Valuing Management Flexibility:

A Basis to Compare the Standard DCF and MAP

Valuation Frameworks

Michael Samis - Graduate Student

Department of Mining and Mineral Process Engineering
University of British Columbia
Tel./FAX: (604) 739 - 2989

Dr. Richard Poulin - Associate Professor

Department of Mines et Metallurgie
Universite Laval
Tel.: (418) 682 - 5783
Abstract

The value of a mining project is typically influenced by many underlying economic and physical uncertainties, a

dynamic project risk structure built on top of these uncertainties, and the possibility of multiple and mutually

exclusive project operation options. The discounted cash flow (DCF) valuation method is widely used in the mining

industry to value projects even though it is ill suited to consider these influences on project value. Modern asset

pricing (MAP) provides an alternative valuation technique. It was developed for use in markets for derivative

securities, where these complexities are common. As a result, MAP is able to incorporate these influences on value

more reliably and consistently than the DCF method. We have used both techniques to value a small copper

property, where management has an option to exploit large lower grade reserves near the end of the project and an

option to abandon the project at any time. The MAP method indicates that the project, in the absence of the options

to abandon or forgo development of the lower grade reserves, is attractive only if an initial decision is made not to

develop the low-grade reserves. The DCF method, as implemented, also indicates this but gives less understanding

as to why this is the case. Moreover, the MAP valuation technique can extend the valuation exercise further by

examining the project with different combinations of management flexibility. This additional analysis indicates that

the existence of the lower grade reserves is valuable when combined with either the option to forgo their

development or with the option to abandon the project or both.

 Valuing Management Flexibility. 1

Introduction1

The mining industry faces many investment opportunities, including investment in existing operations or exploration

for, or development of, new deposits. The success of mining companies is critically dependent upon investing in

projects that add value. Corporate decision-makers use the capital budgeting process to determine the attractiveness

of a project. This process evaluates a project on the basis of the project’s technical characteristics and economic

value of the project. Final acceptance of the project, however, is determined by its perceived economic value.

Project value is derived from the cash flows generated by the project. The present value of individual project cash

flows and hence the value of the project is influenced by the following considerations:

1) the timing of the individual cash flows;

2) the resolution of uncertainty regarding the economic and physical characteristics of the project; and

3) the ability of management to react to the resolution of uncertainty.

The timing of the individual cash flows

Time has an important influence on the value of money that is to be received or spent in the future. People prefer to

receive cash sooner rather than later. Therefore a time discount is included in the valuation of claims to a cash flow:

the longer the time until the receipt of a cash flow, the lower the value of the claim.

The resolution of economic and physical uncertainty

Mining projects are designed and implemented in an uncertain physical and economic environment. As the project

progresses, uncertainty regarding this environment is resolved by the arrival of information, such as grade

revelations and price realizations. The resolution process can be modeled as a tree-like structure in which nodes,

which are called states, represent sets of information that differentiate amongst possible scenarios. The shape of the

tree depends critically upon the type of uncertainties being modeled and their interaction.

Figure 1 details a possible risk resolution model of a mining project that is subject to grade and price uncertainty.

At time 0, management has expectations for grade and future spot prices, which are derived from the probabilities

1
The authors would like to thank Dr. David Laughton of the University of Alberta for his helpful comments
regarding earlier drafts of this paper. Any errors within this article are the sole responsibility of the authors.
 Valuing Management Flexibility. 2

associated with possible future mineral price and grade scenarios. Each state at time 2 represents a possible grade

and price scenario. The exploration program is completed at time 1 and its results indicate if the project is a high- or

low-grade deposit. Mineral price uncertainty is resolved in the financial markets at both times 1 and 2. Note that

the resolution timing is different for each type of risk and that the resolution of geological risk is partially under

management control, while price resolution is not.

Management flexibility

A project often permits management to choose among alternative courses of action. Each of these alternatives

derives its value from its own particular cash flow series and from any possible future project opportunities

associated with it. We assume that management always selects the alternative that has the greatest value at the time

of their decision. This ability is called operational or management flexibility and it affects project value because it

allows management, as uncertainty is resolved, to avoid detrimental outcomes and to participate in advantageous

situations.

