1. Your company wishes to bid for a 10-year lease of a gold mine. The geologists estimate that it is possible to extract 10,000 ounces of gold per year at a cost of 250 per ounce. The price of gold at the time of bidding is 260 per ounce but is estimated to grow at an average rate of 2.5% p.a., whilst the extraction costs are estimated to be roughly constant over the 10 year horizon. The company uses a discount rate of 10% for all its projects, which is 5% above the "risk-free" rate of 10 year government bonds.

DATA

Extraction rate10000(ounces/year)

Costs 210 (/ounce)

Risk free interest 5%

Risk premium 5%

Current gold price 220 (/ounce)

The Project NPV was 1.92 Million.

(a)Discuss on how you would decide whether the company should bid for the mine, taking into account the traditional investment appraisal methods and their associated drawbacks.

[40 marks]

(b)The following graph and statistics demonstrate the outcome of the NPV after 1,000,000 simulation runs. Discuss the implications. [30 marks]

Simulation Statistics

Simulation statistics

Average 2.62

Std Dev 7.05

Max 35.68

Min -8.00

(c) Managers have the ability to close the mine in any given year if it proves to be making a loss and reopen when the mine is profitable again, making the project more flexible. The following graph and statistics demonstrate the outcome of the NPV after 1,000,000 simulation runs contrasting the flexible project with the inflexible one. Access the value of flexibility discussing the relevant implications.

Flexible Project Inflexible Project

Average 4.426 2.607

Std dev 5.620 7.024

Max 35.677 35.677

Min 0.095 -7.996