Topic 4 : ECONOMICS OF SURFACE MINING

Week No. : Week 10-11

No. of Hours : 6 hours

Topic Intended Learning Outcome

At the end of this topic, the student must:

• Solve problems in mine economics;

• Understand the fundamental concepts related to surface mine economics; and

Required Course Materials

CMO No. 99, s. 2017

4.1 Introduction

For one to know whether the material under consideration is 'ore' or simply 'mineralized rock',
both the revenues and the costs must be examined. It is the main objective of this chapter to
explore in some detail each of these topics.

4.1 Future Worth

If someone puts $1 in a savings account today at a bank paying 10% simple interest, at the end
of year 1 the depositor would have $1.10 in his account. This can be written as
FW = PV(1 + i)
where FW is the future worth, PV is the present value, i is the interest rate.

If the money is left in the account, the entire amount (principal plus interest) would draw interest.
At the end of year 2, the account would contain $1.21. This is calculated using
FW = PV(1+i) (1+i)
At the end of year n, the accumulated amount would be
FW = PV(1+i)n
In this case if n = 5 years, then
FW = $1(1+0.10)n = $1.61
4.2 Present Value
The future worth calculation procedure can now be reversed by asking the question 'What is the
present value of $1.61 deposited in the bank 5 years hence assuming an interest rate of 10%?'
The formula is rewritten in the form
𝐹𝑊
𝑃𝑉 =
(1 + 𝑖)𝑛
Substituting FW = $1.61, i = 0.10, and n = 5 one finds as expected that the present value is
$ 1.61
𝑃𝑉 = = $1
(1 + 0.10)5
4.3 Present value of a series of uniform contributions

Assume that $1 is to be deposited in the bank at the end of 5 consecutive years. Assuming an
interest rate of 10%, one can calculate the present value of each of these payments. These
individual present values can then be summed to get the total.

Year 1: Payment
$1
𝑃𝑉1 = = $0.909
(1.10)1
Year 2: Payment
$1
𝑃𝑉2 = = $0.826
(1.10)2
Year 3: Payment
$1
𝑃𝑉3 = = $0.751
(1.10)3
Year 4: Payment
$1
𝑃𝑉4 = = $0.683
(1.10)4
Year 5: Payment
$1
𝑃𝑉5 = = $0.621
(1.10)5
The present value of these 5 payments is
𝑃𝑉 = $3.790

The general formula for calculating the present value of such equal yearly payments is
 (1 + 𝑖)𝑛 − 1
𝑃𝑉 = 𝐹𝑊 [ ]
𝑖(1 + 𝑖)𝑛

Applying the formula in this case yields

(1.10)5 − 1
𝑃𝑉 = $1 [ ] = $3.791
(0.10)(1.10)5

The difference in the results is due to roundoff.

4.4 Payback Period

Assume that $5 is borrowed from the bank today (time = 0) to purchase a piece of equipment and
that a 10% interest rate applies. It is intended to repay the loan in equal yearly payments of $1.
The question is 'How long will it take to repay the loan?' This is called the payback period. The
present value of the loan is

PV (loan) = -$5

The present value of the payments is

(1.10)𝑛 − 1
𝑃𝑉 (𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠) = $1 [ ]
(0.10)(1.10)𝑛

The loan has been repaid when the net present value

Net present value (NPV) = PV (loan) + PV (payments)

Is equal to zero. In this case, one substitutes different values of n into the formula
(1.10)𝑛 − 1
𝑁𝑃𝑉 = −$5 + $1 [ ]
(0.10)(1.10)𝑛
For n = 5 years NPV = -$1.209; for n = 6 years NPV = -$0.645; for n = 7 years NPV = -$0.132; for
n = 8 years NPV = $0.335.
Thus the payback period would be slightly more than 7 years (n ≈ 7.25 years).
4.5 Rate of Return on an Investment

Assume that $1 is invested in a piece of equipment at time = 0. After tax profits of $1 will be
generated through its use for each of the next 10 years. If the $5 had been placed in a bank at an
interest rate of i then its value at the end of 10 years would have been using Equation (4.2).

FW = PV(1+i)n = $5 (1+ i)10

The future worth (at the end of 10 years) of the yearly $1 after tax profits is
(1 + 𝑖)𝑛 − 1
𝐹𝑊 = 𝐴𝑚 [ ]
𝑖
where Am is the annual amount and [(1 + i)n – 1]/i is the uniform series compound amount factor.

The interest rate i which makes the future worths equal is equal the rate of return (ROR) on the
investment.
In this case
(1 + 𝑖)10 − 1
$5(1 + 𝑖)10 = $1 [ ]
𝑖
Solving for i one finds that
i ≈ 0.15

The rate of return is therefore 15%. One can similarly find the interest rate which makes the net
present value of the payments and the investment equal to zero at time t = 0.
(1.10)10 − 1
𝑁𝑃𝑉 = −$5 + $1 [ ]=0
𝑖 (1 + 𝑖 )10
i ≈ 0.15

The answer is the same.

