Garbage in — Garbage out

Consider the opportunity to invest in one of two mine development projects. Both are gold mines in northern Ontario, both have the same grade, the same reserves and the same operating conditions. The results from economic evaluations for each show the following:

ECONOMIC EVALUATIONS

DCF ROR 10% NPV CASH FLOW

% $MM $MM

PROJECT A 10.0 0.0 84.0

PROJECT B 52.4 58.4 159.4

On the surface, the results would appear to favor Project b, but a closer examination would reveal that Projects a and b are, in fact, the same project. The technical data are the same in both cases. How, then, can one project appear to be so much better than the other? How do the evaluations differ? What does this mean to the potential investor?

Everyone likes to put his best foot forward, and a project owner is no different. That is what the owner of Project B does. The owner has used its economic assumptions to show the project in the best light. In this regard, it has taken advantage of an increasing tendency for project investors to look only at the Discounted Cash Flow Rate of Return (DCF ROR) and the Net Present Value (NPV) of a project. Used in conjunction with annual cash projections, the DCF ROR and NPV are powerful means of comparing, ranking and selecting investment opportunities. Used in isolation, however, they are potentially misleading.

TABLE 1

PROJECT `A’ BECOMES PROJECT `B’

DCF 10% CASH

ROR NPV FLOW

PROJECT `A’ % $MM $MM

Simple tax calculation 10.0 0 84.0

Accelerated tax depreciation

100% CCA in tax calculation 12.3 8.5 84.0

Exchange Rate

1% better on Cdn. dollar 12.7 10.3 87.8

Inflation

4% on all costs and revenues 16.6 29.6 143.9

Differential inflation

Price inflation 1% higher than costs 19.0 44.1 186.9

Bank loan 70% debt

Repaid ASAP 23.8 46.4 176.6

Repaid over 15 years 32.3 52.1 160.3

Gold Loan $10 million

Repaid ASAP 36.6 53.2 160.0

Repaid over 10 years 41.1 55.0 159.4

Used Equipment

5% reduction in capital 48.7 57.6 161.4

Start-up

Full production in Year 1 52.4 58.4 159.5

instead of Year 2

The best starting point for any project evaluation is to gather all the basic, known facts into a year-by-year cash flow, free of any extraneous items such as inflation, debt, and taxes. This obliges one to place the data in order, fill in the missing spots, and generally “get it down on paper.” This is what Project A is. The annual cash flow for Project A is shown in Figure 1.

The costs and revenues are in constant dollars in each year of the project. The values are readily recognized and easily checked. No long-term projections of price or inflation are required. The project is financed entirely from equity, with no consideration of debt ratios, interest rates or repayment schedules. The project is calculated on a project, or stand-alone, basis. No consideration is given to the possible tax effects of a larger corporate structure, flow-through shares or large tax pools.

However, while this case appears to avoid the need to make assumptions, it should be understood that it involves just as many assumptions as any other case. For example, the choice of no inflation is a selection of alternatives just as much as, say, 5% inflation is. Nevertheless, the resulting evaluation is effectively free of the economic, corporate, and financial considerations that can cloud the real viability of a project. Furthermore, it is always possible to present any other project in the same way, so that projects can be compared on an equal basis.

So how does Project a differ from Project B? How do you get from one result to the other? It is done with a little creative accounting and the judicious application of everyday economic assumptions. The step-by-step process is shown in Table 1. Let me stress that there are no changes in the project’s technical data. The transformation is achieved with a series of incremental assumptions, each in itself apparently small and benign. It should also be pointed out that any of these assumptions can be found in full feasibility studies submitted to banks and security commissions. All the more reason to understand how they work, as you will see them all around you.

Eight Criteria

* Accelerated Tax Depreciation — Taxes in Project a are calculated with a simple, straight-line depreciation, but tax legislation allows certain assets to be written off at an accelerated rate. This increases the DCF ROR to 12.3%.

