Application of option price model in mining industry merge & acquisition

Abstract

The traditional discounted cash flow valuation (DCF) has many limitations. In order to compensate for some of those limitations, real option valuations (ROV) have been widely accepted and applied. The popularity of ROV is partly related to its ability to analyze flexibility and uncertainties within various industries. We focused on the mining industry, explored the conditions that enable ROV to outperform DCF, and proposed that under certain conditions, ROV may more accurately reflect the market value of a mining firm. We reviewed the current developments of DCF and ROV models and apply both methods to a real Mergers and Acquisitions (M&A) case - Barrick Gold, a very representative mining firm. By comparing DCF and ROV, we discussed the benefits of ROV in mining industry and the premium of the acquirer’s offer price. In addition, pertinent concepts were identified and explored to enhance the understanding of business issues arisen in M&A.