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MIN E 408: Mining Enterprise Economics

Review of Economic Indicators


Resources:
Any economics book
A classic: Runge, 1998. Mining Economics and Strategy. 295 p.
Slides modified from Dr. Oy Leuangthong
Interest Real and Nominal
Project Evaluation Methods
Discounted Cash Flow

Nominal And Effective Rates


If m = # of compounding periods per year and m > 1, then
the effective interest rate, ie > i, the interest rate per
compounding period;
the nominal interest im is given as i*m; and
the effective interest rate ie is given by

ie (1i)m 1

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Nominal And Effective Rates


The effective interest rate increases as the number of periods increase.
E.g. Estimate the effective interest for a nominal rate of
12% p.a. compounded monthly, quarterly and semi-annually.

Nominal Interest Rate of 12% p.a.

12

12.80%
12.70%
12.60%
Effective Interest Rate

ie1 1 12%
1 12.68%
12
4
ie2 1 12% 1 12.55%
4
2
ie3 1 12% 1 12.36%
2

12.50%
12.40%
12.30%
12.20%
12.10%
12.00%
11.90%
0

10

15

20

25

30

35

40

45

Number of compounding intervals, m

Continuous Compounding
Continuous compounding means the number of periods increase
infinitely. Effective interest rate is;

i e e im 1
See corresponding continuous compounding interest factor equations.

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Interest Rate Formulae For Continuous


Compounding With Discrete Payments

Finding F when P is Given:-

F Peim n P F / P, im , n

The future value can be calculated;

Using daily compounding (365 days):

Using monthly compounding:

Using annual compounding

F Peim (365) n

F Peim (12)n

F Peimn

Fundamental Economic Indicators


Interest rates
Cost of borrowed money
Determined by supply of and demand for money and
Inflationary rates

Inflation and escalation


Decline in the value of money measured by its purchasing power.
Weighted average price escalation rate for various sectors of the
economy.

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Fundamental Economic Indicators


Real interest rates
Nominal interest rate adjusted for inflation.
If a bank pays 10% (nominal) on deposits
$1000 deposited will yield $1100 in a year
If liter of gas cost $1 $1000 will purchase 1000 liters today

Suppose inflation rate is 6% after a year


Liter of gas will cost $1.06
The purchasing power of $1100 is in a year 1100/1.06=1,038 liters

Real return on $1000 = 3.8%

Fundamental Economic Indicators


Real Interest rate

1 Nominal interest rate


Real interest rate
1
1 Inflation rate

approximated by
Real interest rate Nominal rate - inflation

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Fundamental Economic Indicators


Cash flow and Inflation
Like interest rates cash flows can be expressed in either real or nominal
terms.
Nominal if actual/current dollars to be received is used.
Real if cash flows are deflated expressed in terms of current dollar.

Example
Gas price is 50 per liter today. Expect prices to appreciate by 4% p.a. for
the next five years. If inflation is 6% p.a. Calculate the nominal and real
fuel cost per year if your annual demand is 2 million liters. Determine the
PV of your costs if nominal discount rate is 12%.

Fundamental Economic Indicators


Cash flow and Inflation

Year

Nominal
cost/liter

Real
cost/liter

Nominal cost
(m$)

Real cost
(m$)

0.50

0.50

1.00

1.00

0.52

0.49

1.04

0.98

0.54

0.48

1.08

0.96

0.56

0.47

1.12

0.94

0.58

0.46

1.17

0.93

0.61

0.45

1.22

0.91

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Discounting- Real or Nominal interest rate?


Real discount rate = 1.12/1.06 1= 5.66%

Nominal
cost (m$)

Year

Real
cost
(m$)

PV of
Nominal
Cost(m$)

PV of Real
Cost(m$)

1.00

1.00

1.04

0.98

0.93

0.93

1.08

0.96

0.86

0.86

1.12

0.94

0.80

0.80

1.17

0.93

0.74

0.74

1.22

0.91

0.69

0.69

5.03

5.03

PV

Nominal cash
flows are
discounted with
nominal discount
rate and real
cash flows are
discounted with
real rates.

Project Evaluation Methods

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Project Evaluation Methods


1. Discounted Cash Flow (DCF):
Cash flow discounted at an investor arbitrarily selected discount rate

Net Present Value (NPV).


Internal Rate Of Return (IRR).
Profitability Index Or Benefit Cost Ratio.
Payback And Discounted Payback Period.

2. Capital Asset Pricing Method (CAPM):


Discount rate quantitatively modeled using the beta of a security or project with
comparable risk as project.

3. Option Pricing Method:


Uses Portfolio replication to duplicate the project as consisting of certain basic
assets that are risk free. The resulting portfolio of assets must have a return
equal to the risk free rate.

Investment Decision Criteria


NET PRESENT VALUE (NPV)
T

CFt
t
t 1 1 RRR
RRR - rate of return
NPV I 0

Decision Criteria - Take project if NPV>0


Example

XYZ Resources is considering an expansion project; immediate cost is


$120,000
Project would increase cash flows by $15,000 per year for 10 years
(starting next year)
Residual salvage value: $48,000
Should XYZ take project if discount rate = 10%?

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Investment Decision Criteria: NPV

Investment Decision Criteria:


PROFITABILTY INDEX (Benefit Cost ratio)

PI

PV (Cash inflow)
I 0 (Cash Outflow)

Take project if PI > 1.

PV
1
I0
PV I0

NPV 0

PV I0 0
IRR internal rate of return, NPV = 0
Solve for simple eqns
Guess and test
Goal seek in Excel

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Investment Decision Criteria:


PROFITABILTY INDEX (Benefit Cost ratio)
For any given project the NPV method and the PI will provide the
same accept/ reject decision
Mutually exclusive projects ??
Scale issue
Project A

Project B

PV of Cash Inflow (m$)

500

100

PV of cash outflow (m$)

300

50

NPV

200

50

PI

1.67

2.0

Investment Decision Criteria:


PROFITABILTY INDEX (Benefit Cost ratio)
What happens to the remaining $400m if project B is accepted?
If there is a project C , PI of A compared with the composite PI of
B and C
Capital rationing firm has capital constraints
There is ranking of projects

PI may be used for ranking - Requires smaller projects to exactly


use up budget else
Consider NPV of all feasible combinations of projects within the
budget.

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Review Of Main Points


Discounted Cash Flow (DCF) is one of the most
common approaches to project evaluation
Various measures that are used for decision making:
Net Present Value (NPV)
If NPV > 0, then project will provide benefit
Profitability Index (PI) or Benefit Cost Ratio
If PI > 1.0, then NPV > 0
Can be used to rank projects
Higher PI, higher the return per dollar on investment

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