For example, consider a project that has an uncertainty resolution structure as outlined in Figure 1. Assume that the

project allows management the following flexibility:

1) to create an operating mine by completing a one-period development program,

2) to defer development because of mineral lease provisions,

3) once the mine is operating, to expand its capacity to process marginal reserves, and

4) to abandon the project at any stage of development or operation.

The full set of available alternatives will not be available at each time because several of these are dependent on

others being implemented previously.

Figure 2 details a set of choices that might be made by management over two time periods. If the exploration

results are favorable, management elects to develop the mine. If the exploration results are unfavorable,

management decides to defer investment for one period to gather more information about future commodity prices.

In the second period, depending on further price revelations and the previous exploration results, management may

elect to expand, produce at design capacity, develop, defer or abandon the project.
 Valuing Management Flexibility. 3

Figure 1. An example of an uncertainty resolution structure for 2 periods in the future

Figure 2. Possible management reactions to uncertainty resolution for 2 periods in the future
 Valuing Management Flexibility. 4

Project valuation techniques

The first step in the valuation of a project is the conversion of economic data, the technical characteristics of the

project, and the choices available to management, into cash flow scenarios.2 The next step is the assessment of the

uncertainties associated with individual project variables, the process by which this uncertainty is resolved, and the

valuation by investors of exposure to these risks. Finally, the valuation must indicate a desirable course of action for

management.

The principal challenge for a valuation is finding a technique that is able to incorporate the effect of time, project

risks and management flexibility into the valuation in an explicit, consistent and practical manner. The valuation

technique should be able to differentiate among the various project risks and allow decision-makers to examine

these risks and their individual effect on project value. Further, a valuation technique should not introduce valuation

biases against different project types. For example, short-term projects should not be favored over long-term

projects because of the valuation method.3 Finally, realistic uncertainty resolution structures and their effect on the

value of stakeholder claims can become very complex. It is therefore essential that a valuation method be such that

calculations can be completed efficiently with results that are understandable.

Discounted cash flow - a prominent valuation technique

The predominant technique used in the mining industry to value projects is the discounted cash flow (DCF)

technique (Goucher, 1992; Bhappu and Guzman, 1995). At its most simple, the DCF technique assesses risk on a

whole-project basis by adjusting forecast net cash flow for the effects of risk and time. This adjustment is called

discounting; the greater the risk of the project and the greater the length of time until the cash flow occurs, the

smaller the discounted cash flow value. The discounted cash flow value is calculated by multiplying the expected

net cash flow by a discount factor, which depends on a risk-adjusted discount rate (RADR) for the project and the

time at which the cash flow occurs.4 The discounted value is called the present value of the cash flow.

2
In our case, the labor and material needed to build and operate the project, along with the mine production, are
combined with scenarios of output prices to produce scenarios of project revenue, operating cost, capital
expenditure, and closure costs.
3
See, for example, Laughton (1996).
4 − ( RADR )∗ t
The adjustment factor is equal to e , where:
RADR = the sum of the cash flow’s annualized risk premium and the annual riskless interest rate.
t = the occurrence time of the cash flow in years.
 Valuing Management Flexibility. 5

Obtaining correct results from the discounting process is critically dependent upon the selection of the RADR.

Typically in practice, an organization uses a single corporate discount rate in the valuation of a wide variety, if not

all, of its projects. Jacoby and Laughton (1992) note that this approach is problematic because it implies that the

average rate of cash flow risk resolution is the same for all projects, which is not the case (see Laughton (1996) for

an example).

Some people (e.g. Moyen, Slade and Uppal, 1996) have proposed that decision tree analysis be used to incorporate

management flexibility explicitly into a DCF project valuation. Unfortunately, different alternatives at decision

nodes on the tree will typically incorporate different risks. Therefore, the same criticisms of the practice of using a

single discount rate to value different projects are also applicable to the practice of using a single discount rate to

value different payoff branches of a project decision tree.

