determine if the project merits the additionalfunding necessary to progress to the next level.DCFROR is the after-tax rate of return thatdiscounts future cash flows by properly taking intoaccount the time value of money. The method isalso referred to as the internal rate of return.

DCFROR is defined as that rate of return thatmakes the after-tax present worth of future cashflows from the project equal to the present worthof after-tax investments. If the project’s DCFROR isgreater than the company’s minimum rate ofreturn, the project is considered economicallyviable. Discounting future cash flows is donethrough formulas of compound interest, discus-sions of which can be found in economicengineering or accounting books.

DCFROR is used in conjunction with othereconomic parameters such as NPV and payback.NPV is defined as the difference between thepresent worth of future cash flow and the presentworth of initial investment using a predetermineddiscount rate (preferably the company’s minimumrate of return). If the difference is positive, theproject is considered economically viable. DCFRORand NPV are related in that the DCFROR is thediscount rate where the NPV of the project is zero.

Payback is a simple method that does notincorporate time value of money concepts.Payback is the period of time required topayback the initial investment from future cashflow. Although the method does not accountfor time value of money, it is a useful evaluationparameter because it provides some indicationof how long the company has to wait to get itsmoney back. A company may be able to survive2 to 4 years before positive cash flows arrive.Periods of much longer time than this may straincompanies beyond their financial means.

The concept of minimum rate of return is asignificant discussion by itself where authors have

ISSUE NO. 71 — October 2005

Introduction

In order for mining companies or investors tomake statements regarding the mineral reserves ofa project, security exchanges throughout theworld require owners to validate the economicviability of the project. Engineers typically makethis determination through economic evaluationusing a tool called cash flow analysis. Simplystated, a cash flow analysis is cash in (revenuefrom sales) less cash out (direct operating costs,taxes, royalties, capital expenditures – or any out-of-pocket expenditure) which yields net cashflow. These cash flows are typically estimated onan annual basis and discounted back to thepresent moment in time to determine thediscounted cash flow rate of return (DCFROR) ornet present value (NPV) of the project.

Economic evaluation and financial analysis arecommonly, though incorrectly, usedinterchangeably. Economic evaluation is themethod used to determine the economic viabilityof a project. It is the primary measure ofalternative investment opportunities. Financialanalysis is the method used to analyze how aproject will be funded; whether it will be 100percent owner equity, a combination of equity anddebt, a joint venture arrangement or somecombination of these financial terms. However,cash flow analysis can be used to evaluate theeconomic impact of the various financing optionson the project.

Economic evaluation can be used virtually anytime in a project’s life: from the pre-explorationstage to assist in determining the size and tenorof a mineral target (conceptual level), during theexploration stage (pre-feasibility level), throughproject development and financing (feasibilitylevel). As projects progress through the variousstages of evaluation, the cash flow modelparameters will be replaced with betterestimates and engineering data in order to

Copyright 2005 by Pincock, Allen and Holt, a division of Runge Inc. All Rights Reserved.

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C A L E N D A R○ ○ ○ ○ ○ ○ ○ ○ ○ ○ ○

China Mining 2005

November 14–17, 2005

Beijing International Congress Centre

Beijing, China

e-mail: jan.klawitter@china-

mining.com

Mines and Money London

November 21–23, 2005

Hilton London Metropole Hotel

London, United Kingdom

e-mail: tracey.fielder@mining-

journal.com

Gold & Precious Metals

Investment Conference

November 27–28, 2005

San Francisco Marriott

San Francisco, California

e-mail: iiconf@iiconf.com

NWMA Annual Convention:

Exploring the Modern Minerals

Renaissance

December 5–9, 2005

Red Lion Hotel at the Park

Spokane, Washington

e-mail: pheywood@nwma.org

Mineral Exploration Roundup

2006

January 23–26, 2006

Westin Bayshore Resort & Marina

Vancouver, B.C., Canada

e-mail: llelliott@chamberofmines.bc.ca

Runge Professional Development

Courses

Mining for Non Miners - Nov. 30

Dragline Mining System - Dec. 1-2

Mining Economics - Dec. 5-6

Truck and Loader Systems - Dec. 7-9

Calgary, Alberta, Canada

Economic Evaluation of Mining Projects

2

rather an allowance used to reduce taxableincome. Use of non-cash items to reducetaxable income is dependant on laws of thegoverning entity as levied by the taxingauthority. Restrictions or additional taxesmay be levied on income leaving thegoverning country. It is the responsibility ofthe company and the evaluator to gain anunderstanding of the governing nation’s taxlaw, which often means employing local taxknowledge to assist in properly interpretingand applying the necessary tax laws.

