Chapter 2.
5
INVESTMENT STRATEGY FOR MINING PROJECTS
D ENNIS A RROUET
Investment decisions in the mining industry, as in any other,
normally focus on numerical methods comparing alternative
investments. While these methods are important, the process of
investment strategy, making the investment, and operating a
project during its economic life, involves much more. Many key
people in various disciplines provide varying degrees of input
over the life of the project, and their input can play a major
role in the investment strategy process. This chapter reviews
principles and concepts covering investment within a home coun-
try and in foreign countries, showing how these many and dispa-
rate elements blend together and change over time. It is comple-
mented by coverage in Section 6, Mine Evaluation and
Investment Analysis.
2.5.1 MINING INVESTMENTS
Investments in the mining industry have many characteris-
tics not found in most other industries. These include the fol-
lowing.
2.5.1.1 Finding or Exploration
Either generative or opportunistic exploration must be
funded for a company to get/renew investments that will be
profitable in the future. These programs, which may be struc-
tured as individual efforts, partnerships, or joint ventures, take
time to develop good prospects/projects.
2.5.1.2 Size
In the past, projects had high ore grades and were easily
mined and processed. In the latter part of the 20th century, the
norm for mining projects was lower-grade deposits, large-scale
mining, and processing using high technology equipment. Often
these projects required infrastructure to make them feasible. As
a result, mining became highly capital intensive. Projects costing
in the hundreds of millions of dollars are more and more
common.
2.5.1.3 Life
Projects generally have very long lives. Many years pass
between first finding ore-grade material, proving up the reserves,
planning the project, and construction. Additional years must
pass before capital costs are recouped, and thereafter even more
years are needed for equity investors to make an adequate return.
2.5.1.4 Product
By their nature, mining projects produce a major product,
although byproduct or coproducts are often produced. In gen-
eral, the product produced in the mining process is not sold to
the final customer. Rather, this raw product is often sold to
others who, after adding value to it, may or may not sell to the
final customer. As a result, demand for “raw” mining products
is “derived” and therefore subject to price and volume swings in
addition to those generated by the final customer.
96
2.5.1.5 Profile
Projects are usually “high” profile wherever they are located
because they are “natural resources.” In some countries, they
often get much more media and political coverage than they
might elsewhere. If this situation exists, or may come to exist,
attitudes and business ground rules can change very quickly;
what appears to be a good investment one day can quickly
become less attractive.
2.5.2 INVESTMENT STRATEGIES
Historically, mining investors explored, developed, and op-
erated until the deposit was exhausted. The only question was
proving up enough ore to support a profitable investment. While
this strategy has been and can be successful, it assumes little
change during the life of the project.
Recent dramatic changes in the price and volume of mining
products, operating costs, and government attitudes, among
other considerations, have led to the reexamination of a once
successful strategy. Under the newer thinking, general ap-
proaches to a successful mining investment now include these
strategies.
1. Cost Leadership. The objective is to have all operating
costs for a project below that of average costs in the industry.
Low costs result from a combination of ore grade, mining diffi-
culty, dilution, economies of scale, development of the operation
including infrastructure, technology, low cost of utilities and
materials, location relative to markets, and access to low-cost
transportation.
2. Differentiation. Here, the product offered is high valued
and special to the market served.
3. Focus. The objective is to fulfill a market need ignored by
others in the industry.
4. Coattails. When an industry has a single or few competi-
tors, the “new entrant” may be accepted; economic return to the
dominant producer(s) can be better (but less than before the new
entrant), if the dominant producer(s) cede portions of the market
and maintain price leadership rather than lower price to stop the
new competitor.
5. Volatility Exploitation. The emphasis is on low fixed costs
and low start-up and shutdown costs. As a result, in periods of
high prices, a mine may be operated very profitably. While this
strategy may apply to a good mining project that has successfully
operated for many years, investors may be able to buy shut mines
at very low cost, operate the property for a short time, and have
a very attractive investment. Alternatively, developing ore bodies
with these quick in-and-out-of-operation characteristics could
prove profitable, depending on circumstances and assumptions.
2.5.3 CALCULATION METHODS
