Page 286 - Introduction to Mineral Exploration

11: PROJECT EVALUATION 269

BOX 11.3 Sensitivity analysis.

This example is taken from a feasibility study completed on a coal mine in western Canada. In the study
it was apparent that two of the critical factors were variation in production cost and in tonnage of coal
sold as these could both have a serious effect on the cash flow. These factors were varied and expressed as
DCF ROR:

VARIATION IN MINE PRODUCTION COST
Base case +5% +10% −5% −10%
26.6% 22.3% 18.5% 31.5% 36.9%
VARIATION IN TONNAGE OF COAL PRODUCED SOLD

Base case +5% +10% −5% −10%
26.6% 33.9% 42.9% 20.2% 14.5%
Obviously the lower the tonnage produced the lower the revenue and the lower the DCF ROR, etc.
None of the variations bring the DCF ROR to less than the hurdle of 15%. Results are best presented
graphically.

range of discount rates the DCF ROR value lower quartile of all major primary producers of
correlates as a straight line (Box 11.3). Conse- that commodity. This is based on the premise
quently by calculating a series (3–4) of positive that if the commodity prices fall, and there is a
and negative NPVs at selected discount rates corresponding reduction of project revenue,
the DCF rate can be seen graphically at the then their operation will be protected by a
point where NPV equals zero. cushion of other and higher cost producers,
Generally, mining companies finance miner- who, it is assumed, will be forced to reduce
alisation for development which has a value production at an early date thus stabilizing the
equal to or exceeding a DCF rate of return of commodity price. It is worth noting, however,
15% after tax or 20% before tax has been that a project with such a low production cost
deducted. would have a favorable investment rate of re-
turn (either NPV or DCF) and would be ranked
highly by these techniques.
Comment
The NPV method of valuation requires man-
These quantitative economic modeling tech- agement to specify their desired rate of return
niques have contributed much to an improve- and indicates the excess or deficiency in the
ment in the process of investment decision cash flow above or below this rate while DCF
making. During the 1980s, however, there was provides the project’s rate of return and does
an increasing concern with the totality of min- not consider the desired rate. As a comparison
eral projects and a greater emphasis on aspects between the two it is said that NPV provides
such as business risks associated with rapidly a conservative ranking of projects compared
rising capital requirements due to inflation, the with DCF.
unpredictability of future economic condi- Long versus short run considerations have to
tions, sophisticated financing arrangements, be assessed. As an example compare two occur-
and host government attitudes. rences of mineralisation, one with a 15-year life
Some mining organizations have used com- and a 15% DCF and another with a 5-year life
parative production cost ranking to reduce and a 20% DCF. If the short life, high DCF
investment risk. They require that the produc- project is selected, management must consider
tion cost to market for a new project is in the the business opportunity at the end of the