As mentioned earlier depreciation anddepletion are non-cash allowances.Depreciation is an allowance for capitalinvestment over the useful life of an asset.Most countries allow some form ofdepreciation for the majority of miningindustry assets. Countries may have severalcategories of depreciation depending on theasset’s use. Generally the faster the write-off, the more likely this will trigger someform of alternative minimum tax calculation.Depletion is an allowance for a nonrenew-able resource. Depletion is only allowed insome countries.

Every country has some class of taxationgenerally taking many different forms.While companies may have negotiated anincome tax holiday, there may be otherforms of taxation such as the value addedtax (VAT) on not only final product sales, butmajor equipment components coming intothe country. Although it’s likely the companywill receive a tax credit for VAT later in theproject’s life, the money is required at theproject’s startup, adding to capital invest-ment.

Once taxes are removed from the incomestream, the mine operator is left with netoperating cash flow. Net operating cashflow is further reduced by capital costs,changes in working capital, acquisition costsand required land payments. The resultingcalculation yields the project’s annual netcash flow. This calculation is performed forevery production year and each additionalyear beyond the last production year wherereclamation is required. These net cashflows are discounted to a present time todetermine the NPV and DCFROR of theproject.

One important component of cash flowanalysis that requires special attention isworking capital. Working capital is themoney required for day-to-day operations. Itis particularly critical during the project’sstartup phase and is often a significantexpense requirement. However, working

devoted entire books to the subject.Several factors make up the minimumrate of return, which in general termsconsist of the company’s cost of capitalwith some allowance for risk. Mostevaluators look to the company’s chieffinancial officer to provide the minimumrate of return for economic evaluations.Although determining the minimum rateof return for projects is beyond the scopeof this paper, suffice it to say thatdetermining the minimum rate of returnis not a simple calculation.

Companies often request evaluators toperform economic evaluations on a pre-tax basis for a variety of reasons.However, most people do not realize thatpre-tax evaluations require one to usepre-tax discount rates, which are not thesame as after-tax discount rates. As justdiscussed, determining a minimumdiscount rate is a complicated matter,without having to calculate a new pre-taxdiscount rate. It should also be notedthat pre-tax evaluations are not accept-able to establish mineral reserve state-ments because taxes represent operatingcosts and are therefore, required to beincluded in the cash flow analysis.

There are two basic situations in evaluatingprojects: 1) one is referred to as ‘stand-alone’ where all tax deductions and creditsare carried forward and used against futureproject income and taxes, and 2) the otheris when the project is evaluated within thecorporate envelope where income existselsewhere in the organization such that alltax deductions, credits and savings aretaken when incurred to gain the mostfavorable economic advantage. Althoughsome companies may have no choice,companies tend to evaluate projects using‘stand-alone’ as the base case. While thisevaluation does not present the besteconomic scenario, it does tend to allowthe projects to be evaluated on their ownmerit. Later in the evaluation process,companies can incorporate the project intothe corporate evaluation scenario toanalyze the combined economic advan-tages.

DCFROR and NPV are the most widely usedinvestment decision methods in the miningindustry because they properly account fortime value of money and they allowdifferent mineral projects to be analyzed ona common basis. These methods allowcompanies to properly rank investmentalternatives in order to make the bestdecision where to employ their money.

Mine Planning and Cash Flow Analysis

Economic evaluation of alternative mineplans requires estimation of the project’smine and process production parameters,royalties, operating costs, taxes, capitalcosts and ongoing capital replacementcosts. Table 1 illustrates what goes into atypical cash flow for any given year.

Table 1 Annual Cash Flow Diagram

Gross Revenue Less transportation, smelter/refining,

marketing and downstreambeneficiation charges

Less royalties Less operating costs Net Operating Revenue Less non-cash items: Depreciation Depletion Amortization Net Taxable Income Less taxes Plus credits Net Income After Tax Plus non-cash items Net Operating Cash Flow Less capital costs (initial and sustaining) Less working capital Less acquisition costs Less land payments Net Cash Flow

Gross revenue from the mine takes intoaccount annual tons produced, ore grade,mine recovery, and process recovery allmultiplied by commodity price to generatetotal gross revenue. Deductions from grossrevenue consist of product transportationcosts from the mine site, additionalbeneficiation costs and marketing costs.Royalties based on net smelter return valueare calculated at this point, further reducinggross revenue. Direct operating costsincluding mining, processing, general,administrative, property taxes, severancetaxes, corporate overhead charges andongoing reclamation costs are subtractedfrom gross revenue, generating net operatingrevenue.

