Definition of Project Finance
Financial institutions use a particular type of lending known as project finance when funding a developing mining project. The loan is repaid from the cash flows generated by the project with no recourse, or only limited recourse, to the company as a whole. In non-recourse lending, no tangible assets exist until the operation is brought into production.
Clearly the lender will be exposed to all the risks associated with the project which could result in revenue being insufficient to service debt. Banks will thus always take a conservative stance when evaluating the economic viability of a project and may look to the project sponsor to provide corporate guarantees for the loan. If the sponsor is a junior company with little or no collateral, the role of government-backed guarantees becomes important.
Project finance is not readily available to junior companies with proven deposits but no operating production. These companies may instead generate funds from the equity market to bring the project to the stage of being a viable operation. Once steady cash flows have been established, debt finance then becomes both possible and attractive and is used to develop the project to its optimum potential.
Project finance is also used to develop a particular component of well established operations, such as new mining equipment, the rehabilitation of old or the sinking of new shaft systems, or upgrading of a treatment plant.
Why Project Finance?
Mining projects are capital-intensive ventures with an inherently high risk, and as such are often not deemed sufficiently creditworthy to obtain traditional financing. The project sponsors may be unwilling to carry the risks and assume the debt obligations associated with traditional financing even if it is available. Project finance is an attractive alternative as it allows the risks associated with the project to be shared with the principal lender.
The main advantage of non-recourse funding is that the sponsor has no obligation to service the debt if cash flows generated through mining operations are insufficient to cover the principal and interest payments on the loan. The lender has the security of a collateral guarantee from the sponsor and an economic completion test (ECT) if a project is being developed from the feasibility stage.
An ECT acts as a safeguard for the lender against any flaws in the feasibility study encountered during the construction phase and over the start-up period of the project. Once the project has passed the ECT then the guarantee falls away, and the only asset the bank can claim is the actual cash flow itself.
Sponsors typically seek to finance the development and construction costs of a mining project on a highly geared basis, often around 60% to 70% debt. Such financing permits the sponsor to put fewer funds at risk and develop the project without diluting its equity investment in the venture.
Project finance can also lead to reductions in the cost of capital, as lower cost, tax-deductible interest is used rather than higher cost, taxable returns on equity. Financing should be structured to maximise tax benefits and ensure that all available tax benefits are taken advantage of by the sponsor.
Project Financing Participants
The sponsor or developer of a mining project is the organising body that controls and has an equity interest in the company or other entity that owns the project. In mining projects there is often more than one sponsor, and these will normally join together under a joint-venture agreement to form a single corporation/partnership that will essentially function as the project owner.
A joint-venture agreement must be carefully drawn up with legal involvement and must clearly state the respective rights and responsibilities to the project of the parties involved.
The lender of project financing is a financial institution or group of financial institutions that provide the capital loan to the project company. Lenders are usually corporate investment banking groups, though NGO involvement in project finance is important in developing world countries. Due to the non-recourse nature of project finance, the lender takes a security interest in all of the project assets.
If the sponsor is a junior company with little or no collateral, governments may be required to provide the lender with a guarantee on the loan. This practice is particularly common in the former Soviet Union region, where formerly state-owned projects now seeking to develop in the private sector are backed by national governments in their applications for project finance.
An Introduction to Modelling Metal Project Finance – February 1, 2010
Schedule to Project Finance
The development of a project to the stage where project finance becomes viable involves going through the following stages:
- resource definition drilling of exploration target;
- preliminary feasibility study;
- further project development expenditure;
- full feasibility study; and
- information memorandum.
Preliminary Feasibility Study
Once an economic mineral resource has been identified by an exploration group, a preliminary feasibility study is undertaken by a small group of experienced professionals to determine if further expenditure on the project is justified. The foundation of the pre-feasibility study is the development of a geological model which forms the basis of the reserve estimation.
Geostatistical techniques can then be applied to determine if the deposit has been correctly sampled and provide an indication of the uncertainty associated with the estimated grade. The whole integrity of a project will be called into question if the geostatisticians have to place any qualification on the reliability of the sampling programme.
Once the geometric form and size of the deposit and the concentration of the mineral have been established, an initial design for the mine and mineral processing stages can be considered. It is particularly important that the rate of production should be on a scale which is appropriate to the size of the ore body. A mine life much in excess of 10 years does not enhance the net present value (NPV) of the project, while too short a mine life does not permit adequate return on capital.
A simple discounted cash flow analysis based on some broadly based engineering assumptions can then be set up, provided the reserve estimation is reliable. This will establish the overall financial viability of the project and allows a basic sensitivity analysis to be undertaken.