* Exchange Rate — Since the project is in Canada and gold is quoted in U.S. dollars, it is an easily supported assumption that there will be a more favorable exchange rate during the project life. A 1% advantage over the original exchange rate increases the DCF ROR to 12.7%.

* Inflation — Inflation is a fact of life today, and it is easily argued that it should be included in an evaluation. Broadly speaking, a 1% increase in inflation will add 1% to the DCF ROR. In Project B, both costs and price are assumed to have a 4% inflation rate throughout the project life. This increases the DCF ROR to 16.6%.

* Differential Inflation — The power of compounded annual rates can be seen if one assumes that price will increase at a higher inflation rate than costs. At a 1% per year inflation differential, the DCF ROR increases to 19%.

* Bank Loan — It is seldom the case that a project is financed entirely from equity. A ratio of 30% equity to 70% debt is not unusual. If the debt is repaid as rapidly as cash flow permits, the DCF ROR increases to 23.8%. If the debt can be repaid over a longer period (say 15 years), the DCF ROR increases to 32.3%.

* Gold Loan — A gold loan is much like a second, low-interest, bank loan in terms of its impact on the DCF ROR. A $10-million gold loan repaid as rapidly as possible increases the DCF ROR to 36.6%. If it can be repaid over 10 years, the DCF ROR increases to 41.1%.

* Used Equipment — If the capital budget is too tight, someone is bound to suggest that used equipment be purchased for some items. If capital costs can be reduced 5% by purchasing used equipment, the DCF ROR rises to 48.7%.

* Start-up — It is often argued that a mine and plant are so simple to operate that full production will be achieved in the first year of operation instead of the second year (as assumed in Project A). Achieving full production in the first year increases the DCF ROR to 52.4%.

So using eight criteria (with none stretched to its full potential), it is possible to show the original gold project as a 52.4% DCF ROR prospect. And there are even more avenues to explore if flow-through shares, corporate tax pools and government grants are available. The annual cash flow for Project b is shown in Figure 2.

Now that we have looked at the bright side, what happens if not all these assumptions come about? What happens if some of them work against you? Consider the following list of problems:

— The exchange rate moves 2% in the wrong direction.

— The real growth in prices is 1% less than inflation.

— The bank insists on its debt being repaid in seven years.

— The gold loan is only $5 million.

— The gold loan must be repaid as soon as possible.

— Capital costs are over budget by 5%.

— Full production is not achieved until Year 2.

Do any of them sound familiar? They have the effect of bringing the 52.4% Project b down to a 15.5% DCF ROR, and if debt and inflation are removed from the evaluation, the DCF ROR is only 8.3%. The point is that the assumptions do not always work in a positive direction. Certainly, they won’t all work in a positive direction at the same time, and the consequence of this should be examined and understood. Each one of these reverses from the “optimized” case is not only reasonable — some might even be expected. Stripped of the embellishments and with inflation removed, Figure 3 shows an ever-diminishing real margin and a project that would not be attractive.

The purpose of this paper is to show that it is possible to make a project appear to have an amazing range of DCF RORs or NPVs, even though the technical details of the project (the facts which can be checked and confirmed) are not altered. Only the assumptions relating to the economic factors need to be changed, and these assumptions are often a matter of interpretation and opinion that are difficult to refute. The project investor, the owner and the executive are all confronted with project evaluations every day. It is hoped that these examples have illustrated the kind of assumptions that can make a project appear to be “too good to be true,” and has provided a checklist of some significant items to look for in an evaluation.

How then should a project be evaluated? Is there a right method to use? The answer is no, there is no right method, only the method that is right for you. The main thing is to ensure that all alternative investment opportunities are evaluated in the same way, with the same criteria. While I would suggest that a Base Case without debt or inflation be calculated as a starting point, the final assumptions for the evaluation will depend on how you perceive the economic environment in which a project exists. Watch your assumptions and don’t mislead yourself.