Problem:

Suppose GeKay Inc. has a two-year lease over a small copper deposit; the government acquires all rights to the property at the end of the lease. It is known that the deposit contains eight million pounds of copper. Mining would involve a one-year development phase that would have an immediate (t = 0) cost of $1.25 million.

At the end of the development phase (at t = 1), if GeKay decides to continue and mine the copper, GeKay would then pay all its extraction costs to a subcontractor, in advance, at a rate of 85 cents per pound (8 million pounds).

This amounts to a cash payment of $6.8 million one year from now (at t = 1). GeKay would also then (at t = 1) sell the rights to the copper to be recovered (8 million pounds) to a third party at the spot price of copper at that time. Copper prices follow a process such that percentage price changes are normally distributed with mean 7% and standard deviation 20%; the current price is 0.95 cents per pound.

The required return for copper mining projects is 10% and the riskless rate of interest (continuously compounded) is 5%.

Determine the net present value NPV of GeKay's potential $1.25m mining venture with standard Discount Cash Flows (DCF) analysis and compare it to the NPV from Real Options analysis.

Summary of question:

This question basically belongs to Finance and it explains about calculation of net present value for the mining venture with standard discount cash flow analysis and compare it with the net present value of real options analysis. This has been presented in the solution with detailed calculations.