1. ISSUE NO. 71 — October 2005
C A L E N D A R Economic Evaluation of Mining Projects
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Introduction determine if the project merits the additional
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China Mining 2005
funding necessary to progress to the next level.
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November 14–17, 2005
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In order for mining companies or investors to DCFROR is the after-tax rate of return that
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Beijing International Congress Centre
make statements regarding the mineral reserves of discounts future cash flows by properly taking into
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Beijing, China
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a project, security exchanges throughout the account the time value of money. The method is
e-mail: jan.klawitter@china-
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world require owners to validate the economic also referred to as the internal rate of return.
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mining.com
viability of the project. Engineers typically make
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this determination through economic evaluation DCFROR is defined as that rate of return that
Mines and Money London
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using a tool called cash flow analysis. Simply makes the after-tax present worth of future cash
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November 21–23, 2005
stated, a cash flow analysis is cash in (revenue flows from the project equal to the present worth
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Hilton London Metropole Hotel
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from sales) less cash out (direct operating costs, of after-tax investments. If the project’s DCFROR is
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London, United Kingdom
taxes, royalties, capital expenditures – or any out- greater than the company’s minimum rate of
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e-mail: tracey.fielder@mining-
of-pocket expenditure) which yields net cash return, the project is considered economically
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journal.com
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flow. These cash flows are typically estimated on viable. Discounting future cash flows is done
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an annual basis and discounted back to the through formulas of compound interest, discus-
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Gold & Precious Metals present moment in time to determine the sions of which can be found in economic
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Investment Conference
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discounted cash flow rate of return (DCFROR) or engineering or accounting books.
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November 27–28, 2005 net present value (NPV) of the project.
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San Francisco Marriott DCFROR is used in conjunction with other
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San Francisco, California
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Economic evaluation and financial analysis are economic parameters such as NPV and payback.
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e-mail: iiconf@iiconf.com commonly, though incorrectly, used NPV is defined as the difference between the
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interchangeably. Economic evaluation is the present worth of future cash flow and the present
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NWMA Annual Convention: method used to determine the economic viability worth of initial investment using a predetermined
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Exploring the Modern Minerals of a project. It is the primary measure of discount rate (preferably the company’s minimum
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Renaissance alternative investment opportunities. Financial rate of return). If the difference is positive, the
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December 5–9, 2005 analysis is the method used to analyze how a project is considered economically viable. DCFROR
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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
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Spokane, Washington percent owner equity, a combination of equity and discount rate where the NPV of the project is zero.
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e-mail: pheywood@nwma.org debt, a joint venture arrangement or some
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combination of these financial terms. However, Payback is a simple method that does not
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cash flow analysis can be used to evaluate the incorporate time value of money concepts.
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Mineral Exploration Roundup
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2006 economic impact of the various financing options Payback is the period of time required to
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January 23–26, 2006 on the project. payback the initial investment from future cash
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flow. Although the method does not account
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Westin Bayshore Resort & Marina
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Vancouver, B.C., Canada Economic evaluation can be used virtually any for time value of money, it is a useful evaluation
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e-mail: llelliott@chamberofmines.bc.ca time in a project’s life: from the pre-exploration parameter because it provides some indication
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stage to assist in determining the size and tenor of how long the company has to wait to get its
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Runge Professional Development of a mineral target (conceptual level), during the money back. A company may be able to survive
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Courses exploration stage (pre-feasibility level), through 2 to 4 years before positive cash flows arrive.
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Mining for Non Miners - Nov. 30 project development and financing (feasibility Periods of much longer time than this may strain
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Dragline Mining System - Dec. 1-2 level). As projects progress through the various companies beyond their financial means.
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stages of evaluation, the cash flow model
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Mining Economics - Dec. 5-6
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Truck and Loader Systems - Dec. 7-9 parameters will be replaced with better The concept of minimum rate of return is a
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Calgary, Alberta, Canada estimates and engineering data in order to significant discussion by itself where authors have
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Copyright 2005 by Pincock, Allen and Holt, a division of Runge Inc. All Rights Reserved.
2. devoted entire books to the subject. Mine Planning and Cash Flow Analysis rather an allowance used to reduce taxable
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Several factors make up the minimum income. Use of non-cash items to reduce
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rate of return, which in general terms Economic evaluation of alternative mine taxable income is dependant on laws of the
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consist of the company’s cost of capital plans requires estimation of the project’s governing entity as levied by the taxing
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with some allowance for risk. Most mine and process production parameters, authority. Restrictions or additional taxes
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evaluators look to the company’s chief royalties, operating costs, taxes, capital may be levied on income leaving the
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financial officer to provide the minimum costs and ongoing capital replacement governing country. It is the responsibility of
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rate of return for economic evaluations. costs. Table 1 illustrates what goes into a the company and the evaluator to gain an
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Although determining the minimum rate typical cash flow for any given year. understanding of the governing nation’s tax
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of return for projects is beyond the scope law, which often means employing local tax
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of this paper, suffice it to say that Table 1 Annual Cash Flow Diagram knowledge to assist in properly interpreting
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determining the minimum rate of return and applying the necessary tax laws.