The evaluation of a mining investment starts with the con-
cept that the rate of return over future periods measures the
financial productivity of capital. In other words, a return of x%
or more would be adequate for an investor. Return has been
 INVESTMENT STRATEGY FOR MINING PROJECTS 97
defined many ways over the years. Some of these measures and Returns
their peculiarities are detailed in the following. Accounting
Modern financial theory for measuring return on investment
uses an interest factor to equate cash inflow (outflows) in differ- Average net income 3.3
ent time periods. Thus $1 invested at 10% increases to $1.10 at Return on investment = 16.5%
Investment 20.0
the end of the first year, $1.21 after the second, etc. Similarly,
$1.21 received two years hence has a present value of $1 today, Return on average Average net income 3.3
= 33.3%
“discounted” at 10%. investment Average investment 10.0
Mathematically,
Payback: Years needed for 2 years
2 cash inflows to
FV = S1 (1 + i) + S2 (1 + i) + . . . (2.5.1)
equal cash outflows
Interest
S1 S2 + . . . (2.5.2)
PV = Present value 10% interest rate = $3.1
(1 + i) + (1 + i)2
Discounted cash flow return = 17.8%
where FV is future value, PV is present value, S is cash inflow
(outflow) per period, and i is interest or discount rate. Thus The controversy over what measure to use has largely been
investment returns are calculated by equating cash outflows for resolved in favor of the discounted cash flow method. Each
investment to cash inflows from operations (revenues less all individual or organization may use one or a number of these
cash operating costs, interest, taxes, maintenance and capital return measures to increase communication of “return” to the
expenditures, debt repayment), discounted at an appropriate in- many parties involved with the investment decision. Which mea-
terest rate. sure(s) parties use relates to factors peculiar to their own circum-
Example 2.5.1. stances.
The sophisticated decision maker knows that behind these
Project data (in million dollars) precise calculations are tangible and intangible data that are
Investment year 1 = $10, year 2 = $10 $20 uncertain. To cope with this uncertainty, decision makers use a
Operating cash flow year 3, 4, and 5 = $10 $30 number of techniques including the following:
Depreciation—life 3 years 1. More Accurate Forecasts. A worthy objective, but uncer-
—amount $20 tainty is not addressed.
Debt financing none 2. Higher Cutoff Rate. With a higher cutoff rate, a degree
Capital investment after start up none of risk is recognized as part of an investment. However, the
Solution. probability of returns exceeding the threshold is not recognized.
3. The Base and Most Likely Case. Returns are calculated
Depreciation per year $6.7 using “averages” for input variables. The base case is presumed
Average investment. Investment less one-half total $10 to be conservative, that is, low risk by implication. The most
depreciation likely case is moderate risk.
Average operating cash flow per year $10 4. “What If” Scenarios. A series of returns are calculated
Average net income. Average operating cash flow $3.3 using averages for all but one variable. For example, the base
per year less average depreciation per year case return is run at sales increases/decreases of 5%, l0%, and
15%. While this methodology shows the sensitivity of returns to
Investment Present Value change in specific variables, the likelihood of these events is not
and Operating $1 discounted Revalued quantified.
Cash Flows at l0%* Cash Flow 5. Simulation. Probability curves on each input variable are
developed based on estimates of those most knowledgeable in a
Year 1 (10) 0.909 (9.2) given area, for example, operating cost, selling price, etc. There-
2 (10) 0.826 (8.3) after, a probability is randomly selected from each probability
3 10 0.751 7.5 curve and then used to calculate a discounted cash flow rate of
4 10 0.683 6.8 return. Then the process is repeated many times. The probability
5 10 0.621 6.2 of all anticipated returns can then be graphed as shown in Figs.
3.1 2.5.1 and 2.5.2. Then assessing the project and comparing it to
other projects is easier and more meaningful.
Investment Discounted Cash Flow
and Operating $1 discounted Revalued 2.5.4 COST OF CAPITAL
Cash Flows at 17.8% Cash Flow
For an investment to add value, it must earn more than the
Year 1 (l0) 0.849 (8.5) cost of capital—the cost of debt and equity each weighted based
2 (10) 0.721 (7.2) upon the proportions of debt and equity the corporation targets
3 10 0.612 6.1 for its capital structure over the investment period.
4 10 0.519 5.2 While there are several models for calculating the cost of
5 10 0.440 4.4 capital, each at best is an estimate. The capital asset pricing
0.0 model that follows is the most widely used formulation. For
*Discount factors assume revenue received once per year. Year debt cost, calculate interest on incremental debt with a maturity
1 equals 1 divided by 1.10; year 2 equals 1 divided by 1.21, etc. similar to the investment less tax savings generated by deducting
98 MINING ENGINEERING HANDBOOK

