asset pricing – a valuable real option complement to discounted cash flow
modelling of mining projects, in Proceedings
Project
Evaluation 2007
, pp
113-120
(The
Australasian Institute of Mining and Metallurgy:
Melbourne).