Unless the operation has the enviableposition of a negotiated tax holiday duringit’s first few production years, net operatingrevenue is subject to taxation. Taxationtypically includes national (federal), state(provincial) and local taxes. Non-cash items,which may consist of depreciation,depletion and/or amortization, are appliedto reduce taxable income. Non-cash itemsare neither capital nor operating costs, but

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33

capital is not the usual capital expense andas such, is not an allowable tax deduction.Cost items typically included in workingcapital are: 1) inventories such as rawmaterials, spare parts, supplies, product-in-process and finished products, 2) accountsreceivable, 3) accounts payable, and 4) cashon hand. Depending on the level of projectstudy, working capital may be estimatedusing detailed accounts of the aforemen-tioned items or through order-of-magnitude estimates based on 10-20percent of the fixed capital investment or1- 3 months of operating costs taking intoconsideration the type of process and howlong before the first saleable product isavailable to market. Remote projectlocations may require a higher workingcapital cost.

While working capital is invested at thestartup of an operation, it is usually shownas being recovered at the end of theproject’s life because the componentsinitially required are considered recouped atthe end of mine life. However, somecompanies are providing more workingcapital throughout the project life to allowfor various unknowns and fluctuatingmonetary exchanges or increases. In somecases working capital may be recoveredearly in the project life or it may never berecovered, depending on the project’scircumstances.

Sensitivity Analysis

It is highly recommended that the evaluatorperform the primary project economicevaluation based on a project stand-alonesituation and 100 percent owner equity (nodebt financing). This case will provide asound baseline from which all other casescan be evaluated and compared.

Although engineers make every effort toreasonably estimate mine and processproduction parameters, as well as capitaland operating costs, uncertainties exist,which need to be evaluated. These “whatif” concerns can be addressed throughsensitivity analysis.

The cash flow program can be setup toevaluate changes in tons, grade, recovery,product price, capital and operating costsrelative to different discount rates.Evaluators typically graph the results in“spider diagrams,” which illustrate theimpact on project economics when any oneparameter is changed while other param-eters are held constant. The steeper thecurve the more sensitive project economics

is to the change in the parameter. Therange of changes generally runs plus orminus 10 to 20 percent, or possibly higherfor conceptual level studies.

These results provide the company with asense of critical parameters indicatingwhich ones should be closely monitored.Generally one of the primary parametersmost sensitive to project economics isrevenue followed by either operating orcapital costs. Revenue factors consist ofgrade, recovery and price and a givenpercentage change in any one of thesecarries exactly the same impact on revenue.

Although sensitivity analysis is an importantaspect in economic evaluations, it is asingle point parameter test. Sensitivityanalysis does not account for the likelihoodor probability of any particular parameterbeing within a certain range or distributionnor how that distribution impacts theproject’s economics. While probabilitytheory with respect to economic evaluationis very interesting, its subject matter isbeyond the scope of this paper. With theproliferation of computer software, severalcommercial packages are available to test aproject’s economics to various probabilisticmodels.

Limitations of DCFROR and NPV

Although DCFROR and NPV are probablythe most widely used and generallyaccepted economic evaluation toolsavailable in the industry, they are notwithout limitations. Neither DCFROR norNPV account for the magnitude of theinvestment in a project. A project with acapital investment of $100 million mayshow the same DCFROR as a projectrequiring a $1 billion investment. DCFRORdoes not account for differing project lives.A project with a 10 year life may shownearly the same DCFROR as a project witha 20 year life. NPV is the only tool whichcan adequately account for projects withvarying lives.

The main point of this is that companiesand investors should not rely solely on oneeconomic parameter for decision making. Itis important and perhaps critical that allavailable economic parameters be usedtogether to provide a reasonable picture asto the economic health of a project. Armedwith the project’s economic evaluationsand the political analysis of variouscountries, companies should be in a goodposition to make an informed decisionregarding the mineral property.

Leverage and the Effect on DCFRORand NPV

Not that long ago most projects werefinanced from the owner’s equity capital.More recent projects are of such magnitudeand risk that other sources of capital arerequired to bring the project into produc-tion. Debt financing is one such source,which is why it is worth discussing theimpact leveraging has on DCFROR and NPV.

