You are an analyst engaged to assess a new mining project being considered by Pinder Ltd. The project has the following characteristics:

• The government has offered Pinder Ltd the right to extract iron ore from a site in South Australia for the next 2 years for the sum of $10m today.
• The government has offered Pinder Ltd the right to extend for another 3 years on top of this for an additional $2m payable today.
• If they acquire this additional right, Pinder Ltd would not need to make a decision about whether to extend for another 3 years until the original right had expired (in two years time). That decision would be made on the basis of the value of the remaining iron ore in two years time.
• If they choose to extend their right in two years time, Pinder Ltd. will need to pay the Government $4m at that time.

On the basis of the information described above and assuming that Pinder Ltd was going to acquire the initial lease for $10m

(a). What is the embedded real option in this project?

(b). Can the real option be regarded as a call option or a put option? What are the underlying asset and the exercise price of the option? Explain the similarity between the real option and a financial option based on the exercise decision Pinder Ltd. would make in two years time.

(c). What is the cost of embedding the real option in the project, and what would be a reason why Pinder Ltd. should consider adding this flexibility in the project?