Modern asset pricing - an alternative project valuation framework

An alternative valuation technique, called modern asset pricing (MAP), exists that provides a more explicit method

of determining the effect of risk and management flexibility on project value. The MAP approach involves

identifying the various project risks and building a scenario tree (Figure 1 is an example), whose structure is defined

by the underlying risks, for the life of the project. In each state of the scenario tree, the project cash flow has an

amount, which is dependent upon project and market parameters (e.g. grade and mineral price) and the management

alternative being considered. In this sense, MAP, when applied to opportunities with management flexibility, is a

form of decision tree analysis. However, it differs from other forms, including DCF-based decision tree analysis

proposed by Moyen et al (1996), in the process used to calculate payoff values on the tree. The “risk-adjusted”

mean of each payoff is first determined, just as in analysis of projects where management flexibility is not an issue

(e.g. Laughton, 1996). Each payoff outcome used in the calculation of this mean is weighted according to a risk-
5
adjusted, as opposed to the true, probability distribution across the states on the scenario tree. The value of a

payoff claim is then calculated by discounting the risk-adjusted mean at the riskless interest rate.

The MAP valuation approach achieves the appropriate risk adjustment by the differential weighting of states

between the risk-adjusted and true probability distribution. For commodity market scenarios, this risk adjustment

5
The so-called “risk-neutral probability” of the binomial option pricing method is an example of the risk-adjusted
probability distribution. See Cox, Ross and Rubenstein (1979) or Hull (1993) for a discussion regarding risk-
neutral probabilities.
 Valuing Management Flexibility. 6

tends to increase the weight of cash received in low commodity price scenarios, if those are scenarios where the

economy is not as likely to be doing well. In such scenarios, access to an incremental bit of cash is worth more to

risk-averse investors than it would be in scenarios where the economy is doing well. The weights are determined by

examining how this risk-aversion is reflected in the financial market prices. For projects where cash flow amounts

increase with commodity prices, this process produces discounting for risk as follows. States with lower prices, and

thus with lower cash flows, are weighted more in the calculation of the risk-adjusted mean than in the calculation of

the true mean. This action makes the risk-adjusted mean less than the true mean. A simple illustration of a MAP

valuation argument is provided in Trigeorgis (1996), Salahor (1998), Bradley (1998) and Laughton (1998).

The success of this approach depends upon the ability to identify the most important project risks, to describe the

resolution of these risks by a probabilistic process, and to be able to calculate values on the resulting tree. Several

numerical techniques are available to calculate project value. These range from the relatively simple, such as the

binomial method (Cox, Ross and Rubenstein, 1979), to the very sophisticated, which may combine finite difference

methods for solving coupled partial differential equations with free boundaries and Monte Carlo simulation of

terminal payoffs (e.g. Laughton, 1991; Laughton and Jacoby, 1991). Unfortunately, the simpler numerical

techniques can restrict the modeling flexibility of analysts, essentially by restricting the number of uncertain

variables that can modeled.6 For example, they have difficulty valuing projects where there is more than one

uncertain output, where there are independent cost and revenue uncertainties, or where there is path dependence in

the project cash flows (e.g. due to tax-loss carryforward provisions in the tax system).

Valuation example: a copper mine with expansion and abandonment opportunities

Background information

To compare MAP and standard DCF, consider the following example. A mining company is assessing an

underground copper deposit for development. The deposit has reserves of 5.8 million metric tonnes containing 4.5%

copper. The exploration program for the project has also revealed the existence of a lower grade ore zone, which, if

developed, would extend the life of the mine. This zone contains 21 million tonnes of ore with an average grade of

2.8% copper. The structure of the deposit is such that the company must consider two basic development

alternatives. The first alternative entails developing the deposit as a 9-year project, which exploits the high-grade

6
This does not prevent simple numerical techniques from providing important conceptual insights.
 Valuing Management Flexibility. 7

zone only. Table 1 summarizes the production statistics, capital expenditure program and closure costs associated

with the first alternative.7

The second alternative involves developing the deposit as an 18-year project where mine production is expanded

with the development of the low-grade zone several years before the exhaustion of the high-grade zone. Table 2

outlines the production statistics, capital expenditure requirements and closure costs of this alternative.

