Valuing a Silver Mine Project in the face of Silver Price Uncertainty

By Dr. Luis A. Martínez Tipe, PhD Director General & Principal Researcher, CAIDTech Originally published: June 2, 2016

This is the summary of one of the problems to be analysed during day 3 (Quantitative Real Options Analysis) of the course/workshop titled "Open Pit Mine Project Evaluation in the Face of Uncertainty: A Practical Approach”. http://randoanalytics.com/wp-content/uploads/2016/05/2016-Course-Flyer-.pdf THE INVESTMENT PROBLEM                                                                             A mining firm is trying to decide whether to invest in a silver, zinc and lead mine project. The decision to invest and develop is irreversible, in that after development management cannot disinvest and recover the capital investment. To keep matters simple, the silver will be taken as the only metal to influence in the value of the project because it covers 90% of the potential production. We will assume that the development and extraction can be started immediately.  INITIAL PROJECT CONDITIONS

The technical/operational/economic characteristics of the project are:

• The project requires an initial investment of USD 48 million (CAPEX);

• Production cost assumed to be US$7.5 per ounce of silver produced;

• There are not variable extraction costs;

• Life of mine is estimated to be 5 years;

• The annual silver production (million Oz) for the next 5 years are estimated to be 0.051, 0.842, 2001, 3337, and 3416, respectively.

• Annual risk adjusted discount rate is 10%;

• - Management has the option to invest now or defer project investment and development for 1 year at a cost of $1.0 million (paid at the end of the year). 

• Salvage value = Closure cost + selling of all assets, is expected to be break-even (i.e., US$0).

• For practical and comparison purposes, all cash flow calculations will be done using the annual RADR of 10%, so all results can be compared against the bench mark, i.e., the traditional discounted cash flow (however for the sake of completeness the annual risk free rate is 4%);
  

PROJECT UNCERTAINTY Uncertainty over the value of the project is closely related to the dynamics in silver prices. Currently silver is priced at US$16/Oz. However, it is foreseen that silver prices will change in the following years with a volatility of 28%, and following a Geometric Brownian Motion (GBM).

MANAGEMENT QUESTIONS

• Given the size of investment outlay, the current silver price, and the dynamics (volatility) of silver price over time, is this a good investment? 

• Should management invest now, or should it wait and see how silver prices will develop next year?

• What is the cut-off investment that management should consider to decide to either invest today or next year?

• What is the maximum cost management should negotiate to have the option to defer project investment for 1 year?

• How would the project value and decision making vary with different initial silver prices?

Click here for downloading the white paper: http://randoanalytics.com/wp-content/uploads/2016/05/Silver-Mine-Example-LinkedIN.pdf

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For more information about the course/workshop "Open Pit Mine Project Evaluation in the Face of Uncertainty: A Practical Approach”, click in the link:

http://randoanalytics.com/wp-content/uploads/2016/05/2016-Course-Flyer-.pdf Editor's note: This article was written in 2016. Since then, CAIDTech has developed and applied the probabilistic frameworks described here across multiple mine projects in Latin America and Australia, integrating geological variability, operational dynamics and economic uncertainty into a single quantitative model. Learn more at [caidtechnology.com]