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0 08/2006

Techniques

Assoc Prof Serkan Saydam

The University of New South Wales

Assoc Prof Emmanuel Chanda

The University of Adelaide

2011

The moral right of the author has been asserted

The presentation forms part of the Resource Estimation, an MEA

Course

All rights reserved. The presentation is licensed to MEA for

educational purposes in MEA courses only

Introduction

All capital investment decisions involve the concept of

investing funds at the present time with the

expectation of receiving a return at some future date.

Need to be examined estimated future streams of

income in an attempt to determine value.

Need to be fully understood the role of the time value

of money as this forms the basis for any financial

analysis or valuation.

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The economists tend to be interested in;

1. Forecasting (supply, demand, price and capital

cost),

2. The structure of mineral and commodity

industry and the competitive behavior of the

firms comprising those industries, and

3. In public policy, especially as related to energy,

the environment, and land management.

Revenue ($) = Metal Price ($/t) x Grade (%) x Tonnage (t)

Cost ($) = Total Cash Cost ($/t) x Tonnage (t)

Gross Revenue Operating Cost = Gross Profit (taxable income)

Gross Profit (taxable income) Tax = Net Profit

Net Profit Capital Costs = Cash Flow

Cash Flow refers to the net inflow or outflow of money that occurs

during a specific time period.

Designed to assess the size of return on

investment in the project

And the probability of that return occurring

Based on the assumed values of key

parameters

THE FINANCIAL EVALUATION CANNOT

CONFIRM THE TECHNICAL FEASIBILITY OF

THE PROJECT

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EVALUATION GUIDELINES

Made at a point in time

Sunk costs

Constant $ or current $

For comparing alternatives, make sure techniques

used permit fair comparisons

Manual evaluations

Computer financial models

Investment decision versus sale/purchase

evaluation

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CASH

Cash is the lifeblood of the enterprise

Cash flows are actual $ spent or received

Non-cash items (e.g. depreciation) are

important as far as they affect cash flows

Project cash flows for a period are inflows

minus outflows - may be +ve or -ve

Periods are usually years; may be quarters or

months, depending on the size of the project

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Inflows - sales revenue; may include other

minor items

Outflows - Initial capital expenditure,

working capital, maintaining capital,

operating costs, taxes, royalties,

rehabilitation costs, etc

Royalties, ? Treat as reductions in revenue

Off site costs, such as realisation costs, ?

Treat as reductions in revenue

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WORKING CAPITAL

Component of intial cap. ex. - to fund op. costs

until sales revenues arrive - in theory recovered

at end of mine life

Required throughout project life but generally

supplied by sales revenues

Itemised on a period by period basis in detailed

financial models

Avoid double counting in financial model but

must be counted in initial funding requirement

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CURRENCY

Local currency

Because costs in local currency

Convert revenues to local currency

Forecast exchange rates can dominate the

evaluation

Foreign projects in host country currency

In cases of foreign country hyperinflation, use a

stable currency, e.g. US$, if sales revenues in

US$

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CONSTANT VS CURRENT $

$ change in value over time

Constant $ - generally average value of $ of the day at

time of evaluation, preserved throughout project life.

Current $ - $ of the day for each period in the future requires calculation of the change in value from period

to period, i.e. usually inflation rates

Costs affected by local inflation, revenues by world

inflation, up to a point. Mineral commodity revenues

controlled by supply and demand most of the time.

INTEREST RATES

A function of the time value of money

On debt, represent low risk return

Therefore, risky investments offer higher

return

Diversified equity investments offer about

6% above the risk free rate

Government bonds represent risk free rate

Interest rates and discount rates closely

linked

Time value of money

A principle based on the timing of cash flows that states $1.00 to be received

in the future is less valuable than $1.00 received today.

Discounting

A large future amount of cash is reduced to its smaller current equivalent.

Compounding

A smaller amount of cash earns interest and accumulates to a large amount

in the future.

P : Present single sum of money (at time zero)

F : Future single sum of money

A : Amount of each payment in a uniform series of equal payments made

at the end of each period

n : Number of interest compounding periods

i : Period compound interest rate

C : Capital investment

L : Salvage value

I : Period income

Discounting Techniques

Simple interest

Simple interest is calculated by application of the rate to the initial

investment principal each interest compounding period. Total interest paid

over the repayment is proportional to the length of the loan schedule.