Development of the low-grade zone begins in year 7 of the project and mine production is expanded incrementally

during the next three years. Note that the production statistics of the first 7 years of the project are the same for both

development alternatives.

The grade of the deposit and the project costs are assumed known with certainty in order to simplify the comparison

between the two techniques. The only source of project uncertainty is the real copper price.8 It is assumed to

change over time according to a specific probabilistic process, called a diffusion process. Uncertainty regarding

short-term price changes is represented by a normal distribution with variance proportional to the term considered.

In addition, we specify that the short-term price changes are proportional to the price at the time. A diffusion with

these properties is called a lognormal random walk diffusion. It produces a multivariate lognormal distribution for

any finite set of prices. In our example, the expected changes in the price produce a flat term structure of real

copper price expectations (means) of $1.00 per pound. The price covariances produce an annualized (daily)

proportional standard deviation, or volatility, in price movement of 20 per cent (1 per cent). Claims to copper in the

financial market (e.g. fully funded forward contracts) reflect the systematic risk of copper with a 2% risk premium

in their expected return.9 Data regarding the project’s economic environment are presented in Table 3.

7
This closure cost model is not based on any particular industry observations other than closure costs tend to
increase with mine life and production capacity. A more detailed model of closure costs would have to reflect
such components as equipment salvage value and environmental clean-up costs.
8
See Paddock, Siegel and Smith (1988), Frimpong (1992), Whiting, Laughton and Frimpong (1993), and Laughton
(1998) for examples of MAP valuation models that include both price and geological uncertainty.
9
A random walk diffusion is not consistent with observed copper price behavior and is used for simplicity of
exposition. A reverting diffusion, where the price tends to revert in the face of short-term shocks to a long-term
(possibly time-dependent or stochastic) equilibrium, may be more suitable (see Laughton and Jacoby, 1993).

A constant risk premium is consistent with constant volatility in a random walk diffusion. The volatility and risk
premium parameters were chosen to provide a concrete example and, while plausible within the confines of a
random walk model, do not reflect any detailed analysis of the behavior of copper spot and forward prices. Price
modeling is the subject of ongoing research (e.g. Schwartz, 1997).
 Valuing Management Flexibility. 8

Project time ( year ) 0 1 2 3 4–9

Production ( million tonnes per year ) 0.364 0.728
Grade ( % copper ) 4.500 4.500
Copper production ( million pounds ) 36.079 72.159
Operating cost ( $ / tonne ) 53.760 53.760
( $ / pound of copper ) 0.542 0.542
Capital expenditure ( $ million ) 27.000 30.000 20.000 17.000 0.000
Closure cost ( $ million ) 2.000 6.000 13.000 14.500 23.50010

Table 1. Production statistics, capital expenditure and closure costs for the development of higher grade reserves.

Project time ( year ) 7 8 9 10 11 – 18

Production ( million tonnes per year ) 0.728 1.000 1.800 2.190 2.190
Grade ( % copper ) 4.500 3.600 3.000 2.800 2.800
Copper production ( million pounds ) 72.159 79.295 118.943 135.066 135.066
Operating cost ( $ / tonne ) 53.760 53.760 53.760 53.760 53.760
( $ / pound of copper) 0.542 0.678 0.814 0.872 0.872
Capital expenditure ( $ million ) 30.000 35.000 30.000 20.000 0.000
Closure cost ( $ million ) 20.500 24.000 30.000 38.000 78.00011

Table 2. Production statistics, capital expenditure and closure costs for the development of lower grade reserves.

