This thesis examines 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.
The Hotelling Valuation Principle formally represented in Miller and Upton 1985a provides a measure of the present value of the expected future cash flows from mining operations. However, reliance on cash flows alone and with the added assumption of constant proportionality in mining revenues and extraction costs has limited practical appeal. A more realistic approach is advocated by the seminal paper of Brennan & Schwartz (1985a) that formally values option-like operating characteristics together with cash flows in the context of mining firms. To date, the empirical evidence in support of the relevance of real options based valuation frameworks to mining firm valuation is extremely limited (see Palm, Pearson et al. 1986; Paddock, Siegel et al. 1988; Bailey 1991; Quigg 1993; Kelly 1998; Mod and Tufano 2002).
With this background in mind, this thesis 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 than discounted cash flow models such as the Hotelling Valuation Principle. A significant portion (73.8%) of the market-assessed 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 evidence suggests that the value associated with operating options depends on whether the current spot price is near to the cost of extracting the commodity. Firms with highly profitable mining opportunities exhibit very low premiums. When the operating option to extract ore is deep in-the-money (the commodity price is well above the extraction cost) the option to close has little value. The market appears to be valuing the present value of expected future cash flows from mining operations and attributing an insignificant value to operating flexibility, because the current operating status is unlikely to change. Likewise, the option to close is most valuable for firms for whom the option to extract is out-of-the-money (commodity price is less than the extraction cost) or near-the-money (commodity price is close to the extraction cost).