ISSUE NO. 71 — October 2005 C A L E N D A R Economic Evaluation of Mining Projects ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○ Introduction determine if the project merits the additional ○ China Mining 2005 funding necessary to progress to the next level. ○ November 14–17, 2005 ○ In order for mining companies or investors to DCFROR is the after-tax rate of return that ○ Beijing International Congress Centre make statements regarding the mineral reserves of discounts future cash flows by properly taking into ○ Beijing, China ○ a project, security exchanges throughout the account the time value of money. The method is e-mail: jan.klawitter@china- ○ world require owners to validate the economic also referred to as the internal rate of return. ○ mining.com viability of the project. Engineers typically make ○ ○ this determination through economic evaluation DCFROR is defined as that rate of return that Mines and Money London ○ using a tool called cash flow analysis. Simply makes the after-tax present worth of future cash ○ November 21–23, 2005 stated, a cash flow analysis is cash in (revenue flows from the project equal to the present worth ○ Hilton London Metropole Hotel ○ from sales) less cash out (direct operating costs, of after-tax investments. If the project’s DCFROR is ○ London, United Kingdom taxes, royalties, capital expenditures – or any out- greater than the company’s minimum rate of ○ e-mail: tracey.fielder@mining- of-pocket expenditure) which yields net cash return, the project is considered economically ○ journal.com ○ flow. These cash flows are typically estimated on viable. Discounting future cash flows is done ○ an annual basis and discounted back to the through formulas of compound interest, discus- ○ Gold & Precious Metals present moment in time to determine the sions of which can be found in economic ○ Investment Conference ○ discounted cash flow rate of return (DCFROR) or engineering or accounting books. ○ November 27–28, 2005 net present value (NPV) of the project. ○ San Francisco Marriott DCFROR is used in conjunction with other ○ San Francisco, California ○ Economic evaluation and financial analysis are economic parameters such as NPV and payback. ○ e-mail: firstname.lastname@example.org commonly, though incorrectly, used NPV is defined as the difference between the ○ interchangeably. Economic evaluation is the present worth of future cash flow and the present ○ ○ NWMA Annual Convention: method used to determine the economic viability worth of initial investment using a predetermined ○ Exploring the Modern Minerals of a project. It is the primary measure of discount rate (preferably the company’s minimum ○ Renaissance alternative investment opportunities. Financial rate of return). If the difference is positive, the ○ ○ December 5–9, 2005 analysis is the method used to analyze how a project is considered economically viable. DCFROR ○ Red Lion Hotel at the Park project will be funded; whether it will be 100 and NPV are related in that the DCFROR is the ○ Spokane, Washington percent owner equity, a combination of equity and discount rate where the NPV of the project is zero. ○ ○ e-mail: email@example.com debt, a joint venture arrangement or some ○ combination of these financial terms. However, Payback is a simple method that does not ○ cash flow analysis can be used to evaluate the incorporate time value of money concepts. ○ Mineral Exploration Roundup ○ 2006 economic impact of the various financing options Payback is the period of time required to ○ January 23–26, 2006 on the project. payback the initial investment from future cash ○ flow. Although the method does not account ○ Westin Bayshore Resort & Marina ○ Vancouver, B.C., Canada Economic evaluation can be used virtually any for time value of money, it is a useful evaluation ○ e-mail: firstname.lastname@example.org time in a project’s life: from the pre-exploration parameter because it provides some indication ○ ○ stage to assist in determining the size and tenor of how long the company has to wait to get its ○ Runge Professional Development of a mineral target (conceptual level), during the money back. A company may be able to survive ○ Courses exploration stage (pre-feasibility level), through 2 to 4 years before positive cash flows arrive. ○ ○ Mining for Non Miners - Nov. 30 project development and financing (feasibility Periods of much longer time than this may strain ○ Dragline Mining System - Dec. 1-2 level). As projects progress through the various companies beyond their financial means. ○ stages of evaluation, the cash flow model ○ Mining Economics - Dec. 5-6 ○ Truck and Loader Systems - Dec. 7-9 parameters will be replaced with better The concept of minimum rate of return is a ○ Calgary, Alberta, Canada estimates and engineering data in order to significant discussion by itself where authors have ○Copyright 2005 by Pincock, Allen and Holt, a division of Runge Inc. All Rights Reserved.
