The market premium for the option to close: Evidence from Australian gold mining firms

This paper assesses whether the market valuation of gold mining firms contain a premium for the option to close. Real options theory states that the managerial flexibility with respect to operating decisions of the firm have a recognisable and identifiable value. Together with the present value of expected cash flows (incorporated via the Hotelling Valuation Principle), existing theory purports that the value of the option to temporarily close a firm’s mining operations is embedded in the market price (see Brennan and Schwartz 1985a). Tests of whether observed market values incorporate operating flexibility is central to our understanding of the processes that drive market values and has implications for the relevance and suitability of known theoretical pricing frameworks. This paper assesses the relevancy of the option to close for mining firm valuation. This is achieved by examining 41 Australian gold mining firms listed on the Australian Stock Exchange from 1987 to 1994 that are actively engaged in gold mining extraction and production. A pooled cross-sectional regression analysis analyses 234 firm-year observations to identify the degree of association between the actual (market determined) and theoretical option premiums on the basis of the overall sample. Further robustness checks are then undertaken for sub-sample quartiles ranked on a specific firm characteristic, moneyness. This research establishes that market prices incorporate a premium that reflects the option to temporarily close operations, implying that the comprehensive valuation construct of Brennan & Schwartz (1985a) is more representative of the market’s assessment of mining firm value. A significant portion (73.8%) of the marketassessed value of mining operations is captured by the Hotelling Valuation Principle. The difference between the present value of expected future cash flows and the market value of mining operations is accounted for by the options to close (R = 62.7%). Further, the existence and magnitude of the option premium to close is dependent on other observable attributes of the mining firm, specifically the degree of moneyness of the firm’s operations. The Market Premium for the Option to Close: Evidence from Australian Gold Mining Firms.