Parameter Value / Type Parameter Value

Current copper price ( $ / pound ): 1.00 Copper price volatility ( % annual ): 20
Copper price distribution: Lognormal Copper price risk premium ( % / yr ): 2
Copper price expectations trend: Flat Riskless interest rate ( % / yr): 3

Table 3. Economic data

10
The closure cost incurred if the mine is shut down in year 9; there is a linear relationship for closure costs between
years 3 and 9.
11
The closure cost incurred if the mine is shut down in year 18; there is a linear relationship for closure costs
between years 10 and 18.
 Valuing Management Flexibility. 9

Standard DCF valuation

A constant forecast real copper price of $1.00 per pound and a real annual 10% RADR were used in the DCF

valuation of both base project alternatives.12 This valuation approach does not explicitly incorporate the random

nature of the copper price model or the structure of the project. These elements of the valuation are included

implicitly in the project RADR. In addition, the standard DCF valuation does not calculate the benefits of

management flexibility.

The 9-year project alternative has a net present value (NPV) of $24.5 million. The 18-year project alternative,

where management expands the operation regardless of conditions at year 7, has a NPV of $3.0 million. Neither of

these results directly account for management’s ability to make profit maximizing decisions during mine operation,

such as project abandonment in response to low copper prices, or mine expansion in year seven if and only if the

copper price is high enough. The results of the DCF valuation indicate that the mine should be developed without

the lower grade reserves.

MAP valuation

The MAP method provides a more detailed and reliable valuation because it explicitly includes the copper price

model, project structure and various combinations of flexibility into its valuation.13 The flexibility combinations

included the ability to abandon the project at any time by incurring a closure cost and the option to develop the

lower grade reserves. Each base alternative considers the option to develop the low-grade reserves from a different

perspective. The 9-year base alternative incorporates the development option as an opportunity to expand.

Conversely, the 18-year base alternative models the development option as an opportunity to forgo expansion.

These various operating options are important elements of the project valuation because management is under no

obligation to exhaust the reserves or even to complete their development.

12
This figure is not based on any superior insight into the selection of an appropriate RADR. The authors believe
that this figure is reasonable and defendable in light of the practices used in the mining industry to determine an
RADR. Moreover, the 7% risk premium (built into the 10% RADR) may be consistent with the 2% risk premium
we have postulated for copper claims. This is due to the prevalence of operating leverage in the mining industry
(see Laughton, 1996).
13
The MAP valuation was implemented using the binomial approximation method (Cox, Ross and Rubenstein,
1979) on a personal computer with a program written in Pascal. The authors thank Dr. Laughton of the University
of Alberta for checking our results with finite difference methods.
 Valuing Management Flexibility. 10

Management flexibility Project value Value of flexibility

( $ million ) ( $ million )
18-year base case
Base case; no management flexibility. -202.4 N/A
Option only to abandon (lower grade reserves to be developed). 117.6 320.0
Option not to develop lower grade reserves. 93.7 296.1
Options not to develop lower grade reserves and to abandon. 123.9 326.3
9-year base case
Base case; no management flexibility. 25.2 N/A
Option only to abandon (lower grade reserves not to be developed). 39.1 13.9
Option to develop lower grade reserves. 93.8 68.5
Options to develop lower grade reserves and to abandon. 123.9 98.7

Table 4. MAP calculation of project value; various management flexibility combinations.

The valuation results are presented in Table 4 and they show that the presence of management flexibility adds

significantly to the value of the project. In the case of the 18-year base alternative, the opportunity to abandon the

project is revealed as the most valuable single option. Conversely, the ability to expand the project in year 7 is the

most valuable in the 9-year base alternative. When there is no management flexibility available, the results show

that the project should be developed and operated according to the 9-year base alternative. In addition, this

valuation also demonstrates that the interaction of different types of management flexibility influences the

incremental value of each option (Trigeorgis, 1993). For example, the 18-year alternative shows that the ability to

forgo expansion adds $296.1 million to project value when the abandonment option is not available. In contrast, it

only provides an additional $6.3 million in value when it is combined with the abandonment option.