Full Feasibility Study
Most junior companies do not have the resources required to meet the high cost of generating all the data needed to undertake a full feasibility study and then fund the study itself. This phase of project development is often funded by bringing on board a major joint venture partner or by raising finance through share issues on the stock market.
Essentially, the technical component of the prospectus for a market listing on one of the senior stock exchanges involves the preparation of a pre-feasibility study. Typically, a junior company with a proven deposit will attempt to establish a production capability once equity funding has been obtained. This will provide material for a full feasibility study.
Before a mining project can proceed from the exploration and evaluation stage to full-scale production, all available data and relevant factors are compiled and evaluated as part of the full feasibility study. This should analyse every technical, financial and other aspects of the project. The major topics that are expected to be covered include:
- grade and reserve estimation;
- mining method and plan;
- mineral processing design plan and test results;
- capital costs, taxation and royalty assumptions;
- operating cost estimates;
- product price assumptions and negotiated sales contracts;
- environmental considerations and operating permits; and
- financial modelling.
Typically, a full feasibility study would involve a team of at least 10 professionals who could take up to a year to complete the task. It would be used as a blueprint when calling for tenders and awarding multi-million dollar contracts.
An information memorandum builds on the full feasibility study and results in the document required by the bank in any application for debt finance. While this document would incorporate a full technical feasibility study, a bank would also require background information on the borrower.
This includes audited company accounts, a profile of the company structure and senior personnel, the legal framework of the company, the proposed loan terms and all the necessary information on exactly how the loan will be administered, controlled and protected. This material is all incorporated in the information memorandum.
Sensitivity analysis would be undertaken on the financial model and key parameters such as operating costs and capital costs would be varied. Clearly much greater confidence will be placed on estimates provided by an experienced mining company than junior companies with no production experience.
While junior companies can hire consultants to provide technical reports covering operating and capital costs acceptable to the lender, they will need to assemble an experienced management team. Getting a mine and processing plant to perform to their design capabilities is as much an art as a science. A proven track record is clearly an advantage.
The information memorandum will also require an environmental audit to be carried out with specific reference to liability for previous mining activity. Superfund legislation in the US can hold lenders responsible for environmental damage at sites where loans have long since been repaid, or where degradation occurred before it was owned by the mining company to which the bank has provided debt finance.
The Lender’s Decision Making Process
The lender will initially review the submitted information memorandum and it is then frequent practice to hire an independent consultant to perform a due-diligence test or prepare an independent feasibility study. Banks will construct their own financial models and carry out detailed sensitivity analyses. Potential risks must be identified and quantified prior to committing to a project.
Given the number of independent and interdependent variables present in a mining operation, it is quite impossible to envisage all possible scenarios that could prevail during actual mining. Monte Carlo techniques are sometimes used to simulate some of the possibilities, but these assume the statistical independence of the parameters, which is clearly not valid.
Once the project finance analysts have reviewed and accepted the information memorandum, their findings will be presented to a credit committee which is responsible for the ultimate accept/reject decision. The background information on the borrower and credit guarantees are particularly important at this stage.
The Purpose of Modelling
The size and complexity of a project’s financing requires accurate financial analysis, and modelling plays a vital role in charting a project’s cash flows. Both the lender and sponsor alike need to establish that future revenues will be of sufficient magnitude to meet loan repayments on schedule while still producing a residual profit for the sponsor.
Discounted cash flow (DCF) modelling thus forms an integral part of the preliminary and full feasibility studies and allows the economic viability of a project with debt finance to be tested.
Cash flow modelling should be undertaken throughout project development, with an increasing level of detail as more data becomes available. A preliminary feasibility should include a simple DCF model that allows the overall financial viability of the proposed operation to be established.
By the time a project reaches full feasibility level, detailed engineering studies and market evaluations will have been undertaken and capital costs, operating costs, and predicted sales levels can be defined with confidence. A full feasibility cash flow model will thus be more refined and will incorporate tax and royalty formulae and full project financing scenarios. A detailed sensitivity analysis will also be included.
In evaluating an information memorandum, the lender will scrutinise the cash flow model of the project and employ independent consultants to verify the cost assumptions used. The lender will perform a risk analysis on the model inputs and analyse the project financing component in order to determine the bank’s optimum lending scenario.
DCF Analysis and the Time Value of Money
The principle of discounting cash flows is based on the logic that money received in the future is worth less than that same amount received today, due to the opportunity of earning additional revenue on that sum if it were to be invested elsewhere. Suppose there is a choice of receiving $1000 today and investing it or receiving $2000 in ten years time.