Chances that rate of return will be achieved or bettered

Anticipated rate of return

Probability of achieving
Percent return at least the return shown

0% 96.5%

5 80.6

10 75.2
15 53.8

20 43.0
25 12.6

30 0

Fig. 2.5.2. Anticipated rates of return under old and new approaches
(Hertz, 1979).

annual difference between the rates of return of stocks and gov-

ernment bonds, it is possible to use this factor in calculating a
Fig. 2.5.1. Simulation for investment planning (Hertz, 1979).
firm’s equity cost regardless of the absolute level of interest
rates. Specifically, the equity risk premium is multiplied by an
individual stock’s beta and the result is added to the current
interest from taxable income. For equity cost, calculate the risk risk-free rate of government bonds to determine that company’s
free rate of return, the yield on government securities, plus an equity cost.
equity risk premium, for investing in equities. The yield on gov- Example 2.5.2.
ernment securities compensates debt investors for the “real”
interest rate plus the expected inflation rate. The equity risk Project Data
premium compensates the equity investor for added risk and is Risk free government interest rate 9%
equal to the expected equity market return less the risk-free rate Interest rate on new borrowings 10%
multiplied by the riskiness of the stock or the beta. Betas are Income tax rate 40%
calculated by running linear regression analyses between past Expected return on equity market 15%
returns for a stock and past returns for the market. Then the Beta 1.5
volatility of the stock is compared to the volatility of the market. Capital mix over investment horizon debt 40%
Thus a stock with a beta of 1.20 is 20% more volatile than the equity 60%
market. Betas are published by Value Line, Merrill Lynch, and Solution.
other financial institutions.
In one of the classic studies of long-term investment returns, Weighted
Ibbotson and Sinquefield (1989) calculated the risk and return Cost (%) Weight Cost
of stocks, bonds, and treasury bills and the rate of inflation for Debt 10% – 10% (0.4) 40% 2.4%
1926–1987. According to this study, the historical (1926–87) Equity 9% + (15% – 9%) 1.5 60% 10.8%
arithmetic average equity risk premium of stocks vs. government
bonds was 6.8%. Since the equity risk premium is the average Cost of Capital 100% 13.2%
 INVESTMENT STRATEGY FOR MINING PROJECTS
Investment decision making involves more than just deciding
to make a project expenditure or not. The process involves de-
termining the amount of acceptable project risk, the financial
capability of the investing organization, and the risk profile of
each investment in its portfolio. Every situation needs to be
analyzed separately.
The corporate objective is to maximize earnings (over the
cost of capital) commensurate with acceptable risk. However, at
some point in a corporation’s life cycle, the risk profile is altered
due to price and volume changes, competitor actions, etc. These
dynamic changes in the corporation’s risk profile are also present
in the risk profile of an individual project.
A project’s risk exposure is usually greatest prior to comple-
tion. But the exposure varies over time, as one would expect,
according to the initial risk profile of the project and subsequent
changes in the dynamic variables affecting the project. The proj-
ect’s risk profile is superimposed on that of the company, and
the relative size of the project will affect its potential impact on
the entire company. Upon completion, the project will have a
proportionate impact on the overall risk profile of the company
and, ideally, the periods of adverse returns on the project will
not coincide with the periods of financial difficulty for the rest
of the company. Otherwise, a restructuring of the project and/
or the company may be necessary. Thus, the corporate decision-
making process must explicitly integrate the project risk profile
with the corporate profile.
The decision process also encompasses the entire life of an
investment. The find, invest, and hold strategy implies one in-
vestment decision. However, in a more volatile world, knowl-
edgeable decision makers keep track of the value of their invest-
ment with a view to capturing excess valuation. This “recapture”
changes the capital structure and the risk profile. It may be done,
for example, through the sale of a partial or whole interest in
the investment; the excess can be used to adjust the risk profile