The process of bringing the future payments back to time zero is called ‘discounting’.

4.6 Cash Flow (CF)

The term 'cash flow' refers to the net inflow or outflow of money that occurs during a specific time
period. The representation using the word equation written vertically for an elementary cash flow
calculation is
Gross Revenue
-Operating Expense
=Gross Profit (taxable income)
-Tax
=Net Profit
-Capital Costs_____________
= Cash Flow
A simple example (after Stermole & Stermole, 1897) is given in the table below.
In this case there is a capital expense of $200 incurred at time t = 0 and another $100 at the
end of the first year. There are positive cash flows for years 2 through 6.
Year 0 1 2 3 4 5 6
Revenue 170 200 230 260 290
-Operating Cost -40 -50 -60 -70 -80
-Capital Costs -200 -100
-Tax Costs -30 -40 -50 -60 -70
Project Cash Flow -200 -100 +100 +110 +120 +130 +140

4.7 Discounted Cash Flow (DCF)

To 'discount' is generally used synonymously with 'to find the present value'. In the previous
example, one can calculate the present values of each of the individual cash flows. The net
present value assuming a minimum acceptable discount rate of 15% is

𝑌𝑒𝑎𝑟 0 𝑁𝑃𝑉0 = −200 = −200.00

−100
𝑌𝑒𝑎𝑟 1 𝑁𝑃𝑉1 = = −86.96
1.15
100
𝑌𝑒𝑎𝑟 2 𝑁𝑃𝑉2 = = 75.61
(1.15)2
110
𝑌𝑒𝑎𝑟 3 𝑁𝑃𝑉3 = = 73.33
(1.15)3
120
𝑌𝑒𝑎𝑟 4 𝑁𝑃𝑉4 = = 68.61
(1.15)4
130
𝑌𝑒𝑎𝑟 5 𝑁𝑃𝑉5 = = 64.63
(1.15)5
 140
𝑌𝑒𝑎𝑟 6 𝑁𝑃𝑉6 = = 60.53
(1.15)6
̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅̅
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 = $55.75

The summed cash flows equal $55.75. This represents the additional capital expense that could
be incurred in year 0 and still achieve a minimum rate of return of 15% on the invested capital.

4.8 Discounted Cash Flow Rate of Return (DCFROR)

To calculate the net present value, a discount rate had to be assumed. One can however calculate
the discount rate which makes the net present value equal to zero. This is called the discounted
cash flow rate of return (DCFROR) or the internal rate of return (ROR). The terms DCFROR or
simply ROR will be used interchangeably in this book. For the example given in section 4.6, the
NPV equation is
100 100 110 120 130 140
𝑁𝑃𝑉 = −200 − + + + + + =0
1 + 𝑖 (1 + 𝑖 )2 (1 + 𝑖)3 (1 + 𝑖)4 (1 + 𝑖)5 (1 + 𝑖)6

Solving for i one finds that

i ≈ 0.208
In words, the after tax rate of return on this investment is 20.8%

4.9 Cash Flows, DCF and DCFROR including depreciation

The cash flow calculation is modified in the following way when a capital investment is depreciated
over a certain time period.

Gross Revenue
-Operating Expense
-Depreciation
=Taxable Income
-Tax
=Profit
+Depreciation
-Capital Costs
 = Cash Flow

In this manual no attempt will be made to discuss the various techniques for depreciating a capital
asset. For this example it will be assumed that the investment (Inv) has a Y year life with zero
salvage value. Standard straight line depreciation yields a yearly depreciation value (Dep) of

𝐼𝑛𝑣
𝐷𝑒𝑝 =
𝑌
The procedure will be illustrated using the example adapted from Stermole & Stermole (1987).

Example. A $100 investment cost has been incurred at time t = 0 as part of a project having a 5
year lifetime. The salvage value is zero. Project dollar income is estimated to be $80 in year 1,
$84 in year 2, $88 in year 3, $92 in year 4, and $96 in year 5. Operating expenses are estimated
to be $30 in year 1, $32 in year 2, $34 in year 3, $36 in year 4, and $38 in year 5. The effective
income tax rate is 32%.

The cash flows are shown in table shown below.