Which is the most valuable outcome? The answer clearly depends on the prevailing interest rate. If it happens to be 5%, the money would be worth $1629 at the end of ten years and so it would be better to wait. On the other hand, if the current rate happens to be 10% the sum would be worth $2594 in ten years time and so it would be preferable to take the money now and invest it. The break-even interest rate in this scenario is about 7.2%.
Modelling incremental discounted cash flows analyses the financial viability of a project by not only testing that generated revenues are substantially greater than costs and debt service requirements, but also by measuring the present value of those profits. The underlying philosophy in DCF analysis is that the project is to be compared with investing the same stream of cash flows elsewhere. One of the essential questions in DCF analysis is how to choose the discount rate.
Discounted cash flows can be used to determine the Net Present Value of the project, which is essentially a present valuation of the potential of the deposit to generate future profits. NPV is calculated as follows:
Projects with an NPV greater than zero will produce greater revenues than their costs at the minimum acceptable rate of return (the discount or hurdle rate), and mutually exclusive investment opportunities are ranked by magnitude of NPV.
The Internal Rate of Return (IRR) and Payback Period of a project can also be calculated from a model of future cash flows. IRR is essentially the discount rate at which NPV at time zero of all cash flows is equal to zero, and is calculated as follows:
A project is profitable if the IRR exceeds the opportunity cost of capital (the project’s discount rate), and mutually exclusive scenarios are ranked by magnitude of IRR.
Payback period is simply the time taken for the initial capital investment to be recovered by the stream of annual positive cash flows, and is not generally used alone for making an investment decision as it takes no account of the time value of money.
Developing a Spreadsheet-Based Model
The most important elements to remember when developing a spreadsheet model of projected cash flows are clarity, consistency, and flexibility.
The spreadsheets used in some projects can be very large and complicated, with entries going from page to page. Spreadsheet cells call for results from other cells which in their turn call other cells. It is not always easy to follow the logic of the steps being carried out and, when the spreadsheet is very convoluted, there is a real possibility of artefacts being introduced. Even if there are none, it becomes very difficult to test the project’s sensitivity to input parameters.
There is great benefit to be gained from a consistent basic layout with a clear flow of logic throughout. Input pages, calculations, and output reports should be kept in separate areas. This course has employed the use of IC-MinEval, a purpose-designed software package for the financial evaluation of mining projects.
IC-MinEval automates all the stages required to produce an Excel-based DCF model of a mining project through a series of clearly defined menu-driven forms that prompt the user to enter all the necessary technical and financial variables. Once the key technical and financial data has been entered, it is checked and a comprehensive series of Visual Basic routines ensures that a set of Excel worksheets are generated to form a customised DCF model.
The DCF method of analysis has the advantage that a model can be constructed which reflects the primary technical features of the project. This does, however, require a level of knowledge about the operation which may not be available outside the company, but it is still possible to develop a model based on comparative scenarios which can provide the basis for a preliminary valuation. This is the approach followed by IC-MinEval and adopted in this course.
The first step in creating a spreadsheet cash flow model is to compile all available project information on an input sheet database. This includes all the technical information which will allow calculation of mine life, annual ROM production and annual production of saleable commodity. The input sheet must also contain project cost information to allow calculation of annual capital, operating, and transportation costs. Finally, financial data must be input, including sale price, tax and royalty rates, project discount rates, and project financing information.
A separate series of worksheets can then be created to calculate the annual production, sales and costs. The results are then used to construct a model of the cash inflows and outflows in each year of the project’s life.
A mine life much in excess of 10 years does not enhance the NPV of the project, while too short a mine life does not permit adequate return on capital. A project with a very long potential lifespan should thus only be modelled over the first 10 to 15 years of its life. It is unlikely that a mine with a longer life could operate effectively without additional capitalisation and so the cash flow forecasts for the later years would be highly subjective in any case.
Project Input Data
The input data needed to construct a spreadsheet-based cash flow model is divided into project technical information and financial information. IC-MinEval has a series of input screens which prompt you for all the necessary data, navigated from an input menu screen (Figure 1). The basic technical inputs can be subdivided as follows:
- general project information;
- resource information;
- mining rates;
- commodity price;
- expenditure; and
- environmental and closure provisions.