of the project and thus the corporation and to create new value
by developing or buying undervalued investments, repaying fi-
nancial commitments or paying shareholders.
2.5.5 DECISION MAKING
Decision making for a mining investment is a process. It
involves decisions within many separate disciplines that are then
linked together. The initial economic decision is to invest or not
to invest and thereafter to grow, maintain, or disinvest.
Good communication within the organization and with out-
side consultants is extremely important. It speeds decision mak-
ing and it minimizes misunderstandings. But often it is over-
looked as a key element that helps the decision process progress
smoothly.
Also poor negotiation with outside parties can lead to major
problems and unforeseen penalties. The process is critical to
every aspect involved in a project. Experienced personnel have
a better understanding of what to expect, how to act, and what
to demand. They pay attention to:
1. Organizing Their Positions. They plan for changing nego-
tiation strength, interference by others in the organization, insuf-
ficient internal communication, etc.
2. Empathizing with Others. They place themselves in anoth-
er’s position to understand different ways of thinking; they recog-
nize the need for “saving face.”
3. Determining the Role of Government. They try to under-
stand the politics, the role for private enterprise in the country,
status of businessmen, government involvement in negotiations,
etc.
4. Focusing on the Decision-Making Process. They weigh
economic and political criteria, the role of personal relations and
99
personalities and the amount of time assigned to negotiations by
others.
As the decision-making process approaches the go/no-go
decision, senior management and finally the board of directors
become more and more involved. By this time, all work is re-
viewed to check for consistency, risk, and possible omissions or
areas that need more work pending the final decision. “Due
diligence” is an investigatory safeguard and is particularly im-
portant. It covers reserve verification, project risks, projected
capital and operating costs and their variability with volume,
competitive assessment, market analysis, and financial analysis.
The due diligence process is normally conducted again when,
and if, potential equity investors and/or project finance are
needed. Then money providers are given up to date factually
correct data on the project together with a discussion of potential
risks.
2.5.6 PROJECT FAILURES
While failure only happens to others and will not occur in a
well-planned project, history teaches us that financial failures do
occur, often despite the best plans. Indeed, the risk of failure
may increase in the future. First, a number of metal and non-
metal mining products that have been relatively price stable now
show more significant price volatility (e.g., gold, aluminum, iron
ore). Second, low price cycles are relatively longer at lower
levels—at least recently—thereby increasing financial stress.
Third, increased costs per unit of production and relatively
higher interest rates make financial returns more difficult to
achieve. Finally, the frontiers for “new” mineral deposits are
increasingly in remote areas.
The causes for financial failure of investment in projects can
include one or more of the following:
1. Delays in completion causing delay in revenues.
2. Unplanned capital cost overruns.
3. Technical failure.
4. Failure of contractor(s) and supplier(s).
5. Increased price or shortage of raw materials.
6. Estimated grades and amounts unavailable due to insuf-
ficient drilling, complex geology, errors, unforeseen faults, rock
competences, etc.
7. Technical obsolescence.
8. Operating failure.
9. Loss of competitive position in the market.
10. Uninsured casualty losses.
11. Force majeure.
12. Refinancing risk.
13. Increased taxes, direct and indirect.
14. Foreign exchange, artificial rates, availability, etc.
15. Government interference, changes in laws, rules, regula-
tions.
16. Expropriation.
17. Poor project management.
In hindsight, project failures fit into “nice” categories shown
previously. Unfortunately, during a project’s demise, the vision
is rarely clear. While a check list can be helpful, even in retro-
spect the root causes are often overlooked. These root causes
include:
1. The risk profile for each business variable (reserves, capi-
tal and operating costs, competition, etc.) changes during the life
