The Application of Discounted Cash Flow and Real Option Analysis Methods for Coal Mining Projects with Abandonment and Expansion Options: A Case Study of Pt X in East Kalimantan, Indonesia

Abstract

Recent rising coal prices starting in the second half of 2016 has motivated both existing coal companies and new players to dig deeper to expand their production capacities and to explore new sites. This exposes them to higher risks. A tool that not only quantifies business opportunities but also takes into account uncertainty in coal projects becomes crucial. The traditional valuation method of discounted cash flow (DCF) analysis has been used for very long time but it is not sufficient for mining because it does not capture the high uncertainty and operational flexibility in the industry. An alternative valuation method, real option (RO) analysis can complement the limitations of DCF. Most studies related to RO Analysis application in mining project have focused on coal price and mining cost volatilities, but none has examined the impact of foreign exchange rate volatility, especially the exchange rate between the US dollar (USD) and the Indonesian Rupiah (IDR) to the project value. This study aims to enrich the literature on RO analysis application using an Indonesian coal company as a case study. It shows that RO analysis improves decision making by taking into account uncertainty and management flexibility. Furthermore, this study examines how different volatilities impact project value. Besides price and cost volatilities studied previously, this study examines one additional parameter, the USD IDR exchange rate volatility, as well as how different option maturities affect project value. A case study analysis using quantitative method of project evaluation or capital budgeting is applied. Data are analyzed using descriptive and linear regression to form input parameters. First, DCF is applied; then, in order to capture uncertainty and management flexibility, RO Analysis is applied to complement the DCF method. This study confirms that RO Analysis improves decision making by accounting for uncertainty and management flexibility in the calculation. Volatility and option maturity are key parameters impacting the project value. The higher the volatility is, the higher the project value is. The longer the option life is, the higher the project value is. Keywords—Real Option Analysis, Discounted Cash Flow, Project Evaluation, Capital Budgeting