Analyzing the Profitability of Metal Mining Investments with System Dynamic Modeling and Real Option Analysis

Jyrki Savolainen Analyzing the profitability of metal mining investments with system dynamic modeling and real option analysis Lappeenranta 2016 64 pages + publications Acta Universitatis Lappeenrantaensis 731 Diss. Lappeenranta University of Technology ISBN 978-952-335-040-3, ISBN 978-952-335-041-0 (PDF), ISSN-L 1456-4491, ISSN 1456-4491 The importance of ex-ante analysis of metal mining investments has grown in recent years. The decreasing profitability of new projects and unpredictable metal markets pose a challenge to the currently applied models of profitability analysis. The purpose of this research is to investigate simulation and system dynamic (SD) models applicable to real option analysis of metal mining investments. Real options in general refer to flexibility of projects which can both decrease the negative effects of uncertainty and, on the other hand, enhance the positive future realizations of the projects. This thesis is a collection of articles with common theme of enhancing the simulationand SD-models used for real option valuation of metal mining investments. Within the framework of real option analysis it is claimed that metal mining investments are a distinct object of study, which have specific characteristics that should be taken into account in their real option analysis. The research methods of this thesis include literature review and modeling. Two distinct simulation models are created: a system dynamic simulation model and a static simulation model. The models are used to run analyses with illustrative case examples that have their background in the metal mining industry. The results suggest that metal mining investments can be treated as techno-economic systems by using the SD-methodology and that the use of system dynamic simulation based analysis allows a more detailed and realistic ex-ante modeling of metal mining investments and of the connected uncertainties. It is shown that system dynamic models are able to model compound and interacting real options that exist on a single asset. Based on the results of this work it seems that under non-ideal conditions the profitability of metal mining investments is linked to the financing of these projects. High leverage with a fixed debt servicing schedule may inhibit the use of managerial flexibility that may cause a loss of project value. It is suggested that an optimal debt-equity ratio exists that maximizes the project value per percentage point of equity invested.