of the project.
2. Sponsors often neglect the vested interests of the project
decision makers, whose future may be enhanced by a project go
ahead, especially when excessive optimism is expressed.
100 MINING ENGINEERING HANDBOOK
2.5.7 PROJECT STRUCTURE AND PARTICIPANT
CHECK LISTS
In order to minimize the downside risk of a project, it is
important to focus on certain key issues at the outset. These
issues, which relate to the structure of the project and the opera-
tional aspects of the project, are summarized in the following in
check list format (also see Fig. 2.5.1).
2.5.7.1 Direct Owners
Parent or holding company structure can have undesirable
impacts on financing, taxes, risk profile, future restructurings.
2.5.7.2 Ultimate Owners/Completion Guarantors
Completion guarantors could include third parties such as
suppliers, offtake purchasers, and governments (particularly in
the case of project infrastructure).
2.5.7.3 Domestic Bank Lenders/Guarantors
Domestic bank credit or lending is a major feature of most
project financings. Domestic experience with other projects, lo-
cal practices, etc., can assist in getting the optimal finance pack-
age. In addition, domestic institutions can help support the proj-
ect with foreign lenders.
2.5.7.4 Foreign Bank Lenders/Guarantors
Foreign lenders include all lenders not domestic to the proj-
ect. Many of these institutions are chosen to lead a project financ-
ing if they are well established domestically. In large financings,
representation by institutions from many countries is encouraged
in less-developed areas. The theory is that the local governments
will not expropriate, embargo funds, etc., for fear of reduced
funds being available to the country.
2.5.7.5 Guaranteed Lenders
These are generally export credit agencies, regional develop-
ment banks, other foreign government lenders, institutional lend-
ers, and occasionally debt participants in leveraged leases. The
parties advance funds under guarantees or standby letters of
credit, which take the project risk and charge a guarantee fee.
Concessional rate and term financing is generally achieved in
this way, since lenders in this category will not accept project
risks.
2.5.7.6 Equipment Suppliers
Use of equipment from different countries should be evalu-
ated. Prices and terms are often more attractive from one country
vs. another.
2.5.7.7 Lessors
Leveraged leasing is often used as part of a project financing.
Amount and terms will determine the use of leases.
2.5.7.8 Offtake Purchasers
Marketing arrangements can be a critical part of the credit
supports needed to finance a project, especially where floor prices
or minimum offtake levels are needed to meet debt service. In-
volving purchasers and lenders or their advisors in the early
stages of market planning can be critical.
2.5.7.9 Engineering Consultants/Contractors
Consultants often establish the technical, marketing, and
financial feasibility of major projects Sometimes an overall proj-
ect feasibility consultant is used, but the trend has been towards
using specialists.
2.5.7.10 Auditors
Auditors (for accounting and taxes) can provide useful infor-
mation on the proposed ownership and financing structures.
If off-balance-sheet accounting treatment is planned, auditors
should be involved early in the project.
2.5.7.11 Legal Counsel
Project development inevitably involves lawyers. Their areas
of involvement include agreements with customers, major suppli-
ers, consultants, financial institutions, investors, other partner/
venture owners, governments, etc. In most situations, lawyers
should have prior mining project experience.
2.5.7.12 Financial Advisors
Investment banks, merchant banks, and commercial banks
have undertaken advisory roles to determine the optimal financ-
ing for mining projects. For a fee, they will screen, select, and
negotiate terms and conditions with financial institutions supply-
ing funds. In some cases, they will supply their own funds.
2.5.7.13 Federal, State, and Local Governments
and Their Agencies
Numerous approvals are necessary to obtain a mining lease
to construct and operate a mine. Approvals are normally needed
before loan drawdowns, and all are required before completion
supports are released by lenders. Lenders want to minimize the
chance that government intervention will frustrate a project’s
completion and operation.
2.5.7.14 In-house Expertise
Skills are needed in the areas of geology, mining, milling,
