To find examples of industry consensus or approaches to particular issues and techniques, mining staff of the securities commissions in Canada will use technical reports filed on the system for electronic document analysis and retrieval (SEDAR), which were prepared by highly credible sources, including international consulting firms, well-known experts, and major mining companies. However, one assumption in which there appears to be no obvious consensus on SEDAR is the appropriate discount rate applied when calculating a project’s net present value (NPV).
Factors to consider when determining appropriate discount rate for project NPV
Discount rates are dependent on many project factors and characteristics, including the marketability of the commodity to be mined, the location of the project, the stage of development, and the size and capability of the project’s owner. While reports filed on SEDAR can be useful guidelines, it is important to ensure that the reports a company relies upon as sources for determining its project’s discount rate come from mining companies of a similar scale, stage of development, and with comparable characteristics. A company’s key consideration when selecting discount rates for a project is the rate of return that is likely to attract a major investor. Often the actual discount rate used by the company does not address the risks of the individual project.
To begin, different discount rates should be applied to different commodities. For example, mixed base metal/precious metal projects, such as copper-gold, would be expected to attract higher discount rates than precious metal projects like silver-gold. Because precious metal projects encounter fewer barriers to sell their product, they should have a basic discount rate of six to eight per cent; base metal projects should have a 10 per cent discount rate; and industrial minerals or speciality metals with no purchase agreements in place and no clear marketing strategy should have an additional two to three per cent added.
The jurisdiction of the project should also be reflected in the discount rate. For example, Chile- or Nevada-based projects would not typically attract additional discounts to their cash flows as these regions are viewed as relatively stable jurisdictions for developing long-term mines. However, projects in some areas of Australia may now attract additional discounting due to the uncertainty around mining taxation. Projects in the Democratic Republic of Congo may also need to tack five to seven per cent onto the discount rate due to sovereign risk perceptions, as well as political and taxation uncertainty.
Also, when precise information pertaining to access and the mining or processing methods to be used are lacking, or when environmental sensitivities and permitting requirements are uncertain, higher discount rates should be applied. For instance, a project in production would be considered low-risk, so no additional discount would be added; a project at the Preliminary Economic Assessment stage could have an additional two to three per cent discount rate added to cover unknowns associated with the level of project definition and cost accuracy. However, when adding to the discount rate in the latter situation, a company should be careful to avoid handicapping the project by using overly conservative production costs and process parameters – these should already be accounted for by increases to the discount rate.
The size and experience of the project owner is another factor to be taken into consideration. If the owner is a recognized major miner with credible experience in operations and mine development in the project’s jurisdiction, no additional discount would be added to the cash flows. However, a two-to-three per cent increase to the discount rate could be considered if the owner is a junior whose management team has limited development and operational experience, if it faces obstacles in developing major infrastructure requirements, or if it has had no previous exposure to mine development in the project’s jurisdiction.
All of the points mentioned should be considered when determining an appropriate discount rate for NPV. And, as previously mentioned, caution should be exercised when considering comparable disclosure by credible sources on SEDAR. The discount rate used in a financial analysis of an operating gold project in Nevada, owned by a major, should not be considered appropriate as the discount rate for a junior’s base metal project at a PEA stage in Mali.
Greg Gosson (left) is the technical director of Geology & Compliance for AMEC Americas Limited. He is a member of the CIM Standing Committee on Mineral Reserve and Mineral Resource Definitions, and a member of CSA Mining Technical Advisory and Monitoring Committee, which is an industry advisory committee on NI 43-101. Graham Wood is the technical director of Financial Services for AMEC Americas Limited. He directs the economic evaluation services of AMEC’s Mining & Metals division. He has conducted financial and economic analyses on dozens of advanced mining projects worldwide.