Cumulative payment (simple interest) = P i n

Example

$1,000 principal at simple interest of 6% per annum for 120 days gives

Solution

Simple interest = $1,000 0.06 (120/365) = $19.73

Discounting Techniques

Compound interest (period, nominal, effective and

continuous)

Compound interest is calculated separately for each period

within the repayment schedule.

Interest paid in a period is the rate multiplied by the

outstanding principal for that period.

Rate = x per cent per TIME FRAME compounded each

PERIOD LENGTH

Normally, compound interest rates are expressed using a

TIME FRAME of a year. However, the PERIOD LENGTH for

compounding is very often a much shorter time such as a day

or a month.

P(1+i)n = F

More Examples

Calculate the future worth that $2,000 today will have 4 yrs

from now if interest is 5% per yr compounded annually.

P(1+i)n = F

The F/Pi,n factor can be found from interest tables or it can

be calculated mathematically to be (1 + 0,05)4=1.216

Example: Compound Interest

This means earn interest on interest

Now:

o F1 = P + P*i = P(1+i) = 100 + 100(0.1) = $110

o F2 = P(1+i) + i[P(1+i)]= 100(1.1)+0.1*100*1.1 = $121 = P(1+i)2

o F3 = P(i+i)2 + i[P(1+i)2] = P(1+i)3 = 100(1.1)3 = $133.10

o In general:

F = P(1+i)n

Consider:

10% compounded semi-annually:

Same as 5% compounded every six months!

o F = 100(1+0.05) (1+0.05) (1+0.05) (1+0.05) (1+0.05) (1+0.05)

= 100 (1.34) = $134; compared with $133

NB: first term: 100(1+0.05) = P(1+i) @ end of first 6 months;

100(1+0.05)(1+0.05) = P(1+i) @ end of 2nd six month

o OR

F = 100(1+0.10/2)2*3 = 100(1+0.05)6

In general:

o r = nominal rate of interest (% per year)

o m= Times per year interest rate is compounded

o Example: nominal = 10% per compounded semi-annually

=> 5% compounded 6 months!

o The EFFECTIVE RATE, (i) = rate compounded once a year

which is equivalent to the nominal rate compunded n times per

year

In general:

o i(effective) =

m

1 + 1

m

0 .1

= 1 +

1 = 10 .3%

2

Exercise:

o Calculate the effective interest rate if the nominal rate, r = 18%

compounded once per month. Answer: 19.6%

o Calculate the effective interest rate if the nominal rate, r = 10%

compounded quarterly. Answer: 10.4%%

o HINT:

1 + 1

m

Original Example: Future value of $100 after 3 years,@ nominal

interest rate of 10% compounded semiannually.

o Or, we could use the effective rate:

F = P(1+ effective i)n = 100(1+0.1025)3 = $134.01

Activity: Determine the effective rate for a nominal of 5%

compounded:

9Annually

9semiannually

9Quarterly

9Daily

9Continuously = Hint: effective i = P(ern)

INTEREST FORMULAS

o Future Value F of a present amount P:

F = P (1+i)n

o Ex.: You deposit $5000 today @10% interest for five years.

How much will accumulate of we compound annually?

Answer: $8,052.50

o What if we compound semiannually?

Answer: $8,144.50

o Find P of $5000 received at the end of 5 years.

Answer: $3,104.50

ANNUITY

Set of money payments made periodically under certain stated

conditions.

o Annuity certain = fixed number of payments

o Contingent annuity = number of payments conditional

o Life annuity = made during the life of a person

o F = sum at the end of n periods; P = Present value

(1 + i )n 1

F = A

periods

ANNUITY

How much will accumulate in a fund if $2,500 is invested each

year for 5 years at 10%?

Answer: $15,262.5

o HINT:

(1 + i )n 1

F = A

SINKING FUND

Equal payments which will amount to some Future Value at the

end of n years @ i% interest.

o Transpose the equation for Annuity!

i

A = F

n

(1 + i ) 1

o (A/F, i, n) => sinking fund factor:

Find A given F

UNIFORM SERIES

Present value of an Annuity

o Formula:

(1 + i ) n 1

P = A

n

i (1 + i )

o (P/A, i, n) => sinking fund factor: Find P given A

CAPITAL RECOVERY

Used in typical car and home loan..

o Formula:

i (1 + i )

A = P

n

(1 + i ) 1

n

(1)Use formulas

(2)Read factors from Interest tables (on Moodle)

(3)Use Microsoft Excel

Practice makes perfect (nearly)!

