Individual Case Study

Oyu Tolgoi Project in Mongolia

Aili Kuang (MBA candidate)

Schulich School of Business
York University

Slide 1
2 October 2007
Information Sources

• Executive summary from the Oyu Tolgoi Project Integrated

Development Plan (IDP) – August 2005
• Oyu Tolgoi Project - Southern Oyu Open Pit Technical Report
– January 2006
• The Globe and Mail and Financial Post

Slide 2
2 October 2007
Key assumptions

• The project start time is 2007 ( 2 years after the original start date
identified in the IDP).
• Fixed and variable costs incurred for the project are based on the
information disclosed in IDP and adjusted from 2005 to 2007
constant monetary terms at an inflation rate of 6%/year.
• The production schedule and capital expenditure are based on the
operating cash flow and schedules disclosed in the IDP executive
summary.
• Current gold price expectations are flat with an expected price of
$550/oz. The copper price is assumed to revert to a long-term
expectation of $1.40/lb.

Slide 3
2 October 2007
 Project overview – expanded case

2.00

• Deposit contains 1.5b tonnes

Gold or copper grade (g/t; %)

of ROM ore with payable metal 1.60

content of 10.1 M ozs of Au 1.20

and 34.2b lbs of Cu. 0.80

• Maximum production rate of 0.40

52.2 million t/y and a 35 year 0.00

0 5 10 15 20 25 30 35 40

production life. Gold

Project time (year)
Copper

– AU revenue 12%; CU revenue 88% 70

• Total capital expenditure of 60

$6.1b; development capital is 50

US$/ROM tonne

$3.4b and sustaining capital is

40

30

$2.7b. 20

10

0
0 5 10 15 20 25 30 35 40
Project time (year)

Expected unit revenue Expected unit operating cost Expected unit operating profit
Slide 4
2 October 2007
Mongolian tax regime

• Royalty: 2.5% of mineral revenues less smelter / refining charges.

• Windfall tax: 68% on excess revenue above a gold price of $500/oz
and a copper price above $1.18/lb.
– Excess metal revenue is reduced for concentrate transport, smelter, and
refining costs
– Windfall tax payments are a deductible for corporate income tax.
• Corporate income tax: 30% on taxable income.
– Tax losses may be carried forward 4 years, straight line depreciation of
development capital over 5 years and sustaining capital over 10 years.
– Tax holiday for the first 5 years of production and a 50% tax credit for
production years 6 to 10.

Slide 5
2 October 2007
Conventional
DCF NPV analysis
• Conventional DCF uses a fixed price projection to estimate cash
flow NPV for equity and windfall tax.
• Various price scenarios are to estimate the value impact of the
windfall tax. This approach is flawed because metal price and
windfall taxes fluctuate over the life of the project.
N P V f o r E q u it y ($ m illio n )
C u \ A u p r ic e s 500 550 600
1 .2 2934 3071 3208
1 .4 4098 4234 4331
1 .6 4667 4711 4755
N P V f o r W in d fa ll T a x ($ m illio n )
C u \ A u p r ic e s 500 550 600
1 .2 0 0 0
1 .4 0 2 43
1 .6 739 845 951
Slide 6
2 October 2007
 Metal price assumptions –
Stochastic copper and gold price models

• Non-reverting gold price • Reverting copper price model

model with current price with long-term price
expectation of $550/oz. expectation of $1.40/lb.
1200 4.00

1100 3.50

1000
3.00

Mineral price ($/unit)

Mineral price ($/unit)

900
2.50
800
2.00
700

600 1.50
Long-term expected price = US$1.40/lb

500 1.00

400
0.50
300
0.00
200 0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10 Project time (year)
Project time (year)

Slide 7
2 October 2007
Monte Carlo
DCF and Real Option NPVs

Cash flow stream No WFT ($ million) With WFT ($ million)

Discounted cash flow (8% discount rate)
Equity 4522 3631
Royalty 271 271
Corporate income tax 1168 995
Windfall tax N/A 1064
Real options (2% global risk adj.; risk free rate of 3%)
Equity 5581 4936
Royalty 365 365
Corporate income tax 1519 1385
Windfall tax N/A 779
Slide 8
2 October 2007
Risk adjustment methods
for Real Options and DCF
• DCF applies a standard discounting rate to all participants. It
assumes that uncertainty grows at a constant rate through time.
• RO approach applies risk adjustment at the source.
– Price uncertainty is adjusted during stochastic simulation of metal prices
– Time discounting factor 3% is then applied to include time value of
money
• By risk-adjusting at the source, RO recognizes uncertainty variation
between individual stakeholders and project stages.
– The main revenue source for Oyu Tolgoi comes from copper. Copper
price uncertainty saturates in the long-term due to price reversion. RO
recognizes reversion by allowing the copper price risk adjustment to
stabilize. This has a large value impact on long-term cash flows.