devoted entire books to the subject. Mine Planning and Cash Flow Analysis rather an allowance used to reduce taxable ○ ○ ○ ○Several factors make up the minimum income. Use of non-cash items to reduce ○ ○rate of return, which in general terms Economic evaluation of alternative mine taxable income is dependant on laws of the ○ ○consist of the company’s cost of capital plans requires estimation of the project’s governing entity as levied by the taxing ○ ○ ○ ○with some allowance for risk. Most mine and process production parameters, authority. Restrictions or additional taxes ○ ○evaluators look to the company’s chief royalties, operating costs, taxes, capital may be levied on income leaving the ○ ○financial officer to provide the minimum costs and ongoing capital replacement governing country. It is the responsibility of ○ ○ ○ ○rate of return for economic evaluations. costs. Table 1 illustrates what goes into a the company and the evaluator to gain an ○ ○Although determining the minimum rate typical cash flow for any given year. understanding of the governing nation’s tax ○ ○of return for projects is beyond the scope law, which often means employing local tax ○ ○ ○ ○of this paper, suffice it to say that Table 1 Annual Cash Flow Diagram knowledge to assist in properly interpreting ○ ○determining the minimum rate of return and applying the necessary tax laws. ○ ○is not a simple calculation. ○ Gross Revenue ○ ○ ○ Less transportation, smelter/refining, As mentioned earlier depreciation and ○Companies often request evaluators to ○ marketing and downstream depletion are non-cash allowances. ○ ○ Depreciation is an allowance for capital ○perform economic evaluations on a pre- ○ beneficiation charges ○ ○tax basis for a variety of reasons. Less royalties investment over the useful life of an asset. ○ ○However, most people do not realize that Less operating costs Most countries allow some form of ○ ○ depreciation for the majority of mining ○pre-tax evaluations require one to use ○ Net Operating Revenue ○ ○pre-tax discount rates, which are not the Less non-cash items: industry assets. Countries may have several ○ ○same as after-tax discount rates. As just Depreciation categories of depreciation depending on the ○ ○ asset’s use. Generally the faster the write- ○ ○discussed, determining a minimum Depletion ○ ○discount rate is a complicated matter, Amortization off, the more likely this will trigger some ○ ○without having to calculate a new pre-tax Net Taxable Income form of alternative minimum tax calculation. ○ ○ ○ Depletion is an allowance for a nonrenew- ○discount rate. It should also be noted Less taxes ○ ○that pre-tax evaluations are not accept- Plus credits able resource. Depletion is only allowed in ○ ○able to establish mineral reserve state- Net Income After Tax some countries. ○ ○ ○ ○ments because taxes represent operating Plus non-cash items ○ ○costs and are therefore, required to be Net Operating Cash Flow Every country has some class of taxation ○ ○included in the cash flow analysis. Less capital costs (initial and sustaining) generally taking many different forms. ○ ○ ○ ○ Less working capital While companies may have negotiated an ○ ○There are two basic situations in evaluating Less acquisition costs ○ income tax holiday, there may be other ○projects: 1) one is referred to as ‘stand- forms of taxation such as the value added ○ Less land payments ○ ○ ○alone’ where all tax deductions and credits Net Cash Flow tax (VAT) on not only final product sales, but ○ ○are carried forward and used against future major equipment components coming into ○ ○ ○ the country. Although it’s likely the company ○project income and taxes, and 2) the other Gross revenue from the mine takes into ○ ○is when the project is evaluated within the account annual tons produced, ore grade, will receive a tax credit for VAT later in the ○ ○corporate envelope where income exists mine