Natural resources: Cost of capital and discounting – Risk and uncertainty

Abstract

Notable contention remains around what discount rate should be used in the determination of the net present value (NPV) of a mining operation's discounted cash flows (DCF). It is typically deemed simpler to apply a single “corporate discount rate” that satisfies the targeted project's return associated with the investment capital outlay and some unquantified element of risk. This targeted return will ideally incorporate the actual cost of capital, being the weighted average cost of capital (WACC), incorporating the capital asset pricing model (CAPM) for the equity component and the cost of debt (the inter-bank lending rate with an additional lending margin). In addition, it will also incorporate some gut-feel or indeterminate additional return factor, to account for risk, to appease the project owners and its associated shareholders. This additional project risk being captured in a discount rate is contentious, as it generally is not quantified. In addition, while there may be some argument to justify why a single, all-encompassing discount rate should be used, notably for a short-life operation, can a single discount rate applied over the life of an operating asset actually be justified? Can a single rate be equally justified for medium and long-term operations as it is for short-life operations? Importantly and accepting that the WACC and hence the discount rate vary over time, how does the risk and the uncertainty associated with a mining project get factored into the valuation, and should these factors remain static, or should they be considered separately and also be varied over on operation's life?