Following a recent Edumine four-day short course, “Valuation of Mineral Projects Based on Technical and Financial Modelling” in POHTO’s Oulu facility in Finland, one of the delegates raised an interesting point that has wide relevance to active operations.
The Valuation course covers project appraisal as a forward-looking perspective at the pre-production stage. As a manager on an active operation the delegate, in his daily work, has to deal with multiple development scenarios which are an inherent part of mine planning.
The delegate asked about the utility of applying the principles of discount cash flow modelling at the pre-funding stage, which allows comparison between development scenarios in an active operation based on the performance indicators of NVP, IRR and pay-back.
These would provide a snapshot of the value derived from a given period of production where there is a simple relationship between the amount of ore produced and the capital cost. In an active operation though, an investment in a particular element, for example footwall pre-production development and drill hole sampling, might be part of the normal cycle of mining as production proceeds.
There is no fixed end point which can be incorporated into a DCF model. Other performance indicators, such as cash costs and tonnage of ore delineated, then become more relevant in ranking development decisions. He pointed out that the scenarios are seldom so marginal that DCF modelling is likely to expose a feature that would not already be apparent from normal mine planning.
The Valuation course may add more content around the boundary condition that applies to the normal allocation of sustaining capital in pre-production development on an active mining operation with a defined mine life, compared to the creation of what is essentially a new mine, albeit exploiting the same deposit.
In the former case this is part of routine mine planning with costs met from cash flow. There is no merit in setting up a DCF model if for no other reason than that the time span is seldom more than five years whereas the optimum period for applying the technique at a 10% discount rate is about 15 years.
The main flexibility is around allocation of cost between capital expenditure and operating costs. In accounting terms, it is best if this can be allocated to operating costs to allow immediate tax relief. Tax relief on capital cost is obtained through depreciation where benefit is deferred.
With the development of a new mine in the Valuation course I use a hypothetical case study, the objective of which is to evaluate the different alternatives available to a mining company operating in the Peruvian Andes following the discovery of an undeveloped deposit close to its operating mine.
This grants them options such as the opportunity to extend mine life, increase annual production and to introduce a drastic change in the mineral processing method.
Using debt also means that the full Capex of $460M does not have to be met from the cash flows of the parent company generated from their existing operations. These can then be distributed as dividends.
This, in turn, enhances share price and allows the equity portion of the capital requirements to be raised through a rights issue. Equity investors also have the comfort that in order to secure this level of debt the bankers would have undertaken a rigorous technical review of the project.
The role of independent engineers instructed by the banks ensures better planning and better management at the EPC stage.
The case studies in the Valuation course also covered the transition from surface to underground which often involves significant capital investment ($2.6B in the case of Venetia). These are manifestly new mines that will exploit deep extensions of the same deposit.
In summary, a medium sized company considering developing essentially a new mine (albeit on the same deposit) at a cost of around $500M should consider the use of project finance.
The banks will be very comfortable as operating cost estimates will be well constrained and production will be undertaken by experienced operators. Where the development of the new mine is going to cost over $2B then, this is the domain of the large international mining companies that will use their corporate cost of capital for evaluation studies and act essentially as their own investment bank.
Lending to subsidiaries on a rolling basis ensures they manage the corporate gearing that supports their share price and sets the corporate cost of capital. This does impact on mine planning where a major pit push back is proposed.
Pit optimisation algorithms have to assume a discount rate fixed by the parent company. The operation cannot therefore use a gearing optimisation approach where the subsidiary cannot act as an independent company and raise fresh equity and secure debt from an independent investment bank. They must use the parent’s corporate cost of capital.
This must impact on stripping ratios and may even sterilize some ore — a source of some frustration to planning departments on mines. In some cases, the discount rate they are required to use in mine planning is well above the corporate cost of capital which means a much more conservative stripping ratio is generated.
Valuation of Mineral Projects Based on Technical and Financial Modelling is offered online as a distant learning course June 22 – 26.
(By Dennis Buchanan, Director of the MSc in Metals and Energy Finance, Department of Earth Science and Engineering, Imperial College, London.)