recovery, and process recovery all project’s life, the money is required at the ○ ○ ○ ○elsewhere in the organization such that all multiplied by commodity price to generate project’s startup, adding to capital invest- ○ ○tax deductions, credits and savings are total gross revenue. Deductions from gross ment. ○ ○taken when incurred to gain the most revenue consist of product transportation ○ ○ ○ ○favorable economic advantage. Although costs from the mine site, additional Once taxes are removed from the income ○ ○some companies may have no choice, beneficiation costs and marketing costs. stream, the mine operator is left with net ○ ○companies tend to evaluate projects using operating cash flow. Net operating cash ○ Royalties based on net smelter return value ○ ○ ○‘stand-alone’ as the base case. While this are calculated at this point, further reducing flow is further reduced by capital costs, ○ ○evaluation does not present the best gross revenue. Direct operating costs changes in working capital, acquisition costs ○ ○ ○ and required land payments. The resulting ○economic scenario, it does tend to allow including mining, processing, general, ○ ○the projects to be evaluated on their own administrative, property taxes, severance calculation yields the project’s annual net ○ ○merit. Later in the evaluation process, taxes, corporate overhead charges and cash flow. This calculation is performed for ○ ○ ○ ○companies can incorporate the project into ongoing reclamation costs are subtracted every production year and each additional ○ ○the corporate evaluation scenario to from gross revenue, generating net operating year beyond the last production year where ○ ○analyze the combined economic advan- revenue. reclamation is required. These net cash ○ ○ ○ ○tages. flows are discounted to a present time to ○ ○ Unless the operation has the enviable determine the NPV and DCFROR of the ○ ○DCFROR and NPV are the most widely used project. ○ position of a negotiated tax holiday during ○ ○ ○investment decision methods in the mining it’s first few production years, net operating ○ ○industry because they properly account for revenue is subject to taxation. Taxation One important component of cash flow ○ ○ ○ analysis that requires special attention is ○time value of money and they allow typically includes national (federal), state ○ ○different mineral projects to be analyzed on (provincial) and local taxes. Non-cash items, working capital. Working capital is the ○ ○a common basis. These methods allow which may consist of depreciation, money required for day-to-day operations. It ○ ○ ○ ○companies to properly rank investment depletion and/or amortization, are applied is particularly critical during the project’s ○ ○alternatives in order to make the best to reduce taxable income. Non-cash items startup phase and is often a significant ○ ○decision where to employ their money. are neither capital nor operating costs, but expense requirement. However, working ○ ○ ○ ○ 2
capital is not the usual capital expense and is to the change in the parameter. The Leverage and the Effect on DCFROR ○ ○ ○as such, is not an allowable tax deduction. range of changes generally runs plus or and NPV ○ ○ ○Cost items typically included in working minus 10 to 20 percent, or possibly higher ○ ○capital are: 1) inventories such as raw for conceptual level studies. Not that long ago most projects were ○ ○ ○materials, spare parts, supplies, product-in- financed from the owner’s equity capital. ○ ○ ○process and finished products, 2) accounts These results provide the company with a More recent projects are of such magnitude ○ ○receivable, 3) accounts payable, and 4) cash sense of critical parameters indicating and risk that other sources of capital are ○ ○ ○on hand. Depending on the level of project required to bring the project into produc- ○ which ones should be closely monitored. ○ ○study, working capital may be estimated Generally one of the primary parameters tion. Debt financing is one such source, ○ ○using detailed accounts of the aforemen- most sensitive to project economics is which is why it is worth discussing the ○ ○ ○ impact leveraging has on DCFROR and NPV. ○tioned items or through order-of- revenue followed by either operating or ○ ○magnitude estimates based on 10-20 capital costs. Revenue factors consist of ○ ○percent of the fixed capital investment or One common mistake when evaluating ○ grade, recovery and price