metallurgy, operations, maintenance, taxes, legal, financial, gov-
ernmental, etc.
2.5.8 PROJECT CHECK LIST
Relative to this check list, see Fig. 5.2.2.
2.5.8.1 Technical Considerations
1. Land and minerals: lease, ownership, title, royalties, spe-
cial arrangements.
2. Reserves: geologic setting, ore types, geologic reserves
vs. mineral reserves, proven vs. probable reserves, drilling data,
sampling, methodology of reserve calculation.
3. Mining plan: forecasts of grades and material movements,
geotechnical test results, equipment to be used, personnel re-
quirements and availability, design assumptions.
4. Processing plan: plant layout, equipment needed, man-
power requirements and scheduling, power requirements.
 INVESTMENT STRATEGY FOR MINING PROJECTS
5. Infrastructure: water/power supplies and service avail-
abilities, transport facilities, maintenance workshops, labor
housing.
6. Construction: realistic scheduling allowing for weather,
terrain, personnel requirements, infrastructure needs, labor
agreements.
7. Environment: studies, reports, approvals needed. Limita-
tions and controls affecting: air, water, solid and liquid waste,
land, noise, ecology, power, hospitals, schools, roads, community
services.
2.5.8.2 Products and Markets
1. Customer buying considerations: spot or term contracts,
price—negotiated,tied to other factors such as cost escalators,
f.o.b., c.i.f., exchange rate fluctuations and adjustments, volume
minimums and maximums, quality premiums and penalties,
chances to sell upgraded products, service, engineering, credit,
transport.
2. Customers: number and size, location and growth pros-
pects, relationships with other suppliers.
3. Past and prospective price and volume patterns through a
complete economic cycle for domestic and world product market
served. Usage changes due to obsolescence, use of competitive
materials, technological innovation.
4. Competition: existing and potential.
a. Who are they? What are their strategies for the future?
b. Current capacity utilization and planned expansions.
c. Price discipline, price leaders, relationship of price and
inventory levels, use of contracts, terms and conditions.
d. Cost curve for the industry—compare to prior and
projected prices.
e. Project strengths and weaknesses vs. competition.
5. Government regulations on export, approvals, tariffs.
6. Potential product liability.
2.5.8.3 Operating Considerations
1. Management: experience, responsibilities and pay of key
people.
2. Labor: skills, availability (now and in the future), union
considerations including strikes, prior work practices, pay, in-
centive compensation, production bonuses.
3. Machinery and equipment: operating availability and
costs, flexibility to expand capacity, technical and economic ob-
solescence.
4. Materials: availability, lead times, cost volatility, purchas-
ing practices.
5. Health, safety, security, and employee rights.
6. Maintenance: onsite vs. offsite workshop, availability of
special parts and skilled labor, scheduling.
7. Inventory: amounts and locations, on-site and/or at sup-
pliers.
8. Industry norms: reasons for under/over performance,
programs to enhance, maintain or upgrade vs. norms.
9. Environment: studies, reports, approvals needed. Limita-
tions and controls affecting air, water, solid and liquid waste;
101
land; noise; ecology; power; and hospitals, schools, roads, and
community services.
10. Equal opportunity employment.
2.5.8.4 Financial Considerations
1. Capital availability: sources, currencies, cost, terms,
conditions. Need for refinancings.
2. Capital tied up in assets such as in accounts receivable
and inventory, investment in facilities where services can be
supplied by others.
3. Repayments: schedules, formula and interrelation with
price, volume and margins.
4. Interest rates: variability and protective options.
5. Fees: front-end and continuing.
6. Taxes: land, use, income, royalties, special, direct, in-
direct.
7. Insurance: costs and coverage.
8. Leases: terms, and conditions on operating and financial
leases.
9. Employee costs (other than wages): medical, dental, pen-
sions and other contractual benefits, funding assumptions and
requirements.
10. Foreign exchange: availability, quotes, special transac-
tions.
11. Inflation: inclusion in capital and operating costs.
12. Capital additions and replacements.
13. Cost of outside services, travel, and home office.
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