Solve the problems for Tutorial #2 and LG

pages from 44. Time Value of Money (upload

file from Moodle)

PROJECT PERIODS

Equal length periods cover entire life of project

Permits use of standard compound interest

relationships and rules

Periods = years, generally

May be quarters or months for small projects

Project commences with the first period of

investment

Evaluation relates to beginning of first period

DEPRECIATION

Depreciation is the means of recovering capital

expenditure

Deducted from taxable income because it is recovered

capital, not income

But, since dividends cannot be paid out of capital,

accountants concentrate on the after tax profit without

adding back depreciation

Discounted cash flow evaluations add back depreciation

to evaluate total cash flows of the project.

Dividend payments are not part of the project evaluation.

Depreciation deducted from cash flow to

determine taxable income, and thus tax payable

Depreciation then added back to after tax profit to

determine period cash flow

Positive NPV of cash flows mean capital has been

serviced at the discount rate while invested, has

been recovered and excess return has been

received

Project cash flows for each year (or shorter

period) made up of:

z After tax profit or loss

z Plus any depreciation added back

z Plus adjustments for any after tax items such

as capital expenditures, loan drawdowns or

loan repayments made or received during the

year.

Undiscounted and Discounted

Undiscounted:

z PayBack Period - limited value but still popular.

How long will it take to fully recover the initial

investment in a project?

Useful for investment decisions where obsolescence

is of importance or for investment in developing

countries where instability of tenure is expected.

The weakness of the PbP is that no account of the

time value of money and ignores the cash flows after

the payback period.

Undiscounted:

z Return On Investment or Rate Of Return

to or greater than the firms target ROI are accepted for

development.

z Others are rejected.

z Projects are ranked from the highest ROI down.

z The ROI gives no indication of the value of the project.

Undiscounted:

z ROI and PbP are useful as supplementary measures to

assist in corporate decision making.

z Many companies will only accept projects which meet

certain PbP and, less commonly, ROI measures.

z ROI and PbP are of no use where the purpose of the

evaluation is to establish the value of a project.

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For purposes of evaluation, net cash flow is the measure of profit from

the project.

Total Profit is the cumulative net cash flow over the life of the project.

Total Profit takes no account of the time value of money or of the size

of capital investment required.

What it does do is alert management to the gross size of the project.

Useful indicator of gross size, usually as a result of long life - can be

very useful when companies are using high discount rates.

Two projects may have similar net present values and internal rates of

return but one may have a much greater total profit. This greater total

profit reflects a longer life and all companies prefer long life mines.

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Discounted:

z Net Present Value (NPV)

z Internal Rate of Return (IRR)

z Present Value Ratio (PVR)

z Equivalent Annual Value (EAV)

z All four related - based on the same stream of cash

flows

Most important of evaluation measures

Measure of project value at chosen discount rate

z Positive NPV - investing in project will add value

to the company

z Calculate by discounting all cash flows to same

point in time

z Equal periods

z End of period convention

more NPV

A project achieves economic acceptability when the

sum of discounted receipts exceeds the sum of

discounted expenditures.

period cash flows discounted to the common time

datum.

The formula is:

Project NPV = CF0 + CF1(1+i)-1 + CF2(1+i)-2 + + CFn(1+i)-n

Discount Rate

Theoretically, if the project investment is considered to be riskless, the

discount rate should be the highest risk free rate available to the investor.

No mining investment is risk free.

Many companies tend to use their long run weighted average cost of funds

as the discount rate, as that reflects a market perception of the required

rate of return from such a company.

Some companies increase the discount rate above their cost of capital to

take account of the perceived riskiness of a specific project or in the hope

of identifying potentially higher earning projects.

In that case, the discount rate is called the hurdle rate.

NPV is a function of discount rate as well as stream of cash flows.

The discount rate represents the discount on the future cash flow.

Discounted cash flows are cash flows that have had their value decreased

by the discount rate, compounded by the amount of time until the cash flow

is realized.

This accounts for the time value of money when determining the true value

of the future cash flow. Summing all appropriately discounted cash flows

allows the calculation of the NPV.

IRR

For the most common investment projects, which

involve mainly negative cash flows in the early

years and predominantly positive cash flow in

later years, the NPV is an inverse function of the

discount rate and a zero NPV is generated by a

unique discount rate, called the Internal Rate of

Return (IRR).

In those cases, the NPV goes down as the

discount rate goes up

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more NPV

There can be no unique NPV for any project.