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is not a simple calculation.
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Gross Revenue
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Less transportation, smelter/refining, As mentioned earlier depreciation and
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Companies often request evaluators to ○ marketing and downstream depletion are non-cash allowances.
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Depreciation is an allowance for capital
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perform economic evaluations on a pre-
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beneficiation charges
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tax basis for a variety of reasons. Less royalties investment over the useful life of an asset.
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However, most people do not realize that Less operating costs Most countries allow some form of
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depreciation for the majority of mining
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pre-tax evaluations require one to use
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Net Operating Revenue
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pre-tax discount rates, which are not the Less non-cash items: industry assets. Countries may have several
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same as after-tax discount rates. As just Depreciation categories of depreciation depending on the
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asset’s use. Generally the faster the write-
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discussed, determining a minimum Depletion
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discount rate is a complicated matter, Amortization off, the more likely this will trigger some
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without having to calculate a new pre-tax Net Taxable Income form of alternative minimum tax calculation.
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Depletion is an allowance for a nonrenew-
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discount rate. It should also be noted Less taxes
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that pre-tax evaluations are not accept- Plus credits able resource. Depletion is only allowed in
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able to establish mineral reserve state- Net Income After Tax some countries.
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ments because taxes represent operating Plus non-cash items
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costs and are therefore, required to be Net Operating Cash Flow Every country has some class of taxation
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included in the cash flow analysis. Less capital costs (initial and sustaining) generally taking many different forms.
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Less working capital While companies may have negotiated an
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There are two basic situations in evaluating Less acquisition costs
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income tax holiday, there may be other
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projects: 1) one is referred to as ‘stand- forms of taxation such as the value added
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Less land payments
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alone’ where all tax deductions and credits Net Cash Flow tax (VAT) on not only final product sales, but
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are carried forward and used against future major equipment components coming into
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the country. Although it’s likely the company
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project income and taxes, and 2) the other Gross revenue from the mine takes into
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is when the project is evaluated within the account annual tons produced, ore grade, will receive a tax credit for VAT later in the
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corporate envelope where income exists mine recovery, and process recovery all project’s life, the money is required at the
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elsewhere in the organization such that all multiplied by commodity price to generate project’s startup, adding to capital invest-
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tax deductions, credits and savings are total gross revenue. Deductions from gross ment.
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taken when incurred to gain the most revenue consist of product transportation
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favorable economic advantage. Although costs from the mine site, additional Once taxes are removed from the income
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some companies may have no choice, beneficiation costs and marketing costs. stream, the mine operator is left with net
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companies tend to evaluate projects using operating cash flow. Net operating cash
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Royalties based on net smelter return value
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‘stand-alone’ as the base case. While this are calculated at this point, further reducing flow is further reduced by capital costs,
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evaluation does not present the best gross revenue. Direct operating costs changes in working capital, acquisition costs
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and required land payments. The resulting
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economic scenario, it does tend to allow including mining, processing, general,
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the projects to be evaluated on their own administrative, property taxes, severance calculation yields the project’s annual net
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merit. Later in the evaluation process, taxes, corporate overhead charges and cash flow. This calculation is performed for
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companies can incorporate the project into ongoing reclamation costs are subtracted every production year and each additional
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the corporate evaluation scenario to from gross revenue, generating net operating year beyond the last production year where
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analyze the combined economic advan- revenue. reclamation is required. These net cash
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tages. flows are discounted to a present time to
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Unless the operation has the enviable determine the NPV and DCFROR of the
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DCFROR and NPV are the most widely used project.
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position of a negotiated tax holiday during
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investment decision methods in the mining it’s first few production years, net operating
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industry because they properly account for revenue is subject to taxation. Taxation One important component of cash flow
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analysis that requires special attention is
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time value of money and they allow typically includes national (federal), state
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different mineral projects to be analyzed on (provincial) and local taxes. Non-cash items, working capital. Working capital is the
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a common basis. These methods allow which may consist of depreciation, money required for day-to-day operations. It
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companies to properly rank investment depletion and/or amortization, are applied is particularly critical during the project’s
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alternatives in order to make the best to reduce taxable income. Non-cash items startup phase and is often a significant
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decision where to employ their money. are neither capital nor operating costs, but expense requirement. However, working
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3. capital is not the usual capital expense and is to the change in the parameter. The Leverage and the Effect on DCFROR
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as such, is not an allowable tax deduction. range of changes generally runs plus or and NPV
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Cost items typically included in working minus 10 to 20 percent, or possibly higher
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capital are: 1) inventories such as raw for conceptual level studies. Not that long ago most projects were
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materials, spare parts, supplies, product-in- financed from the owner’s equity capital.
