Difference between revisions of "Project economics"

Revision as of 21:55, 10 February 2011

A critical issue relevant to a mining operation is project economics. It is not restricted to the scope of a mining operation and may be used to determine whether such actions such as replacing equipment or lining a shaft to save on operating costs is viable.

Project economics considers the Net Present Value (NPV) of an operation as a benchmark for determining the value of an asset to the project. In order to calculate the benefit of project economics, the project manager must know the operating cost, the availability, the capital cost, the UCC (Undepreciated Capital Cost), the method of depreciation, the scrap value (or salvage value) and the expected life of each asset involved.

Introduction

The easiest way to keep track of your project's economics is with a spreadsheet. An example of this record-keeping method can be found here: File:Project Economics.xls. To use this spreadsheet, enter known values into the outlined boxes at the top and the calculations will be performed automatically.

In order to understand how this spreadsheet works, the following sections outline the calculations performed. Using this method, you can adapt the spreadsheet to include other things such as UCC or Avoided Costs, where applicable.

Cash Flow

A calculation of cash flow will determine whether the value of your project is greater than the cost of the resources which have been consumed. A cash flow can be found over any period, but is often calculated every six months, annually or over the life of a project. Since taxes are deducted annually in most countries, cash flows are often calculated annually when determining the NPV of the project.

The project is determined to be commercial, or financially attractive if the Value terms (such as Revenue or Avoided Costs) are found to be greater than the Consumption costs (such as capital costs, operating costs, taxes, etc.) in which case the project is financially viable, or:

Cash Flow After Taxation

After taxation has been calculated, the tax saved is added to the cash flow in order to determine the cash flow after taxation. This value will be used in the present value calculations.

Depreciation

Depreciation is a term used to spread the cost of a asset across several years for taxation purposes. This will reduce the annual taxation costs levied against the project until the end of the depreciation schedule. Depreciation is typically calculated straight-line, which means that a fixed percent value is used annually to determine the depreciation claim.

In order to find the value of a depreciation claim using the straight-line method, first determine the scrap value of the asset at the end of the project's life. The value of the asset may reach zero (or become negative), in which case a separate analysis may be conducted to determine whether or not it is worth it to replace the asset.

Straight-Line Method

It may be easier to determine the original value of the asset, then keep track of the depreciation available. The depreciation available is the original value minus the depreciation claim annually. For example, a haul truck which initially costed $750'000 is depreciated at 20% straight-line. The haul truck is bought in Year 0 and there is $750'000 depreciation available. This example is continued in the chart below:

It is important to note that there is a maximum amount which can be depreciated in many jurisdictions. In Canada, the limit is defined by the Canadian Revenue Agency (CRA). The limit on machinery such as an LHD is 30% per annum using the Classes of Depreciable Property guidelines.

Taxation

With reference to project economics, taxation often has a positive effect on NPV but this is not always the case. In order to calculate the taxable income, the operating cost, depreciation claim, UCC and any other taxable costs are subtracted from revenue (often 0 in the case of an asset) and the salvage value of the asset. The taxable income is multiplied by the tax rate to find the tax saved. The tax saved will be a credit to the cash flow of the project.

Inflation

Inflation causes the average prices of goods to rise, and as a result the cost of a project may increase over the life of project. Inflation is not often a consideration in project economics because values are often determined at the start of the project life; inflation may be a consideration in a progress report later on in the project life. First determine the inflation rate each year from the start of the project life, this can found at any national bank website such as the Bank of Canada. Use the first year of project life as the default basket value and set it to a value of 100, then set further years at their indexed inflation values. So if inflation where 7% in year 2 and 5% in year 3, then the basket value is 107 in year 2 and 112.35 in year 3. These index values can be used to determine costs in each year in year 1 dollars, which can be used to determine if the project is on track financially.

Present Value Calculation

Present value is a determination of the worth of the asset to the company at any period in time. The present value of a project is often negative in year 1 due to capital costs with the goal to create a positive present value. The value often becomes positive due to a lower operating cost, higher availability or due to higher efficiency.

Where CF is the cash flow at year t, and i is the interest rate. This value is calculated for each year of the project life then is eventually summed in order to find the NPV.

Applications

Applications of project economics are broad and involve any kind of financial optimization problem in the mining industry. The NPV of an existing asset could be compared to a the NPV of purchasing a new one with a lower operating cost to determine whether or not it is worth upgrading to the new asset. This can be applied to the concept of lining a shaft where the NPV of the unlined shaft is compared to the NPV of lining the shaft, where the operating cost of the unlined shaft is higher but lining the shaft entails a steep capital cost per area of the shaft.

References

1. Ragan, Christopher and Lipsey, Richard (2008). Microeconomics, Twelfth Canadian Edition. p.364 2. Classes of Depreciable Property