A payoff diagram was generated for the seventh year of the project to show the value relationship among the various

alternatives available at the time. Figure 3 shows the project value for each operational alternative (i.e. expansion

initiated, expansion foregone, project abandoned) over a range of copper prices. The value of the project alternative

is equal to the sum of the year-7 project cash flow and the present value in year 7 of the future cash flows (with the

abandonment option available). The diagram shows that management will expand the mine if the copper price is

above $0.92 per pound. If the copper price is between $0.51 and $0.92 per pound, management will continue to

operate the mine but will forgo developing the lower grade reserves. Management abandons the mine if the copper
 Valuing Management Flexibility. 11

300

250

200
Project value ( $ million )

150

100

50

-50
0.45 0.55 0.65 0.75 0.85 0.95 1.05 1.15 1.25
Copper spot prices ( $ / pound )

Remaining project value: no expansion. Remaining project value: expansion. Project abandonment/closure cost.

Figure 3. Remaining project value at project time 7 versus copper spot price – expansion and abandonment options available
 Valuing Management Flexibility. 12

1.00

0.90
Abandonment copper spot prices ( $/lb )

0.80

0.70

0.60

0.50

0.40
0 2 4 6 8 10 12 14 16 18
Project year
Abandonment spot prices; pre-expansion Abandonment spot prices; expanded project
Abandonment spot prices; no expansion No expansion price range in year seven

Figure 4. Critical copper spot during the project – expansion and abandonment options available
 Valuing Management Flexibility. 13

price is below $0.51 per pound. Within the copper price range of $0.51 and $0.65 per pound, management

continues to operate the mine because the present value of the operating project (without developing the low-grade

reserves) is greater than the abandonment cost of $20.5 million. Note that the project incurs a working loss if the

copper price is between $0.51 per pound and $0.54 per pound. Over this price range, management continues to

operate the mine because of the possibility of future price increases.14

Figure 4 is a graphical representation of the best operating policy over the life of the project given the project model

as we have defined it. It displays the lowest spot price at which management will continue to operate the project in

each year (the project is abandoned if the copper price falls below this limit) and the spot price at which the project

will be expanded in year 7. These prices are determined from the payoff diagram of each project year. The lower

line in years 7 to 9 shows the abandonment copper price if the project is not expanded. The upper line represents the

lowest copper price at which the expanded project will remain operating. The vertical line in year 7 displays the

copper price range over which production continues but the low-grade reserves are not developed. In periods of

where no capital expenditure is incurred (years 4 to 9 during non-expanded scenario, years 11 to 18 during lower

grade production) the critical abandonment price increases for two reasons: first, abandonment/closure costs

increase and second the value of future production decreases as the deposit is exploited. The critical abandonment

price has no defining trend during capital expenditure periods (years 0 to 4 and years 7 to 10 during expansion)

because the abandonment spot price is determined by the overall capital expenditure profile.

Discussion of DCF and MAP valuation results

The MAP and DCF methods calculate different values for the same project because they incorporate copper price

risk, operating leverage and management flexibility differently.15 As a direct consequence of its method of

including price risk and operating leverage, the DCF method will overvalue a high-cost project relative to a low-cost

project if the same discount rate is used to value both projects (Laughton, 1996).16 This effect can be illustrated with

the results of the valuation example. A 10% RADR appears justifiable for the valuation of the 9-year project

14
Management may also operate a project at a working loss if there is some benefit to delaying the payment of a
closure cost. Moreover, for this project, there is no benefit from delaying closure costs because these costs (which
are modeled to be known with certainty) increase with time at a rate greater than the risk free rate of return.
15
For a discussion regarding how each valuation technique includes copper price risk and operating leverage, see
Laughton (1996).
16
This is conditional on costs being less risky than revenue and there being no management flexibility available. If
management flexibility is available, no conclusion can be drawn regarding the relative valuations of a high-cost
and low-cost project with the DCF method.
 Valuing Management Flexibility. 14

alternative with no management flexibility because both the DCF and MAP methods calculate very similar values.

