The economic evaluation process of a mineral asset
The economic evaluation process of a mineral asset
Ashton Lombardo, with support from Sherif Andrawes and Adam Myers, Partners in BDO’s deal advisory team, has authored a chapter in the latest Study Handbook by the Australasian Institute of Mining and Metallurgy (AusIMM).
The AusIMM Study Handbook, designed for industry practitioners and decision-makers, provides a framework to guide the process of natural resource project studies. It outlines the steps and technical requirements for each study phase.
The chapter, Economic Evaluation, focuses on the role of financial models in evaluating whether a mineral asset is economic. It highlights the characteristics of effective models and the necessity of these tools as a solid foundation for decision-making and financial planning across each stage of a project lifecycle.
The importance of effective financial models
An effective financial model creates a structured approach to evaluating the economic viability of a mining project. These models assess a project's potential profitability by analysing various financial factors such as capital expenditures, operating costs, revenue projections, and, more broadly, its ability to generate sufficient cash flow. Financial models enable stakeholders (such as Boards and Management Teams) to make informed decisions about whether to proceed with a project, determine which scenario for a project is considered optimal, or seek financing.
Financial models also offer a systematic way to evaluate different scenarios throughout the lifecycle of a resource asset and the potential impact of these scenarios on a project’s financial performance. For example, a financial model can help determine the sensitivity of a project’s profitability to changes in commodity prices, production rates, or operating costs. This allows organisations to identify potential risks and develop strategies to mitigate these risks.
They are also an essential step for securing financing for a mineral asset. Investors and the market rely on these models to assess a project's financial viability and determine the level of risk involved.
The characteristics of effective financial models
An effective financial model is characterised by its simplicity, transparency, flexibility, and adaptability.
- Simplicity: A simple financial model is easier to understand and use, making it accessible to a broader audience. Avoiding overly complex formulas and calculations reduces the likelihood of errors, as more complex models can be challenging to verify.
- Transparency: This is essential for building trust across all stakeholders. A transparent model provides clear audit trails, allowing users to trace the origins of inputs and assumptions. This makes it easier to verify the accuracy of the financial model and ensures all stakeholders have a clear understanding of how the model works.
- Flexibility: A flexible financial model can accommodate changes in inputs and assumptions without requiring significant modifications. This can be useful for mining projects that often face uncertainties and changing conditions. A flexible model allows project managers to update their analyses easily and quickly to make informed decisions based on the latest information.
- Adaptability: An adaptable financial model can be used across different types of projects and scenarios. This is particularly important in the mining industry, where projects can vary significantly in terms of scale, complexity and risk. An adaptable model can be customised to suit the specific needs of each project, making it a valuable tool for the organisation and investors.
Creating a reliable and error-free financial model
A reliable financial model should be built with supportable inputs. Supportable inputs are based on credible sources and can be verified. These inputs could include data on commodity prices, production rates, operating costs, and other key financial parameters. Ensuring that the supportable inputs are organised and accessible is crucial for maintaining the accuracy and credibility of the model.
Error-free models are essential for maintaining the integrity of financial analyses. Errors in a financial model can lead to incorrect conclusions and potentially costly mistakes. To minimise the risk of errors, it is important to follow best practices for model construction, such as using consistent formatting, avoiding hard-coded values, and conducting thorough audits and reviews.
Additionally, financial models should be designed to withstand due diligence. A model's structure and assumptions should be robust enough to hold up under scrutiny from external parties, such as lenders, investors, and regulatory authorities. A well-constructed financial model can provide confidence to stakeholders and facilitate the due diligence process.
Overview of factors to consider when modelling a mining project for a scoping study, pre-feasibility study or feasibility study
Pricing assumptions
The discounted cash flow valuation of a mining project is often most sensitive to forecast commodity prices and exchange rates, as these drive the revenue line. Users of financial models should ensure a reasonable basis for these forecast inputs to a model but be mindful of the risks of relying on historical or broker consensus pricing.
Among other risks and challenges explored further in the full chapter, these pricing inputs can often be subject to significant bias, the commodity may not be homogeneous, and/or there may not be a deep spot market for trading in a particular commodity.
Economics of selling the commodity
A mining study should consider the economics of the commodity, including supply and demand drivers and the end user of the commodity. The chapter sets out a number of questions that should be considered during the preparation of a study, including but not limited to:
- Will the commodity be exported or used domestically?
- Has shipping and freight costs been considered? (where relevant)
- Will the supply of the commodity be contracted? i.e. through an offtake, etc.
- Will there be penalties payable to the buyer for quality issues?
- Are there royalties payable on production?
The above questions should be considered part of the study process, and where relevant, the financial model should reflect the answers to these questions.
Incorporating the requirements of project financiers
It is important to consider the requirements of project financiers when building a financial model, whether it be for a scoping study, a feasibility study, or anywhere in between. Most mining projects will require external funding. Therefore, the chapter explores best practice modelling tips for ensuring a model is fit for purpose for project financiers.
In addition to best practice modelling, the chapter explores a number of ratios that are typically considered by financiers, including:
- Gross leverage ratio
- Interest cover ratio
- Net gearing ratio
- Reserve tail ratio.
The project financier will often require a financial model review from an independent third party, with the scope often determined to provide the financier with comfort over the reasonableness of the model inputs, the mathematical accuracy and the structural integrity of the model.
Taxation
Taxes tend to be oversimplified or ignored in modelling for mining projects. When preparing a mining model, the builder should consider the project's tax jurisdiction, expected tax rates over the project's life, and whether it would be appropriate to model tax losses and/or any withholding taxes on the repatriation of profits to another country.
The role of the economic evaluation process
Effective financial models are vital tools for the economic evaluation of mining projects. They provide a structured approach to assessing the financial viability of projects, enabling stakeholders to make informed decisions. By following best practices for financial modelling, organisations can ensure that their models are reliable and robust, ultimately contributing to the success of mining projects.
The full chapter, Economic Evaluation, in the AusIMM Study Handbook offers detailed insights into the practical aspects of financial modelling, providing valuable guidance on building effective models that can withstand scrutiny and support informed decision-making.
BDO’s natural resources experts have deep industry experience and global resources to support clients in navigating the complexities of the natural resources industry. If you would like to learn more, contact Ashton Lombardo.