Corporate Finance

1. Introduction

Since the publication of the seminal work on real options, it has been recognized that

real option analysis is a valuable analytical tool that allows managers to quantify the value of

flexibility. While the rate of adoption of real option analysis has been uneven across industries, it

has been embraced most enthusiastically in the natural resources industry, where academic

research first proposed the application of these techniques. This chapter details the bidding for

a classic real option in a natural resource industry: the right to develop a copper deposit.

In 1996, the Peruvian government privatized a number of state-owned assets. One of

the first to be privatized was Antamina, a polymetallic ore deposit about 500 kilometers north of

Lima, Peru. The winning bidder would have two years to explore the property before deciding

whether or not to develop the site. This ability to wait-and-see gave rise to a classic

development option, which bidders would need to incorporate into their valuation. The first

section of the paper discusses the practical issues involved in carrying out a real options

analysis, in the tradition of the work of Paddock, Siegel and Smith (1988) and others.

What is unique about bidding for Antamina, however, is not the valuation of the project

per se, but rather the real option embedded in the bidding rules set up by the Peruvian

government, and the resultant implications for the behavior of the bidders and the ultimate

developer of the deposit. In effect, the auction rules had firms submit both the option premium

and the exercise price of the real option to develop the property. By allowing bidders to set

both elements of the bid, the government may have substantially reduced the problem of

winners’ curse and motivated bidders to propose very high investment levels in the plant;