The value of the Real Option:
To calculate the value of un-mine gold, the company has decided to use the Black-Scholes model (refer the Exhibit 4 from the case). The company is the only authority for decision-making about the mining of gold therefore; the mining process of the company has highly depended on the gold prices. The management of the company has mentioned in the case that the underlying asset is the value of the expected gold production. It is also dependent on the strike price of the gold which is based on cost related to the production and extraction of gold.
The discount rate has been used for the calculation of the present value of the operating cost. The discounting rate is equal to the cost of un-levered beta. To find the cost of equity, debt to equity ratio has been used for the valuation (refer the Exhibit 10 of the case for target weights of debt and equity). The growth rate of the company is assumed to be zero as it is already discussed in the case. The risk-free rate and the standard deviation for the calculation have been provided in the Exhibit 7 of the case.
The total value of the un-mined gold has been calculated in the spread sheet, which has shown the majority of the value of the firm. The normal practices done in the gold industry stated that most of the time, the value of a firm is mostly based on the options on the un-mined gold reserves under the ground.
Moreover, Agnico Eagle Mines decided to make a leasing of its property for the period of 16 years, in this way the company has got a right to extract the mine in the period of 16 years. According to the explanation in the case study, the gold prices cannot be forecasted because the current price of gold has been assumed as the present value of the gold prices in future.
The Value of the Firm:
Total value of the firm is based on the following components:
Free cash flow from operations, PV of the tax shields on carry-forwards, development expense carry-forward, value of the excess cash and marketable securities, after tax under-funded pension, value of the un-mined gold and non-operating assets. (Refer spreadsheet for the calculation.)
The Value of Equity:
The bond holders are always on the top priority to the value of the firm therefore; the value of the firm’s equity has been calculated on the residual basis. The total value of the equity is found to be 2,049,654. (Refer to the spreadsheet.)
Conclusion and Recommendations:
After using the Discounted Cash Flow valuation model approach to estimate the value of the firm, it can be concluded that value of the option(s) mostly makes the overall value of a firm. As a consequence, the value of a firm is very sensitive to the value of un-mined gold. To run successful operations of the company, the company has to value its option to mine the gold in the long run. With the help of Black and Scholes model, the company has analyzed the sensitivity of the real option valuation.
The investment made by the company is viable for the exploration and if the exploration has been continued by the company then, the discoveries of new gold mines would be far-reaching. This would increase the value of the real option which in turn, would boost the overall enterprise value of the company. In order to make a strong base in the exploration side, AEM should make their efforts to invest in exploration to increase their reserves. Moreover, a rise in gold prices along with an increase in reserves would help the company to succeed in the future. The company must realize that it would only be able to achieve profitability through an option on the gold which is un-mined......................................
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