Lecture 10

Question 1

When valuing a natural resource company with an option explain the following inputs.

1. Spot price
2. Strike price
3. TIme to expiration
4. Variance
5. Cost of delay
6. The risk free rate

Answer 1

1. Spot rate: Estimated value of resources if extracted today net of production costs
2. Estimated cost of developing the resources is the strike price
3. Time to expiration of options are the time period under the rights to the reserves or the time until reserves are exhausted.
4. Variance in the underlying asset, variability in the price of the resource. Remember volatility is the standard deviation not the variance.
5. Cost of delay: Also called convenience yield or net production revenue. It is the annual after-tax cash flow as a percentage of the resource value. Once the reserve become variable this is what the firm is losing by not developing the reserve, like dividends yield in option models.
6. the risk free rate is the risk free rate of return.

Question 2

How are resource frims differnt from other firms

7 points, get the points discussion is bonus

Answer 2

Volatility of shre prices: Higher returns in the short run but accompanied by higher risk that other industrial firms

Exploration: The need to explore in order to find and define an economic resource

Finite reserves: Finite volume, therefore finite life, depending on production rate.

Commodity price volatility:
Resource stocks exposed to greater external commodity price volatility than industrial stocks. Most exporter are price takers

Capital intensity: Due to high expenditure: exploration, economic of scale, isolation, power and water.

Environmental impact: Restriction and friction on production, legislation may reduce profitability

Land Rights: Some firms buy the land and sometimes the firm just has the right to mine. important to distinguish the two when valuing these firms.

Question 3

What is the method of valuing non-financial assets using options

Answer 3

The method o valuing non-financial assets using options is called real option valuation (ROV)

Question 4

1. Where do resource firms generate cash flows

2. Why are undeveloped options similar to call options

Answer 4

1. Resource firms generate ash flows firm existing developed resources
2. The flexibility to develop resources when conditions are favorable make the development of resources similar to call options.