`Internal rate of return’ one guideline for investment

Then comes the interesting part * * * an estimate will be made of what the annual revenue from a mine will be during production to pay for preproduction capital costs.

This requires a forecast of what metal prices are going to be five or six years in the future, when the mine is finally in production. This is difficult, to say the least. People who invest in commodity markets have a very tough time forecasting what metal prices will be for the next few months, let alone a few years into the future.

To allow for some of these unknown factors, a “sensitivity study” will be carried out. The kinds of questions that are asked in this study are:

— What will happen if metal prices drop by 20% from that assumed in the basic plan? Or by 30%, or by 40%?

— What will happen if the tonnage mined turns out to be lower than that assumed to be present?

— How disastrous will it be if the grade of the ore drops below that assumed in the basic study? If the answers to all these questions are sufficiently reassuring, investors and banks will be found who are prep ared to put their money at risk in return for a greater than average “return on their investment.” How is this measured?

One simple way is to see how many years of net annual revenue (i.e. after operating costs have been deducted) it will take to repay the preproduction capital costs, plus interest. This is known as the “payback” and the shorter it is the better.

A more sophisticated way is to look at the profit that will be accumulated over the lifetime of the operation. If an investor is looking for an interest rate of say, 18%, then it is possible to calculate how much money they would have to invest today at 18% compound interest to end up with the same amount as the accumulated net profit from the mine at the end of its operation. This number is known as the “Net Present Value at 18%” and gives the investor a feeling for how much he should be asked to put at risk.

You will probably realize that as the interest rate is increased, so the “net present value” gets smaller. There will be a unique interest rate at which the net present value drops to zero; this is known as the “Internal Rate of Return” for the project. This is one of the most commonly used yardsticks by which to measure whether a production investment should be made.

Some companies have “rules of thumb” whereby they will never go ahead with a project that has an Internal Rate of Return of less than, say, 16%. If the project involves a metal with a very volatile price action, or if the mine is situated in a particularly unstable part of the world, then they would probably require an Internal Rate of Return of at least 25% to 30%. In the case of a high political risk they would also favor investments which have a quick “payback”]

I hope this brief overview will show you that actually discovering the ore deposit is less than half of the battle. Doing enough studies to convince investors of the viability of the deposit, and then getting all the preproduction work completed, is a time-consuming and costly process.

From the book Gold and Other Metals: How They are Found and Mined by John Gammon, director of the Ontario government’s mineral development and lands branch of the ministry of northern development and mines. Available in Canada through MSS Ltd., 2052 Pen St., Oakville, Ont. L6H 3L3.