and a given ○ ○ projects using borrowed money is to ○1- 3 months of operating costs taking into percentage change in any one of these ○ ○consideration the type of process and how carries exactly the same impact on revenue. perform the cash flow analysis on the total ○ ○long before the first saleable product is ○ investment rather than just the equity ○ ○ portion of the investment. This is another ○available to market. Remote project Although sensitivity analysis is an important ○ ○locations may require a higher working aspect in economic evaluations, it is a reason why evaluators should perform a ○ ○ base case analysis using 100 percent equity. ○capital cost. single point parameter test. Sensitivity ○ ○ ○ analysis does not account for the likelihood It provides a baseline to compare leveraged ○ ○While working capital is invested at the or probability of any particular parameter evaluations. ○ ○ ○startup of an operation, it is usually shown being within a certain range or distribution ○ ○ ○as being recovered at the end of the nor how that distribution impacts the If the after-tax cost of borrowed money is ○ ○project’s life because the components project’s economics. While probability less than the project’s cash investment ○ ○ DCFROR, then it is economically desirable ○initially required are considered recouped at ○ theory with respect to economic evaluation ○ ○the end of mine life. However, some is very interesting, its subject matter is to borrow the money and defer the ○ ○companies are providing more working beyond the scope of this paper. With the remaining equity investment. This will ○ ○ ○ significantly increase the DCFROR and NPV ○capital throughout the project life to allow proliferation of computer software, several ○ ○for various unknowns and fluctuating commercial packages are available to test a of the project by leveraging up these ○ ○monetary exchanges or increases. In some project’s economics to various probabilistic indicators. However, it is important to note ○ ○ ○ ○cases working capital may be recovered models. that leveraging works both ways. If the ○ ○early in the project life or it may never be project’s DCFROR falls below the cost of ○ ○recovered, depending on the project’s Limitations of DCFROR and NPV borrowed money the project will not be ○ ○ ○ ○circumstances. able to service the loan and will generate a ○ ○ Although DCFROR and NPV are probably significantly negative NPV. ○ ○Sensitivity Analysis ○ ○ the most widely used and generally ○ ○ accepted economic evaluation tools Summary ○ ○It is highly recommended that the evaluator available in the industry, they are not ○ ○ ○ The process of economic project evaluation ○perform the primary project economic without limitations. Neither DCFROR nor ○ ○evaluation based on a project stand-alone NPV account for the magnitude of the using cash flow analysis can be a long, ○ ○situation and 100 percent owner equity (no investment in a project. A project with a complicated and arduous task. As the ○ ○ ○ ○debt financing). This case will provide a capital investment of $100 million may project progresses and more detailed ○ ○sound baseline from which all other cases show the same DCFROR as a project information becomes available, the ○ ○can be evaluated and compared. mineral evaluation process becomes more ○ requiring a $1 billion investment. DCFROR ○ ○ ○ does not account for differing project lives. complex and requires further evaluation. ○ ○Although engineers make every effort to A project with a 10 year life may show This situation is somewhat unique to the ○ ○ mining industry and it is very much a ○reasonably estimate mine and process ○ nearly the same DCFROR as a project with ○ ○production parameters, as well as capital a 20 year life. NPV is the only tool which circular evaluation process.. ○ ○and operating costs, uncertainties exist, can adequately account for projects with ○ ○ ○ Economic evaluation through the use of ○which need to be evaluated. These “what varying lives. ○ ○if” concerns can be addressed through cash flow analysis will generate a project’s ○ ○sensitivity analysis. The main point of this is that companies DCFROR and NPV, which allows us to ○ ○ ○ ○ and investors should not rely solely on one systematically and quantitatively evaluate ○ ○The cash flow program can be setup to economic parameter for decision making. It the economic potential of various mineral ○ ○evaluate changes in