Cost of Capital and Discounting – Risk and Uncertainty.
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Much contention still exists around the discount rate to be used in the determination of the net present value (NPV) of a mining operation’s discounted cash flows, so much so that it is typically deemed simpler to just use a single “corporate rate” that satisfies the targeted project’s return associated with the investment capital outlay. This targeted return will supposedly 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), plus some gut-feel or indeterminate additional return factor to appease the project owners and its associated shareholders. This additional project risk being captured in a discount rate is contentious. 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 actually be justified? Can a single rate be equally justified for medium and long-term 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?
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