The CFO of CanGold Company is considering investing in a gold mine in Mongolia. The mine will cost $200 million to get into production and will last for one year. At the end of one year, it is expected to produce 1 million ounces of gold. The price of gold is expected to be $500 an ounce in one year (the forward price). The current price of gold is $300 an ounce. Fixed costs of production are $50 million and variable costs are $250 per ounce. Assume no taxes or CCA. The appropriate discount rate for the mine is 15 percent. Risk-free borrowing and lending is available at a rate of 3 percent per year.
a. Based on NPV, should CanGold invest in the Mongolian gold mine?
b. If in one year, we know that the price of gold will be either $200 per ounce or $850 per ounce:
i. Describe how having the choice of closing the mine can change the value of the asset.
ii. Draw the decision tree for this project.
iv. Value the mine as a call option on gold. (Hint: use the arbitrage arguments behind the binomial option pricing model. Think of the mine as a financial security).