One common mistake when evaluatingprojects using borrowed money is toperform the cash flow analysis on the totalinvestment rather than just the equityportion of the investment. This is anotherreason why evaluators should perform abase case analysis using 100 percent equity.It provides a baseline to compare leveragedevaluations.

If the after-tax cost of borrowed money isless than the project’s cash investmentDCFROR, then it is economically desirableto borrow the money and defer theremaining equity investment. This willsignificantly increase the DCFROR and NPVof the project by leveraging up theseindicators. However, it is important to notethat leveraging works both ways. If theproject’s DCFROR falls below the cost ofborrowed money the project will not beable to service the loan and will generate asignificantly negative NPV.

Summary

The process of economic project evaluationusing cash flow analysis can be a long,complicated and arduous task. As theproject progresses and more detailedinformation becomes available, themineral evaluation process becomes morecomplex and requires further evaluation.This situation is somewhat unique to themining industry and it is very much acircular evaluation process..

Economic evaluation through the use ofcash flow analysis will generate a project’sDCFROR and NPV, which allows us tosystematically and quantitatively evaluatethe economic potential of various mineralinvestments. DCFROR and NPV are the mostwidely used investment decision methods inthe mining industry because they properlyaccount for time value of money and theyallow different mineral projects to beanalyzed on a common basis. Thesemethods allow companies to properly rankinvestment alternatives in order to make thebest decision where to employ their money.

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4

4

Consultants for Mining and Financial Solutions

Pincock, Allen & Holt is a consulting and engineering firm serving the international mineral resourceindustry. 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. Pincock Perspectives is published as a free information service for friends and clients.Information for News Pix is paraphrased from various sources; references available upon request.

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 actualproject is merely coincidental.

This month’s article was prepared by Don Tschabrun, Principal Mining Engineer, don.tschabrun@pincock.com

Table 2

CASH FLOW STATEMENT ($1,000 US)

GOLD MINE PROJECT

OW NER EQUITY (100%)

YEAR PreProd Y1 PY1 PY2 PY3 PY4 PY5 PY6 PY7 PY8 PY9 PY10 PY11 TOTAL

MINE REVENUE 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 ROYALTY (5.0%) 0 672 896 896 896 896 896 896 896 896 896 1,120 9,857

LESS: MINING COST 0 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 0 0 0 32,000

LESS: PROCESSING COST 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 COST 0 400 400 400 400 400 400 400 400 400 400 400 4,400

LESS: LEACH PAD DETOX 0 0 0 0 0 0 0 0 0 0 0 0 0

LESS: RECLAMATION 0 500 500 500 500 500 500 500 500 200 200 200 4,600

TOTAL OPERATING COSTS 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 FLOW FROM OPERATION 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: INTEREST EXPENSE 0 0 0 0 0 0 0 0 0 0 0 0 0

LESS: DEVELOPMENT COSTS 2,730 910 0 0 0 0 0 0 0 0 0 0 3,640

LESS: DEPRECIATION 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: DEPLETION 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 INCOME (LOSS) -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

INCOME TAX @ 44% + PROP TAX -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 ADJUSTMENT -1,201 122 1,079 0 0 0 0 0 0 0 0 0 0

INCOME TAX PAID 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 FLOW FROM OPERATION 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: CAPITAL COSTS 36,800 3,400 0 0 0 0 0 0 0 0 0 0 40,200

LESS: FINANCED CAPITAL 0 0 0 0 0 0 0 0 0 0 0 0 0

LESS: W ORKING CAPITAL 0 2,143 0 0 0 0 0 0 0 0 0 -2,143 0

LESS: DEVELOPMENT COSTS 3,900 1,300 0 0 0 0 0 0 0 0 0 0 5,200

LESS: ACQUISITION COSTS 300 200 0 350 0 325 0 0 0 0 0 0 1,175

LESS: LAND PAYMENTS 0 26 26 26 26 26 26 26 26 0 0 0 207

LESS: INTEREST EXP. 0 0 0 0 0 0 0 0 0 0 0 0 0

LESS: PRINC. PAYMT 0 0 0 0 0 0 0 0 0 0 0 0 0

ANNUAL CASH FLOW -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 SUMMARY

Gold Price ($/Oz): 400

DCFROR: 12.0%

PROJECT NPV @ 5%: $20,208

PROJECT NPV @ 10%: $4,491

PROJECT NPV @ 15%: ($5,244)