MIN E 408: Mining Enterprise Economics

Project Evaluation Methods

Discounted Cash Flow continued

Project Evaluation Methods

1. Discounted Cash Flow (DCF):
Cash flow discounted at an investor arbitrarily selected discount rate

Net Present Value (NPV).

Internal Rate Of Return (IRR).
Profitability index or benefit cost ratio.
Payback and discounted payback period.

2. Capital Asset Pricing Method (CAPM):

Discount rate quantitatively modeled using the beta of a security or project with
comparable risk as project.

3. Option Pricing Method:

Uses Portfolio replication to duplicate the project as consisting of certain basic
assets that are risk free. The resulting portfolio of assets must have a return
equal to the risk free rate.

04-1

Investment Decision Criteria:

Internal Rate of Return (IRR)
IRR is the discount rate that sets the NPV to zero
Independent of the interest rates in the capital market and so
intrinsic to project cash flow
T

NPV I 0
t 1

CFt

1 RRR

Solution by trial and error

Solver or goal seek in Excel does it!
Accept Project if IRR > discount rate (MARR)

Investment Decision Criteria:

Internal Rate of Return (IRR)
$90,000

IRR = 8.445%

NPV

$60,000

$30,000

NPV=-$9,325
$0
0

0.04

0.08

0.12

0.16

-$30,000

Rate of Return

04-2

IRR (Some Problems)

1. No IRR
This project has no IRR:

+ 1,000 3,000

2,500

NPV at 10%:

1, 000

3 , 000
2 ,500

338 . 84
1 .1
1 .12

IRR (Some Problems)

2. Implied reinvestment
Project
A

I0

C1

C2

C3

$-100m

$10m

$50m

$60m

C4
$70m

IRR
24.73%

Misconception that 24.73% is return on 100million; thus

100 (1 0.2473) 4 $242.03m

10m

50m

60m

70m

Reinvestment

3yrs

2yrs

1yr

Total

Amount (m$)

19.40

77.79

74.84

70

242.03

04-3

IRR (mutually exclusive projects)

3. Scale problems: similar to PIs problem

4. Timing Problems
Projects with back-loaded cash flows may look worse with IRR
when both IRRs > discount rate
Project

I0

C1

C2

C3

C4

IRR

MARR

NPV

$-100

$10

$50

$60

$70

24.7%

12%

$35.98

$-100

$70

$50

$30

$10

30.5%

12%

$30.07

IRR (Mutually Exclusive Projects)

100

N P V (m illio n $)

80
60

Project A
Project B

40

35.98
30.07

20
0
0%

4%

8%

12%

16%

20%

24.73%
24% 28%

30.46%
32%

36%

r- discount rate %

04-4

IRR Incremental Approach

Find the difference between the alternatives. The resulting cash flow
should depict net investment

Project

I0

C1

C2

C3

C4

IRR

NPV

A-B

-60

$0

$30

$60

16.54%

$5.91

Choose A

If the difference between alternatives depict

a net borrowing, reverse decision criteria.

Payback Period and Discounted

Payback Period

Payback Period:- The number of years required to recover initial

investment on a project.

The decision rule: Accept all projects with payback periods <= a
particular cut off period .

04-5

Payback Period and Discounted

Payback Period

Year

-$100m

-$100m

-$100m

$20m

$50m

$50m

$30m

$30m

$30m

$50m

$20m

$20m

$60m

$60m

$99m

PBP

With DPBP cash flows are discounted by the appropriate discount rate
and the payback rule applied.

Payback Period and Discounted

Payback Period

The payback period (PBP) and the discounted payback

period (DPBP) are used to reduce the time exposure of
invested capital to risk.
For every project,
DPBP estimate > PBP estimate
If DPBP is > project life
NPV<0
IRR < MARR
PI<1

04-6

Projects with Different Life Spans

Contemplating which of two dozers to buy.
Very similar in terms of output.
Will not directly effect cash flow except through costs.
r =10%.

Initial Cost

Operating costs per year

Life

$100,000

$28,500

$145,000

$24,000

Projects with Different Life Spans

Machine 1

Machine 2

04-7

Projects with Different Life Spans

Replacement Chain
Find common life for the two and calculate NPV over that life.

Uniform Annual Series (UAS) or Equivalent Annual Cost (EAC)

Equivalent Annual Cost

1
1
208,037.42 A
1
5
0.10 1.10
A $54,879.75
1
1
261,842.05 A
1
7
0.10 1.10
A $53,783.8

Machine 1

Machine 2

04-8

Review Of Main Points

Discounted Cash Flow (DCF) Methods:
Net Present Value
Internal Rate of Return
DCFROR and DCFROI
Commonly used in practice
Pay Back Period (PBP) and Discounted Pay Back
Period (DPBP)
Simple and common

04-9