Option pricing for undeveloped resources

The mining assets which will only be developed in the future, conditional on whether or not the
assets have a positive net present value at the decision date, cannot be valued using traditional
DCF method. For them we need to use option pricing model. For pricing a real option using
binomial we need Value of underlying asset (St), the exercise or strike price K, The volatility of
the underlying asset, the time of expiration, Time delay due to development lag & Risk Free rate.
To calculate these values we have taken some assumption:
1. As there is no free-market price formation for lignite used in power generation. This is
because its low calorific value makes transport uneconomic over longer distances. We
have taken volatility in coal prices which is 30% (According to RB index,NEWC
Index,ICI index)
2. Revenue and cost are determined using total revenue from lignite and total cost of
extraction of lignite divided by total lignite production
3. As exercising the option today is not profitable so we used the current profit per unit of
lignite as a proxy for cost of developing new mine resources
4. In the annual report we have total reserve of lignite in Rajasthan and Gujarat but to
calculate minable resources as a percentage of total resources we use Tamil Nadu as a
proxy because the firm is operating there from last 50 years and hence have already
developed mineable resources,
5. To develop a mine huge infrastructure has to be created so long development is to be
expected
6. For risk free rate yield of 10 year govt. bonds is used
Using these assumptions the final value for each variable is
BSM parameter For Rajasthan For Gujarat
Value of underlying asset(St), 81309894052.92 Rs 47018278250.72 Rs
The exercise or strike price K 118444889657.59 Rs 68491969448.05 Rs
The volatility of the underlying asset 30 % 30 %
The time of expiration 20 years 20 years
Time delay due to development lag 5 Years 5 Years
Risk Free rate 8.15% 8.15%


By setting in the inputs in Black-Scholes-Merton model and calculating the value using an excel
spreadsheet tool for real options valuation, we become the value of the natural resource option
equal to Rs 16771637604.13 for Rajasthan mines and Rs 9698371062.67 for Gujarat mines.

To make our model more robust we performed sensitivity analysis on two variable of real option
pricing model (The volatility of the underlying asset & development cost per unit)



From the Sensivity analysis we can see that Option value is some what sensitive with volatility but
little sensitive with cost of developing resource. Sum of the value of base cases of having option to
develop mine in Rajasthan and Gujarat is 1677.16 Crore Rs, Best case is 3577.59 Crore Rs and worst
case is 1366.75 Crore Rs.