Discussion - Determination Of The Optimum Lifetime Of A Mining Project Using Discounted Cash Flow And Option Pricing Techniques - Cavender, B.

Discussion by G. Le Bel The paper proposes three methods to determine optimum lifetime of a mining project 1. The conclusion is that the three methods arrive at the same optimum production rate (by coincidence). It is also stated that: "The stochastic and option pricing models, in addition to providing a more realistic optimum mine life than the traditional NPV (net present value) calculation, showed that the example project has the potential for substantially higher return. By explicitly considering a project's potential risks, the stochastic or option pricing techniques can more accurately describe its probable investment performance." This discussion is intended to demonstrate that: •It is no coincidence that the three methods arrive at the same optimum production rate. • The stochastic and option pricing models do not provide a more realistic optimum mine life than the traditional NPV calculation. •The potential for a substantially higher return is misrepresented. First, a review of investment decision theory in mining is needed. Net present value is the preferred performance measure because of the flexibility offered when comparing various alternatives. However, it presents the following disadvantages: • The discount rate selection is not straightforward. • The NPV obtained represents a deterministic characterization of the variables included in the cash flow calculations, i.e. a single-point estimate. Discount rate selection The opportunity cost of capital represents the rate of return that would be obtained if the capital was instead invested in other opportunities considered to exist. Such opportunities must be bypassed if the available capital is invested in the project studied 2. If these other opportunities carry risk similar to the project under analysis (for example, if they are other mining projects), there is no need to add incremental [ ] risk factors. On the other hand, if these opportunities are represented by the acquisition of government bonds yielding 7%, a risk premium factor must be included. The types of risks associated with a mining venture are shown in Table 1. Together they represent the "business risk" of being a mining company. The individual project risk is important to investors if it differs substantially from the business risk of the company and that of the other investments in mining ventures that we must pass up to invest in this particular project. A risk premium or discount would then be required. This can be illustrated by the following example. Consider that a company has two investment alternatives: one is the Cavender hypothetical project located in Nevada, and the other is the same project located in a civil war zone of central Europe. The second project requires a risk premium factor on the discount rate. Conversely, a project showing highly uncertain returns that are negatively correlated with the returns of the firm's other assets may decrease the company's corporate risk. Deterministic character of NPV calculation The cash flows used in NPV calculations are obtained from a set of variables. These variables are estimated using one parameter obtained from the engineering studies. Each parameter is thus a single value that is often termed a "realistic" or "best estimate" as opposed to "optimistic" or "pessimistic." However, considering that each variable can assume a range of values between the