However, a 10% RADR is not an acceptable parameter for a DCF valuation of the 18-year project alternative with

no management flexibility because this alternative is more risky. This alternative is more risky because it has

greater operating leverage; the 9-year alternative has an operating cost of $0.54 per pound of copper while the last

ten years of the 18-year alternative has an operating cost of $0.87 per pound copper. Hence, unless a larger discount

rate is used to reflect the greater risk of the 18-year alternative, the DCF method will overvalue the 18-year base

alternative relative to the 9-year base alternative. The scale of the overvaluation can be determined by examining

the value differential between the two base alternatives calculated by each method. The DCF method calculates a

value differential of $21.5 million and the MAP method determines the value differential to be $227.6 million. This

comparison shows that the DCF method overvalues the 18-year base alternative with no management flexibility by

$206.1 million.

The ability of each method to value management flexibility is also an important cause of valuation differences. In

the mining industry, the standard DCF method is often used with the implied assumption that a single measure (the

RADR) can be used to describe the impact of mineral price risk and operating leverage, and (possibly) management

flexibility on overall project value across many projects. This assumption permits the valuation calculation to be

greatly simplified at the expense of detailed analysis of how different types of underlying uncertainty and

management flexibility influence project value. The MAP approach, however, is able to provide detailed analysis

because it incorporates the influence of management flexibility explicitly with a scenario tree (in this case derived

from a lognormal random walk copper price model) that describes the possible project cash flows in each year. The

results from the different approaches to valuing management flexibility are stark. The MAP method shows that the

expansion option and the option to abandon the project at any time add significantly to the value of the project. In

addition, the MAP method gives a detailed operating policy for the project. The standard DCF method, however, is

unable to attach any value to these types of management flexibility and only provides an incomplete operating

policy for the project.

 Valuing Management Flexibility. 15

Conclusion

Project value is affected by uncertainty in its economic and physical environment, the dynamic nature of risk during

the project and the flexibility management has operating the project. The predominant quantitative method for

determining project value is the DCF method. The drawback of this method is its inability to include a dynamic

project risk structure, whether induced by management flexibility or not, into its valuation. The MAP approach is an

alternative valuation framework that does not have this shortcoming.

Both these techniques were used to value a copper project that can be expanded by the development of substantial

lower grade reserves at a fixed time before the exhaustion of the high-grade reserves or abandoned at any time. The

DCF and MAP methods both indicated that the 9-year no-expansion alternative is attractive without management

flexibility. They also indicated that the 18-year expansion alternative is unattractive without any management

flexibility, though it appears that the DCF method overvalues this alternative significantly when a 10% discount rate

is used. The MAP valuation technique was also able to carry the valuation exercise further by examining the two

base alternatives with different combinations of management flexibility. The MAP method indicated that the lower

grade reserves became valuable when their development is contingent on copper price realizations or when the

project incorporates an abandonment option. In addition, the MAP method signaled that the expansion scenario in

year seven should be initiated if the copper price is above $0.92 per pound.

These results should be of particular interest to mine planners and corporate strategists. They indicate that methods

that do not account for management flexibility undervalue marginal reserves. The incorrect valuation of marginal

reserves (and other project characteristics) could lead to erroneous decisions regarding the project or inhibit the

consideration of important aspects of the project. These results should also be of interest to parties negotiating the

transfer of mineral properties. They show that substantial value differences may exist between valuation methods

and that the standard DCF method provides fewer insights regarding the characteristics of a mineral property than

may be obtained with MAP methods.

The MAP technique merits honest consideration because it is based on valuation techniques that have wide

acceptance in financial markets, it is noted for its lack of bias against different types of uncertainty and project

structure, and it has the ability to value management flexibility. The standard DCF method, conversely, has been

criticized for not providing an objective framework within which to value different types of projects and for being ill
 Valuing Management Flexibility. 16

suited for the determining the implications of strategic decisions. In addition, academic research (Moyen, Slade and

Uppal, 1996) suggests that methods that incorporate the effects of management flexibility are better than the

standard DCF method at explaining the market valuation of a mining project. This result leads to speculation that

the substantial premium at which mining stocks often trade over a DCF valuation may be partly explained by the

shortcomings of the standard DCF method and not solely by the growth prospects often thought to cause this

valuation premium. Hence, it may be more constructive (and profitable) to use the MAP framework for the

valuation of mining projects.

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