The net present value (NPV) of these cash flows assuming a discount rate of 15% is $43.29
40.4 41.8 43.1 44.5 45.8
𝑁𝑃𝑉 = −100 − + 2 + 3 + 4 + = $43.29
1.15 (1.15 ) (1.15) (1.15) (1.15)5
Year 0 1 2 3 4 5 Cumulative
Revenue 80.0 84.0 88.0 92.0 96.0 440.0
-Operating Cost =30.0 =32.0 =34.0 -36.0 -38.0 -170.0
-Depreciation -20.0 -20.0 -20.0 -20 -20 -100.0
=Taxable 30.0 32.0 34.0 36.0 38.0 170.0
- Tax @ 32% -9.6 -10.2 -10.9 -11.5 -12.2 -54.4
= Net Income 20.4 21.8 23.1 24.5 25.8 115.6
+ Depreciation 20.0 20.0 20.0 20.0 20.0 100.0
- Capital Costs -100.0 - - - - - -100.0
Cash Flow -100.0 40.4 41.8 43.1 44.5 45.8 115.6

The DCFROR is the discount rate which makes the net present value equal to zero. In this case
40.4 41.8 43.1 44.5 45.8
𝑁𝑃𝑉 = −100 − + + + + =0
1 + 𝑖 (1 + 𝑖 )2 (1 + 𝑖)3 (1 + 𝑖)4 (1 + 𝑖)5
The value of i is about
i ≈ 0.315
4.10 Depletion

In the U.S. special tax consideration is given to the owner of a mineral deposit which is extracted
(depleted) over the production life. One might consider the value of the deposit to 'depreciate'
much the same way as any other capital investment. Instead of 'depreciation', the process is
called 'depletion'. The two methods for computing depletion are:
• Cost Depletion
• Percentage Depletion
Each year both methods are applied and that which yields the greatest tax deduction is chosen.
The method chosen can vary from year to year. For most mining operations, percentage depletion
normally results in the greatest deduction.

To apply the cost depletion method, one must first establish the cost depletion basis. The initial
cost basis would normally include:
• the cost of acquiring the property including abstract and attorney fees.
• exploration costs, geological and geophysical survey costs.

To illustrate the principle, assume that this is $10. Assume also that there are 100 tons of reserves
and the yearly production is 10 tons. The $10 cost must then be written off over the 100 total tons.
For the calculation of cost depletion the cost basis at the end of any year (not adjusted by the
current years depletion) is divided by the estimated remaining ore reserve units plus the amount
of ore removed during the year. This gives the unit depletion. In this simple case, for year 1
$10
𝑈𝑛𝑖𝑡 𝑑𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 = = $0.10
100
The unit depletion is then multiplied by the amount of ore extracted during the year to arrive at
the depletion deduction,
𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 = 10 𝑡𝑜𝑛𝑠 𝑥 $0.10 = $1
The new depletion cost basis is the original cost basis minus the depletion to date. Thus for the
year 2 calculation:
𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡 𝑏𝑎𝑠𝑖𝑠 = $10 − $1 = $9
𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑟𝑒𝑠𝑒𝑟𝑣𝑒𝑠 = 90 𝑡𝑜𝑛𝑠
The year 2 unit depletion and depletion deduction are:
$9
𝑈𝑛𝑖𝑡 𝑑𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 = = $0.10
90
𝐷𝑒𝑝𝑙𝑒𝑡𝑖𝑜𝑛 𝑑𝑒𝑑𝑢𝑐𝑡𝑖𝑜𝑛 = 10 𝑥 $0.10 = $1

Once the initial cost of the property has been recovered, the cost depletion basis is zero.
Obviously, the cost depletion deduction will remain zero for all succeeding years.

4.11 Cash Flows, Including Depletion

As indicated the depletion allowance works exactly the same way in a cash flow calculation as
depreciation. With depletion the cash flow becomes:

Gross Revenue
-Operating Expense
-Depreciation
-Depletion
-Taxable Income
-Tax
=Profit
+Depreciation
+Depletion
-Capital Costs
=Cash Flow

The following simplified example adapted from Stermole & Stermole (1987) illustrates the
inclusion of depletion in a cash flow calculation.

Example. A mining operation has an annual sales revenue of $1,500,000 from a silver ore.
Operating costs are $700,000, the allowable depreciation is $100,000 and the applicable tax rate
is 32%. The cost depletion basis is zero. The cash flow is:

(1) Preliminary. Calculation without depletion.

Gross Revenue $1,500,00
-Operating Expense - 700,000
-Depreciation - 100, 000
=Taxable income before depletion $700,000
(2) Depletion Calculation. Since the depletion basis is zero, percentage depletion is the
only one to be considered One must then choose the smaller of:
(a) 50% of the taxable income before depletion and carry-forward-losses
(b) 15% of the gross revenue

In this case the values are:

(a) 0.50 x $700,000 = $350,000
(b) 0.15 x $1,500,000 = $225,000
Hence the depletion allowance is $225,00.
(3) Cash Flow Calculation

Gross Revenue $1,500,000

-Operating Expense - 700,000
-Depreciation - 100,000
-Depletion - 225,000
=Taxable Income $475,000
-Tax @ 32% - 152,000
=Profit $323,000
+Depreciation + 100,000
+Depletion + 225,000
=Cash Flow $648,000