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MEA 2006 V 1.

0 08/2006

Financial Concepts & Discount Cash Flow


Techniques

Copyright 2007-2012 University of New South Wales (UNSW)

This slide presentation was created by


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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Mining is an economic activity


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.

For engineers, profits can be expressed in simple equation form as;

Profits = REVENUES - COSTS


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.

PURPOSE OF EVALUATION PROCESS


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 AND OUTFLOWS


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

Cash Flow Techniques


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

SIMPLE VS COMPOUND INTEREST


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

COMPOUNDING MORE THAN ONCE PER YEAR


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

COMPOUNDING MORE THAN ONCE PER YEAR


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

COMPOUNDING MORE THAN ONCE PER YEAR


In general:
o i(effective) =
m

1 + 1
m

0 .1
= 1 +
1 = 10 .3%
2

COMPOUNDING MORE THAN ONCE PER YEAR


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

COMPOUNDING MORE THAN ONCE PER YEAR


Original Example: Future value of $100 after 3 years,@ nominal
interest rate of 10% compounded semiannually.

o F = P(1+r/m)mxn = 100(1+0.1/2)2x3 = $134.01


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

; find F given P(1)

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

Compound Interest Formulas

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

o => (F/P, i, n) or to find F given an Annuity A @rate I, and n


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

o (A/P, i, n) => Capital Recovery Factor: Find A given P

Determining the Interest Factors:


(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 in DCF modelling


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

Period cash flows


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.

DCF Modeling Techniques


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.

DCF Modeling Techniques


Undiscounted:
z Return On Investment or Rate Of Return

z For decision making purposes, projects with ROIs equal


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.

DCF Modeling Techniques


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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DCF Modeling Techniques


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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DCF Modeling Techniques


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

NPV - WHAT IS IT?


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.

The NPV of the project is the sum of all the individual


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.

more Discount 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

IRR Internal Rate of Return


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 Present Value Ratio


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

B/C Ratio = PVR


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 - Equivalent Annual Value


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??

Sum of all present values gives NPV

$8,881.52

Example 1 - Solving with MS Excel

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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.

Net Present value (NPV) @15%


= -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)

0= -120,000 - 70,000(P/Fi,1) + 100,000(P/Ai,4)(P/Fi,1)

@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

How can you measure the value of a project?


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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Decision making behavior


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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Mine Investment Analysis


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

Production Rate (tonnes/day)


NPV $11/g

NPV $14/g

NPV $18/g

900

1000

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