General information is required on the commodity/ies, and on the mining method that is to be used to exploit the resource. The choice of mining method has important implications for the rate of production, equipment, capital expenditure and mining operating costs. The permitting and construction period also needs to be established in order to determine the total pre-production period of the project, the time after the initial capital expenditure (capex) has been spent before production (and revenue) can begin. In terms of project finance, the end of this period signifies completion when the project’s cash flows become the primary source of debt repayment.
Information is required on the size of the deposit, the grades, and several other mining parameters. The total mineralised volume of the deposit revealed by geostatistical evaluation can be multiplied by the specific gravity of the particular ore-type to calculate the total in situ ore reserve tonnage. The expected mining recovery (the percentage of the in situ ore that can be mined) provided by the engineering study is multiplied by the total in situ ore tonnage to determine the total ore to be recovered.The expected dilution (the amount of waste rock that is mistakenly mined as ore), stripping ratio (the amount of waste material needed to be removed for every unit of ore mined in surface operations), grade (average grade of ore mined that is higher than the economic cut-off) and plant recovery (the percentage of the commodity contained in the ore rock that can be extracted by the plant) are also required in order to establish the quantity of the saleable commodity produced.
The mining rate needs to be established because it directly affects the mine life and capex, as the more rock mined per year, the larger the processing plant and equipment that is required. In addition to the average rate during full production, it must also be established if the mining rate is to be varied over the first few years of production, to model a more realistic slower start up rate. It is particularly important that the rate of production should be on a scale which is appropriate to the size of the ore body. A mine life much in excess of 10 years does not enhance the net present value of the project, while too short a mine life does not permit adequate return on capital.
The reliability of a cash flow model often hinges on the accurate determination of the project’s capex and operating costs. If these are known, or an accurate estimation is made from similar operations, then these figures can be entered directly. However, project costs are often not known with any degree of certainty during the construction of an early financial model. In this case, O’Hara cost formulae can be used to calculate rough estimates of capex and operating costs (OHara and Suboleski (1992)).
Capital costs (capex) are costs in a particular year that will produce benefits in later years. The major capital requirements in mining projects are the cost of constructing the mine site (including purchase of mining equipment), mill and processing plant. Additional costs and expenses that will be incurred in developing a project are termed capital overheads and can be entered into the model as a percentage of the total capex.
Operating costs (op costs) are costs that only produce a benefit for that year and are calculated annually. In order to establish the total operating costs per tonne of saleable commodity, the costs of mining ore, mining waste and processing must be established. There may be annual fixed operating costs (e.g. administration costs, salaries, office overheads) that must also be incorporated into the model. If coal or an industrial mineral product is the commodity in question, an additional transport cost component must be established.
The expected sale price(s) of the product(s) and how this/these will vary over the project life must be established. It must be decided whether the commodity/ies will be sold entirely on the spot market or whether a percentage will be forward sold at a different price. Hedging details must be incorporated into the model if forward sales are to be applied.
The model must reveal how capex payments are to be spread over the first few years of the project and the amount of working capital to be used must be established. The capex is unlikely to all be employed in the first year of the project, depending on delays and the construction period. Working capital is the capital reserve required for the day-to-day running of the operation and can be expressed as a percentage of the annual operating costs, normally set at around 25%.
Environmental and Closure Provisions
A financial model should include the expected environmental costs and additional costs associated with the project’s closure. This may incorporate a fixed bullet payment at the end of the mine life to cover environmental rehabilitation costs, a sink fund at the beginning of production that acts as an environmental bond to cover rehabilitation costs, and annual environmental costs during production and after mining to cover on-going costs. It must be established how long after completion of mining the annual rehabilitation costs have to be paid.
Basic Financial Parameters
The financial inputs to the model set the basic financial parameters of the project, such as tax and inflation rate, depreciation, and project financing scenario (Table 1).
Discount Rate and Cost of Capital
There are two methods of discounting that can be used to calculate the NPV in a financial model. The pre-determined discount rate can be used or the weighted average cost of capital (WACC) can be used. WACC is calculated as follows:
As the NPV is calculated on the cash flows before funding but after tax, an allowance is made for the tax implications of interest payments on debt. The cost of debt is calculated as:
The WACC thus varies according to the debt/equity ratio of the project’s funding structure. The cost of equity is generally higher than the cost of debt, reflecting the higher rate of return required by the equity holders in comparison to the ‘cheaper’ interest rate on debt. Thus the greater the percentage of total capex funded by debt, the lower the WACC and thus the more favourable the calculated NPV. This is an essential principal of project finance.
Project Finance Parameters
Input information is required to set up the financing structure of the project including the amount of debt and equity, interest rate and repayment schedule.