tons, grade, recovery, investments. DCFROR and NPV are the most ○ is important and perhaps critical that all ○ ○ ○product price, capital and operating costs available economic parameters be used widely used investment decision methods in ○ ○relative to different discount rates. together to provide a reasonable picture as the mining industry because they properly ○ ○ account for time value of money and they ○Evaluators typically graph the results in ○ to the economic health of a project. Armed ○ ○“spider diagrams,” which illustrate the with the project’s economic evaluations allow different mineral projects to be ○ ○impact on project economics when any one and the political analysis of various analyzed on a common basis. These ○ ○ ○ methods allow companies to properly rank ○parameter is changed while other param- countries, companies should be in a good ○ ○eters are held constant. The steeper the position to make an informed decision investment alternatives in order to make the ○ ○curve the more sensitive project economics regarding the mineral property. best decision where to employ their money. ○ ○ ○ ○ 33
Example Cash Flow AnalysisTable 2 provides an example cash flow diagram with the various parameters illustrated as discussed in this paper. Any resemblance to an actualproject is merely coincidental. Table 2 C ASH FLO W STATEM ENT ($1,000 U S) G O LD M INE PRO JE CT O W NER EQU ITY (100% ) YEAR PreProd Y1 PY1 PY2 PY3 PY4 PY5 P Y6 PY7 PY8 PY9 PY10 PY11 TO TAL M INE RE VENUE 0 13,441 17,921 17,921 17,921 17,921 17,921 17,921 17,921 17,921 17,921 22,402 197,134 LESS: NSR ROY ALTY (5.0% ) 0 672 896 896 896 896 896 896 896 896 896 1,120 9,857 LESS: M INING CO ST 0 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 0 0 0 32,000 LESS: PRO CESSING CO ST 0 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 33,000 LESS: G &A CO ST 0 400 400 400 400 400 400 400 400 400 400 400 4,400 LESS: LEACH PAD D ETO X 0 0 0 0 0 0 0 0 0 0 0 0 0 LESS: RECLAM ATIO N 0 500 500 500 500 500 500 500 500 200 200 200 4,600 TO TA L O PERATING CO STS 0 8,572 8,796 8,796 8,796 8,796 8,796 8,796 8,796 4,496 4,496 4,720 83,857 NET CASH FLO W FRO M OP ERATIO N 0 4,869 9,125 9,125 9,125 9,125 9,125 9,125 9,125 13,425 13,425 17,681 113,277 LESS: IN TERE ST EXPENSE 0 0 0 0 0 0 0 0 0 0 0 0 0 LESS: DEV ELOP MENT CO STS 2,730 910 0 0 0 0 0 0 0 0 0 0 3,640 LESS: DEP RECIATIO N 0 3,655 3,655 3,655 3,655 3,655 3,655 3,655 3,655 3,655 3,655 3,655 40,200 LESS: DEP LETION 0 152 2,554 2,554 2,554 2,554 2,554 2,554 2,554 2,554 2,554 3,192 26,328 TAXABLE INCO M E (LOS S) -2,730 152 2,917 2,917 2,917 2,917 2,917 2,917 2,917 7,217 7,217 10,835 43,109 IN COM E TAX @ 44% + P ROP TA X -1,201 122 1,387 1,387 1,387 1,387 1,387 1,387 1,387 3,328 3,328 4,969 20,259 TAX ADJUS TM ENT -1,201 122 1,079 0 0 0 0 0 0 0 0 0 0 IN COM E TAX P AID 0 0 309 1,387 1,387 1,387 1,387 1,387 1,387 3,328 3,328 4,969 20,259 NET CASH FLO W FRO M OP ERATIO N 0 4,869 9,125 9,125 9,125 9,125 9,125 9,125 9,125 13,425 13,425 17,681 113,277 LESS : TAXES 0 0 309 1,387 1,387 1,387 1,387 1,387 1,387 3,328 3,328 4,969 20,259 LESS : CA PITAL CO STS 36,800 3,400 0 0 0 0 0 0 0 0 0 0 40,200 LESS : FINANC ED CAP ITA L 0 0 0 0 0 0 0 0 0 0 0 0 0 LESS : W O RKING CA PITAL 0 2,143 0 0 0 0 0 0 0 0 0 -2,143 0 LESS : DE VELOP MEN T C OSTS 3,900 1,300 0 0 0 0 0 0 0 0 0 0 5,200 LESS : AC QUISITIO N CO STS 300 200 0 350 0 325 0 0 0 0 0 0 1,175 LESS : LAND PAYM ENTS 0 26 26 26 26 26 26 26 26 0 0 0 207 LESS : INTERE ST EXP. 0 0 0 0 0 0 0 0 0 0 0 0 0 LESS : PR INC. PAYM T 0 0 0 0 0 0 0 0 0 0 0 0 0 ANNUAL CASH FLO W -41,000 -2,200 8,791 7,362 7,712 7,387 7,712 7,712 7,712 10,097 10,097 14,856 46,236 CASH FLOW SUM M ARY G old Price ($/Oz): 400 DCFRO R: 12.0% PR OJECT NPV @ 5% : $20,208 PR OJECT NPV @ 10% : $4,491 PR OJECT NPV @ 15% : ($5,244) This month’s article was prepared by Don Tschabrun, Principal Mining Engineer, email@example.com Pincock, Allen & Holt is a consulting and engineering firm serving the international mineral resource industry. Your comments and suggestions are always welcome. Contact Pincock, Allen & Holt • 165 S. Union Blvd., Suite 950, Lakewood, Colorado 80228 • TEL 303.986.6950 • FAX 303.987.8907 • www.pincock.com. Pincock4Perspectives is published as a free information service for friends and clients. Information for News Pix is paraphrased from various sources; references available upon request. Consultants for Mining and Financial Solutions 4