In June 1996, executives of the multinational mining company RTZ-CRA contemplate bidding to acquire the Antamina copper and zinc mine in Peru. The Antamina project is being offered for sale by auction as part of the privatization of Peru's state mining company. RTZ-CRA has to determine what the mine is worth and decide whether and how it should bid in the upcoming auction. The bidding rules put in place by the Peruvian government dictate that each company's bid contain two components: an up-front cash amount and an amount the bidder will invest to develop the property if development is warranted after further exploration is completed.
DISCOUNT RATE PARAMETERS
Simulation and Results
Commodity Prices and Yields
No Real Option Case 1
Case 2 No Penalty
Case 3 With Penalty
Mean Reversion Parameters
High Case, Expected Case, Low Case
1. In what way is the development of a copper mine like Antamina a real option? In what way is the bidding structure put in place by the Peruvian government an option? What is the correspondence between these real options and financial options? What other real options does the owner of the Antamina have?
2. Conceptually, how would you build a real options model to value the Antamina project? What data and assumptions would you need? What would be the key assumptions and limitations of the model? Review the model suggested in the reading on the basis of your reactions to these questions.
3. Consider the bids that should be made for the property under these three different sets of auction procedures:
If the winning bidder was legally forced to develop Antamina after completing the exploration phase, and was required to pay the Peruvian government up-front for this project, what is the most they would be willing to bid?
If the winning bidder could choose whether or not to develop Antamina at the end of two years, but was required to pay the Peruvian government a single fee up-front for the right to develop the project, what is the most they would be willing to pay? Under this alternative, there is no investment commitment or penalty; the firm merely pays the government up front, and has the right to develop at the end of two years. If they don’t develop at year two, they lose the right to develop the field.
Under the current bidding rules, the winning bidder states both an initial cash payment as well as an investment commitment that is paid only if they choose to develop the field. Bids are developed by summing up-front amount and 30% of the investment commitment. If you proceed with development, but fail to spend the full investment commitment, the Peruvian government will fine you 30% of the difference. What is the most you would be willing to bid under these rules? How would you trade-off these two components of the bid?
4. What are the incentives brought about by the different auction rules? Do the rules seem to meet what you perceive to be the goals of the Peruvian government?