For the most common investment projects, which involve

mainly negative cash flows in the early years and

predominantly positive cash flow in later years.

- If NPV > 0, the project obtains income which is more than

anticipated interest rate

- If NPV = 0, the project obtains income just for anticipated

interest rate

- If NPV < 0, the project obtains income which is less than

anticipated interest rate

Also called Discounted Cash Flow Rate Of Return

(DCFROR)

The IRR is simply the discount rate that causes the NPV

of a series of cash flows to be zero.

Good for ranking competing projects

No use for valuing projects

Cannot be calculated where all cash flows are positive

NPV is an inverse function of the discount rate and a zero

NPV is generated by a unique discount rate, called the

Internal Rate of Return (IRR).

NPV vs DCF

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PVR measures NPV per unit of discounted investment

Supplements the NPV

2 ways of calculating PVR but both are similar and are used to

supplement the info from the NPV

The PVR may be calculated by dividing the NPV of a project by the

net present value of the capex outflows, discounted at the same rate

as used for the NPV calculation.

So, the PVR is measuring the NPV of the project per unit of

investment.

The NPV does not indicate whether the NPV is the result of a large or

a small investment.

Does not value project

Instead of looking at the difference in PV + and - flow to

analyse projects in NPV calculations, some investors

prefer to look at the ratio of PV (PW) net positive cash

flows to the present worth of negative cash flows.

This ratio commonly called Benefit Cost ratio (B/C ratio).

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more PVR

The alternative method of calculating the PVR is to divide the present

value of all project cash flows excluding capex by the present value of

all capital expenditures, both streams being discounted at the same

rate.

EAV is the equal net cash flow over each year of the project life which

generates the NPV

The Equivalent Annual Value of a project can be calculated by multiplying

the NPV of the project by the Capital Recovery Factor for the number of

years of the life of the project and for the interest rate (discount rate) used in

determining the NPV.

The EAV is a rather specialised tool.

It can be used for choosing between different equipment alternatives, in

which cases the EAVs are Equal Annual Costs and the lowest cost

alternative is selected.

EAVs of competing projects could be very helpful to management in

selecting preferred alternatives, when considered in conjunction with NPV.

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Example 1

A company must decide whether to introduce a

new product line. The new product will have

startup costs, operational costs, and incoming

cash flows over six years.

This project will have an immediate (t=0) cash

outflow of $100,000 (which might include

machinery, and employee training costs).

Other cash outflows for years 1-6 are expected

to be $5,000 per year. Cash inflows are

expected to be $30,000 per year for years 1-6.

All cash flows are after-tax, and there are no

cash flows expected after year 6.

The discount rate is 10%. Calculate the PV for

each year??

$8,881.52

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Example 1

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Example 2

A five year project requires investments of $120,000 at time zero and

$70,000 at the end of year 1 to generate revenues of $100,000 at the end of

each of years 2 through 5. The minimum rate of return is 15%. Calculate the

project NPV and ROR to determine if the project is economically acceptable.

= -120,000-70,000(P/F15%,1)+100,000(P/A15%,4)(P/F15%,1) = $67,389>0

acceptable

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Example 2

Rate of Return (ROR)

@30% =-7,212

@25%=12,928 == by iterating i = 25%+5%(12,928/20,140)=28.2%

>15% economically satisfactory

Trial and error basis

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NPV Example

Economic Evaluation

You cannot manage what you cannot measure

z Simple cash flow analysis

z Discounted Cash Flow Analysis (NPV)

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NPV Analysis

Simple to calculate

Take into account risk

Allows comparison of project with different profiles

Independent of inflation

But;

Does not take into account a project managers

ability to adapt to future changes as they occur.

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What are the corporate objectives?

The first and immutable objective of a public

mining company is to develop the shareholder

value

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Corporate Objectives

Lowest quartile of the cost curve

Develop world class deposits

Hedge to protect investors of price market

fluctuations

Not hedge to expose investors to the market

Increase value through expansion in reserves

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NPV Curve

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Design Criteria

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The optimal production rate is 600 tonnes/day

NPV is sensitive to the gold price, and a positive NPV will not be

obtained if the market price is not above $11/g and this variable is

one that can make or break the mine.

Sensitivity Graph of NPV vs Production Rate

25

NPV ($ million)

20

15

10

5

0

0

100

200

300

400

500

600

700

800

-5

-10

-15

NPV $11/g

NPV $14/g

NPV $18/g

900

1000

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