Sequential investment decisions for mining projects using compound multiple volatility real options approach

Abstract

Managers evaluating investment decisions in mining projects have reported using the net present value approach (NPV). However, NPV has the drawback of collapsing variations from uncertainties in future project cash flows into a fixed expected project value today. Ignoring future uncertainties and contingencies can lead managers to make incorrect up-front binary decisions, such as investing in or abandoning the project now. The real options analysis approach (ROA) instead captures variations from uncertainties as volatilities in project value and allows flexibility in investment decisions to be contingent on information as it is revealed. Managers we consulted agreed that ROA is superior to NPV in principle, but too complex to apply in practice. The advanced mathematics and restrictive assumptions required by analytical ROAs make them especially impractical for real-world projects exposed to multiple uncertainties. Furthermore, real-world projects are often multistage and involve valuing a compound option, which is an option on an underlying option, for sequential investment decisions. Extant numerical compound ROAs have been applied to such projects but suffer from various drawbacks. Amongst other issues, they combine variations from multiple uncertainties into a consolidated volatility of project value. This conceals the impact of each source of uncertainty, resulting in inaccurate project valuation and incorrect investment decisions. We present an innovative compound multiple volatility real options approach (C-MVR) to value a multistage project while accommodating separate volatilities of project value arising from multiple uncertainties for making sequential investment decisions. The resultant value is termed the compound enhanced net present value. Implementing C-MVR for a real coal mining project demonstrates how other ROAs can be seen as inaccurate simplifications that produce erroneous investment decisions. C-MVR provides a rigorous and versatile approach that can be applied to many investment decisions across various industries.