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process and finished products, 2) accounts These results provide the company with a More recent projects are of such magnitude
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receivable, 3) accounts payable, and 4) cash sense of critical parameters indicating and risk that other sources of capital are
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on hand. Depending on the level of project required to bring the project into produc-
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which ones should be closely monitored.
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study, working capital may be estimated Generally one of the primary parameters tion. Debt financing is one such source,
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using detailed accounts of the aforemen- most sensitive to project economics is which is why it is worth discussing the
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impact leveraging has on DCFROR and NPV.
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tioned items or through order-of- revenue followed by either operating or
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magnitude estimates based on 10-20 capital costs. Revenue factors consist of
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percent of the fixed capital investment or One common mistake when evaluating
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grade, recovery and price and a given
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projects using borrowed money is to
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1- 3 months of operating costs taking into percentage change in any one of these
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consideration the type of process and how carries exactly the same impact on revenue. perform the cash flow analysis on the total
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long before the first saleable product is ○ investment rather than just the equity
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portion of the investment. This is another
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available to market. Remote project Although sensitivity analysis is an important
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locations may require a higher working aspect in economic evaluations, it is a reason why evaluators should perform a
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base case analysis using 100 percent equity.
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capital cost. single point parameter test. Sensitivity
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analysis does not account for the likelihood It provides a baseline to compare leveraged
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While working capital is invested at the or probability of any particular parameter evaluations.
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startup of an operation, it is usually shown being within a certain range or distribution
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as being recovered at the end of the nor how that distribution impacts the If the after-tax cost of borrowed money is
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project’s life because the components project’s economics. While probability less than the project’s cash investment
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DCFROR, then it is economically desirable
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initially required are considered recouped at
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theory with respect to economic evaluation
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the end of mine life. However, some is very interesting, its subject matter is to borrow the money and defer the
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companies are providing more working beyond the scope of this paper. With the remaining equity investment. This will
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significantly increase the DCFROR and NPV
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capital throughout the project life to allow proliferation of computer software, several
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for various unknowns and fluctuating commercial packages are available to test a of the project by leveraging up these
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monetary exchanges or increases. In some project’s economics to various probabilistic indicators. However, it is important to note
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cases working capital may be recovered models. that leveraging works both ways. If the
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early in the project life or it may never be project’s DCFROR falls below the cost of
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recovered, depending on the project’s Limitations of DCFROR and NPV borrowed money the project will not be
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circumstances. able to service the loan and will generate a
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Although DCFROR and NPV are probably significantly negative NPV.
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Sensitivity Analysis
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the most widely used and generally
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accepted economic evaluation tools Summary
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It is highly recommended that the evaluator available in the industry, they are not
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The process of economic project evaluation
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perform the primary project economic without limitations. Neither DCFROR nor
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evaluation based on a project stand-alone NPV account for the magnitude of the using cash flow analysis can be a long,
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situation and 100 percent owner equity (no investment in a project. A project with a complicated and arduous task. As the
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debt financing). This case will provide a capital investment of $100 million may project progresses and more detailed
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sound baseline from which all other cases show the same DCFROR as a project information becomes available, the
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can be evaluated and compared. mineral evaluation process becomes more
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requiring a $1 billion investment. DCFROR
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does not account for differing project lives. complex and requires further evaluation.
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Although engineers make every effort to A project with a 10 year life may show This situation is somewhat unique to the
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mining industry and it is very much a
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reasonably estimate mine and process
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nearly the same DCFROR as a project with
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production parameters, as well as capital a 20 year life. NPV is the only tool which circular evaluation process..
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and operating costs, uncertainties exist, can adequately account for projects with
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Economic evaluation through the use of
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which need to be evaluated. These “what varying lives.
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if” concerns can be addressed through cash flow analysis will generate a project’s
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sensitivity analysis. The main point of this is that companies DCFROR and NPV, which allows us to
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and investors should not rely solely on one systematically and quantitatively evaluate
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The cash flow program can be setup to economic parameter for decision making. It the economic potential of various mineral
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evaluate changes in tons, grade, recovery, investments. DCFROR and NPV are the most
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is important and perhaps critical that all
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product price, capital and operating costs available economic parameters be used widely used investment decision methods in
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relative to different discount rates. together to provide a reasonable picture as the mining industry because they properly
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account for time value of money and they
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Evaluators typically graph the results in
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to the economic health of a project. Armed
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“spider diagrams,” which illustrate the with the project’s economic evaluations allow different mineral projects to be
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impact on project economics when any one and the political analysis of various analyzed on a common basis. These
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methods allow companies to properly rank
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parameter is changed while other param- countries, companies should be in a good
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eters are held constant. The steeper the position to make an informed decision investment alternatives in order to make the
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curve the more sensitive project economics regarding the mineral property. best decision where to employ their money.
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33
4. Example Cash Flow Analysis
Table 2 provides an example cash flow diagram with the various parameters illustrated as discussed in this paper. Any resemblance to an actual
project 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, don.tschabrun@pincock.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.
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