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Risk-Adjusted Discount Rates For Mining Projects
Risk-Adjusted Discount Rates For Mining Projects
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Majid Ataee-pour
Amirkabir University of Technology
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Cost of capital
The company cost of capital is usually calculated as a weighted average of the after-tax
interest cost of debt financing and the cost of equity – the weighted average cost of
capital (WACC).
Mohsen Taheri is a The cost of debt is the firm’s borrowing rate and measures the current cost to the firm
PhD student in the Department of borrowing funds to finance projects. Several models for estimating the cost of equity are
of Mining and Metallurgical
Engineering at Amirkabir presented, however, three models are generally accepted: dividend growth models, earnings
University of Technology models and the capital asset pricing model (CAPM).
(Tehran Polytechnic), Tehran,
Iran. Email: Taheri.mhsn@aut.
ac.ir Company cost of capital in practice
In the past two decades several surveys into the practice of capital budgeting have been
Mehdi Irannajad is conducted in different countries. These surveys have covered a range of issues such as:
an Associate Professor in the which capital budgeting techniques were used; how firms ranked the importance of these
Department of Mining and
Metallurgical Engineering techniques; and how discount rates were determined. Some of these surveys have studied
at Amirkabir University the methods that are used by the firms in Australia, the United States, Canada and a
of Technology (Tehran number of European countries to determine the discount rate (Brounen et al. 2004; Gitman
Polytechnic), Tehran, Iran.
Email: Iranajad@aut.ac.ir and Vandenberg 2000; Graham and Harvey 2001; Jog and Srivstava 1995; Kester et al.
1999; McLaney et al. 2009; Truong et al. 2008). Troung et al. (2008) presented a brief
Majid Ataee-pour is comparison of these findings. The results are summarised in Figure 1A and the details of
an Associate Professor in the surveys are presented in Figure 1B.
Department of Mining and
Metallurgical Engineering
These studies found that CAPM and dividend growth models are the most popular
at Amirkabir University methods used in the estimation of the cost of equity. Other methods have less popularity
of Technology (Tehran and the models like the Fama & French three factor model, arbitrage pricing model (APT)
Polytechnic), Tehran, Iran.
Email: Map60@aut.ac.ir
and multi-factor asset pricing model are rarely used in practice.
FIGURE 1b: Details of surveys of cost of capital estimation practices in different countries
A project and its cost of capital Some authors (Brealey et al. 2001, p. 423; Damodaran
A project’s cost of capital is the minimum expected rate of 2004, p. 5) have proposed various methods and guidelines
return needed to attract the required capital. Generally, for estimating the project cost of capital. These methods
this is different from the company’s cost of capital. The are not effective in practice. Anderson et al. (2000) have
project cost of capital depends on the use to which that suggested the premium or discount approach to estimating
capital is put. Therefore, it depends on the risk of the the cost of capital for projects by using the firm’s cost of
project and not on the risk of the company (Brealey et al. capital (WACC) plus or minus a premium to adjust the
2001, p. 422). WACC to take account of differences in risk. If the
TABLE 1: The premium/discount approach to estimate the cost of capital for project
(1980) used the CAPM method for important where: d is the project-specific, constant-dollar, 100%
mining and mining-finance shares of Johannesburg equity discount rate; RF is the real, risk-free, long-term
Stock Exchange (JSE). He estimated β by regression interest rate; Rp is the risk portion of the project discount
analysis. Equation 1 was presented by the cross- rate; and Rc is the risk increment for country risk.
sectional regression of the expected returns for a The risk associated with a project varies with the
large number of individual shares. stage of development of the project. This variation can
be reflected in the discount rate that is used to evaluate
R = 18.5% + β (6.8%) [1]
the project.
2. Summing up the discount rate components. These A survey conducted on Mineral Economics Society
components are mentioned with some differences in (MES) members of Canadian Institute of Mining
different texts. For example, Smith (1995) related Metallurgy and Petroleum (CIM) indicated that they
the discount rate to three components in the were using different rates for stages of the mining project
following equation: (Figure 3). However, there is no sound procedure to
d = RF + Rp + Rc [2] calculate these discount rates (Smith 2002).
FIGURE 4: A method to estimate the risk-adjusted discount rate (RADR) for evaluating mining projects
References
Brealey, R. A., Myers, S. C. and Marcus, A. J. 2001, Fundamentals of Kester, G., Chang, R., Echanis, E., Haikal, S., Isa, M., Skully, M.,
Corporate Finance, 3rd ed., Boston: Irwin/McGraw-Hill, p. 436. Kai-Chong, T. and Chi-Jeng, W. 1999, ‘Capital budgeting practices
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in Europe: confronting theory with practice’, Financial Management, Philippines, and Singapore’, Financial Practice and Education, vol. 9,
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and Sons Inc. www.stern.nyu.edu/~adamodar/. Southern African Institute of Mining and Metallurgy, vol. 106, Feb.,
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finance: evidence from the field’, Journal of Financial Economics, Truong, G., Partington, G. and Peat, M. 2008, ‘Cost of capital estimation
vol. 60, pp. 187–243. and capital budgeting practice in Australia’, Australian Journal of
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corporate Canada’, Financial Practice and Education, vol. 5, pp. 37–43.