The debt/equity ratio and the size of debt will be decided by the lender. This can be expressed as a percentage of the total financing requirements that will be funded as debt. The optimum draw-down period for the debt funding will be agreed between the project sponsor and lender, and may be drawn out over as long a period as the first five years of the project.
Loan type and repayment schedule
The schedule for loan repayment needs to be established in order to complete the cash flow model. The number and size of loan repayments will be negotiated between the lender and sponsor, as will the grace period, if any, before repayments must commence. Loan repayments can be made in equal instalments (straight loan) or made proportional to the production rate (production loan).
There will be other cash flows associated with organising the project finance that must also be included in the early years of the model. These include an up-front fee by the bank for arranging the loan (a percentage of the total loan available), a commitment fee (an annual fee charged on the amount of the loan that has not been used), fixed charges (for agents’ fees, legal documentation, independent reports, etc.) and contingency to act as a cushion against unexpected cost rises, etc. (a percentage of the total required funding).
Loan interest rate
This is the annual rate of interest on the debt as set by the lender.
Return on equity
This is the annual expected return on equity invested as funds. This can be calculated by a variety of methods including the Capital Asset Pricing Model (CAPM). It is often linked to the overall company gearing of the project sponsor.
Demand for Nickel
Top of Form
Bottom of Form
Nickel is one of the more common elements in the composition of the earth, but it is sparingly distributed in the earth’s crust. Nickel is usually found in modest concentrations and occurs in conjunction with a wide variety of other metals and non-metals. The world’s nickel resources occur in two main geological settings:
in secondary minerals such as garnierite and limonite contained in nickel-bearing laterites; and
in sulphide minerals associated with mafic and ultramafic igneous rocks.
The nickel grade of lateritic ore typically ranges from 1-2%, and that of sulphide ore from 1-4%.
Nickel is of considerable economic and strategic importance to many countries, its main use being a critical component in the development of metal alloys. More than 80% of the world’s nickel production is used in alloys, and about 60% of global nickel is used specifically for the manufacture of stainless steel (NIDI (2005)). Nickel is also used in the manufacture of Monel Metal, a corrosion-resistant alloy used by the shipbuilding industry, and is an important strategic metal. Throughout the early 1980s the growth in nickel production exceeded the growth in demand, but the late 80s and early 90s saw this trend reversed as the number of emerging new applications of stainless steel, combined with its rapidly-improving price competitiveness, generated a sustained growth in demand for nickel metal. Indeed, China’s use of nickel-containing stainless steel and its use of primary nickel have grown dramatically and with impressive consistency over the last fifteen years (NIDI (2004)). Nickel stocks were rapidly depleted over the middle years of the 2000s, but recovered during the 2008/9 world financial problem period.
Concern over depleting reserves of sulphide ores, the traditional source of nickel metal, and high nickel prices led to renewed interest in nickel laterite ores that were previously thought too technologically difficult and costly to treat. The introduction of High Pressure Acid Leaching (HPAL) as a large-scale hydrometallurgical method of concentrating nickel metal and cobalt by-products from limonitic laterite ore appeared to enhance the feasibility of laterite deposits as a long-term solution to the continuing demand for nickel. However, poor initial operating performances at major new HPAL processing plants have cast doubt over this technology’s ability to provide a large-scale supply of nickel while operating economically. So sulphide deposits remain the main source of nickel metal. The following working sessions therefore will concentrate on sulphide nickel deposits and provide a review of the major technical aspects of nickel projects that must be taken into consideration in the economic analysis of such operations. Part 5 introduces a typical nickel sulphide case history with which to demonstrate the modelling of nickel project finance.
Prices and Markets
The nickel price is closely linked to the global demand for stainless steel which is in turn governed by industrial productivity associated with the global economic climate. 2007-08 witnessed a huge fall in London Metal Exchange (LME) nickel prices (Figure 1), principally due to the collapse of the world economy resulting in huge drop in demand for and production of stainless steel associated with the recession. 2009 has witnessed a modest resurgence in the LME nickel price as demand has outstripped production.
Since 2002, a booming commodities sector, partly driven by the rapid growth of China, put substantial pressure on nickel suppliers to meet demand. This in turn had a huge impact on prices. However, forecasting forward much is dependent on how sustained the 2009 easing of the recession will be.
The general trend of increasing nickel prices in through most of the mid 2000s, generated renewed interest in the nickel sector. Western Australia in particular witnessed significant increases in production over the past period, with several new major nickel sulphide and laterite projects arising. However, the new HPAL laterite operations in the region did not live up to expectations, with over-optimistic product