Using Monte Carlo simulation with DCF and real options risk pricing techniques to analyse a mine financing proposal

Abstract

This paper uses Monte Carlo simulation with both DCF and real options risk pricing techniques to evaluate an actual project financing proposal for a small gold mine. Project free cash flows accrue to equity, the host government through a royalty and corporate income tax, and creditors through a non-recourse project loan. Net present values of the contingent payouts to each project participant are calculated using real option and discounted cash flow valuation methods. The loan covenants are analysed to demonstrate how they impact value and influence the possibility of default. In particular, a gold hedging covenant is studied whereby gold put options are purchased to provide protection from low gold price environments. The put options are paid for by selling exposure to higher gold prices through call options. The analysis shows that simulation can assist with determining whether financing terms are appropriate and whether these terms can be altered to better suit the project risk profile.