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Use option pricing analysis to determine whether Alchemy Mines should accept the proposed copper mine project.

a. Determine whether the project cash flows have the characteristics of a put option or a call option.

b. Find the implicit strike price (that is, the expected spot copper price in one year at which the firm will elect to commence mining and processing rather than just walk away from the project. Remember that for purposes of calculating the strike price, any amounts already spent are sunk costs.)

c. Calculate the option value of the mine using the Black-Scholes options pricing model. You can calculate the option value for a single pound of copper using per pound price and costs, then multiply that by the total amount of copper to get the total option value of the mine. Alternatively, you can calculate the option value of the mine using the total price of copper and the total costs.

d. Compare the option value of the mine to the cost to acquire it to determine whether to accept the project.

e. Indicate whether Alchemy Mines should accept the project and explain.

Proposed project:

Alchemy Mines is considering an investment in the rights to a copper mine.

Initial investment

The owner of the mine will sell the rights to Alchemy Mines at a cost of $1,000,000 payable immediately. Purchase of the rights entitles Alchemy Mines to all mining rights provided mining commences within one year and continues without interruption until the entire deposit is recovered and the land restored in compliance with regulatory requirements. If mining does not commence in one year, the title to the mine reverts to the seller.

Expected operating variables

The firm has made the following assumptions regarding operating cash flows for the mine:

Recoverable copper: 12 million pounds

Current market price of copper: $3.135 per pound

Expected price of copper in one year: $3.2285 per pound

Expected fixed costs of mining and refining: $5,000,000

Expected variable costs of mining and refining: $2.6435 per pound

Cost to restore the land and remediate environmental damage: $1,000,000

No taxes are paid on profits from the project

If the firm decides to mine the copper, it must escrow all funds necessary to pay the costs of mining, refining and restoration upon commencement of mining.The firm will only mine the copper if it is able to pre-sell the entire recoverable production and receive payment upon commencement of mining.As a result, for net present valuation purposes, all cash flows for the project occur either at time 0 (the initial payment for the rights) or in 1 year (all other expected cash inflows and outflows for the project).

Additional Information:

The firm estimates additional economic variables as follows:

Risk free interest rate equals 2.5%

Expected market return: 12.2%

Beta for copper mining and smelting: 1.62

Standard deviation of annual returns on copper prices: 16.5%

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