Investigation of factors influencing the determination of discount rate in the economic evaluation of mineral development projects

Abstract

For the evaluation of mineral development projects, it is imperative to consider the risks involved in mineral exploration and development and to bear in mind that an adjustment for these risks is a common practice which implies raising the minimum discount rate. A company may for instance use different discount rates depending on the different risks involved so as to compensate for the variability of success. In determining a discount rate, an organization should follow this rule “The greater the risk, the higher the discount rate should be. The discount rate will have a great influence on the economic evaluation of mineral projects. All other factors used for calculating the NPV (Net Present Value) being equal, the project at hand may be accepted or rejected depending upon the discount rate, and the fluctuation of the NPV from positive to negative. It must be pointed out that the determination of the discount rate is the most difficult and vital aspect of “cash-flow analysis.” In practice however the discount rate is usually fixed by top management and then delegated to the respective departments responsible for actual economic evaluation of the investment alternatives. A major problem in determining the appropriate discount rate is that it effectively depends more on subjective perception of the degree of risk or other past experience factors than on a systematic approach. By using a risk-free rate of return, plus a subjectively determined risk premium, a discount rate may be developed, which is expected to compensate the investor for the extra risk involved. In practice the selection of risk-free rate of return is relatively simple. In most cases, the yield on government bonds, under non-inflationary conditions, is adopted as the risk-free rate of return. The real problem lies in the choice of the risk premium which must be adequately adapted to compensate for the additional risks associated with the investment under consideration. Consideration of proper conditions in respect of a specific project under economic evaluation should help to determine the risk premium. The risk premium should be entirely dependent on the risks influencing the mineral development project. All possible risks affecting a mineral development project under consideration should be taken into account, when determining an appropriate risk premium. This is a stupendous task and will imply a large number of risks, which will no doubt make the determination very difficult to tackle and use. Furthermore, there are naturally numerous difficulties in structuring an analysis with many factors, because it is complex and multi-faceted. In order to facilitate the implementation of the determination, there are usually a definite number of key risks to be observed. Risks, crucial for success of the mineral development project, are classified as follows: -- Technical risk - reserve, completion, production -- Economical risk – price, demand, foreign exchange -- Political risk – currency conversion, environment, tax, nationalization From the review of factors influencing the determination of discount rate carried out (Section 4), it is concluded that the quantitative methodology for discount rate should be a process of identifying potential factors (risks), analyzing factors to determine those that have the greatest impact on mineral development, and determining discount rate. It is therefore imperative to find a method whereby all mining risks, together with their probability and impact, and an understanding of the combined effect of all risks attached to the cash flow and the rate of return. Thus then a way of a procedure calculating risk scores is required. Existing knowledge should therefore be used optimally to determine discount rate.