Hard coal project valuation based on real options approach: multiplicative vs. arithmetic stochastic process

Abstract

Precise valuation of the economic efficiency of risky investment projects in the mineral sector has a direct impact on the range of future investments. Since the mid-90s, a number of enterprises have also been giving increased attention to the valuation of managerial flexibility that cannot normally be estimated with classical discounted cash flow (DCF) analysis. This has been the result of a development in the real options analysis (ROA) and the simplification of its algorithms, most of which have been achieved through: ♦ incorporating lattice models, ♦ introducing a single uncertain project parameter (gross present value, PV) as an underlying instrument, ♦ assuming that the underlying asset follows the multiplicative stochastic process, ♦ introducing the ‘marketed asset disclaimer’ (MAD) assumption. Unfortunately, in most cases, models constructed on the abovementioned assumptions and modifications are not consistent with real projects. Some analysts recognize that project PVs might not follow the multiplicative process, which could have a direct impact on the project’s value. In order to improve the MAD approach, the paper proposes a modified model where the multiplicative tree is replaced with an additive one. In addition, methods of ‘additive volatility’ calculation and ‘dividend’ adjustments were suggested.