Slide 9
2 October 2007
Equity and government
cash flow uncertainty

• Windfall tax has largest uncertainty due to metal price change and
reduced cash flow stream at later stage.
• Cash flow uncertainty differs between individual stakeholders.
300%
Coefficent of Variation(CoV, %)

250%

200%

150%

100%

50%

0%
0 5 10 15 20 25 30 35 40
Project time (year)

Equity Royalty Windfall tax Corporate income tax

Slide 10
2 October 2007
Cash flow uncertainty characteristics
and risk adjustments
• Average cash flow variability measured with cash flow coefficient of
variation (CoV): normalized standard deviation for comparison of
varying cash flow values
S.D. of expected cash flowt
CoVt =
Expected cash flow t

• Net cash flow risk discount factors (RDFs) indicate the equivalent
size of the risk adjustment applied to a cash flow.
RDFDCF = E[Rev – OpCost] * RiskDFDCF * TimeDF
E[Rev – OpCost] * TimeDF
RDFRO = E[Rev *RDFMetal – OpCost] * GblRiskDFRO * TimeDF
E[Rev – OpCost] * TimeDF
– RDFs profile should change with variations in cash flow uncertainty
since risk adjustments should reflect investor sensitivity to uncertainty.
Slide 11
2 October 2007
 Equity cash flow
with and w/o Windfall Tax

• Higher cash flows in early years due to higher grades and tax holiday.
• Windfall tax reduces expected cash flow for equity AND lowers
overall uncertainty (confidence interval reduces).

No windfall tax With windfall tax

2500 2500

2000 2000

Cash flow ($ million)

Cash flow ($ million)

1500 1500

1000 1000

500 500

0 0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Project time (year) Project time (year)

Expected equity after-tax cash flow (No WFT) 10% confidence bdy 90% confidence bdy Expected equity after-tax cash flow (WFT) 10% confidence bdy 90% confidence bdy

Slide 12
2 October 2007
Equity cash flow
uncertainty profile and risk adjustments

• Equity CF uncertainty is lower with the windfall tax than without

because windfall tax reduces revenues in high price environments.
• DCF RDF increases linearly and does correspond to the CF
uncertainty profile or the effect of windfall tax on uncertainty.
• RO price RDF negatively mirrors with the cash flow uncertainty
variation and recognizes the effect of windfall tax on CF uncertainty.

Slide 13
2 October 2007
 Equity cash flow
risk adjustment (DCF vs. RO)

No windfall tax With windfall tax

100% 1.0 100% 1.0

RO price
RO price discounting only
discounting only
80% 0.8 80% 0.8

N e t c a s h flo w R IS K d is c o u n t fa c to r
N e t c a s h flo w R IS K d is c o u n t fa c to r
RO risk discounting
RO risk discounting
factor (price+ 2%
factor (price+ 2%

C a s h flo w C o V ( % )
C a s h flo w C o V (% )

general risks)
general risks)
60% 0.6 60% 0.6

40% 0.4 40% 0.4

Equity cash flow risk

profile (CoV)

20% 0.2 20% 0.2

Equity cash flow risk
profile (CoV) DCF risk discounting
factor
DCF risk discounting
factor
0% 0.0 0% 0.0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Project time (year) Project time (year)
Slide 14
2 October 2007
Royalty cash flow
uncertainty profile

• Royalty CF uncertainty is unaffected by the windfall tax.

• DCF RDF does not respond to changes in the CF uncertainty profile.
• RO price RDF negatively mirrors cash flow uncertainty variation.
• Royalty cash flow under RO is larger than DCF because the former
uses smaller risk adjustments.

Slide 15
2 October 2007
Royalty cash flow
risk adjustments (DCF vs. RO)

With and without windfall tax

100% 1.0

RO price
discounting only

80% 0.8

Net cash flow RISK discount factor

RO risk discounting
factor (price+ 2%
Cash flow CoV (%)

general risks)
60% 0.6

40% 0.4

20% 0.2
Equity cash flow risk
profile (CoV)
DCF risk discounting
factor
0% 0.0
0 5 10 15 20 25 30 35 40
Project time (year)

Slide 16
2 October 2007
Corporate income tax
with and without windfall tax

• Lower corporate income tax in early years due to a tax holiday and
capital depreciation during the first 10 years of production.
• Windfall tax reduces expected corporate income tax cash flow AND
lowers overall uncertainty (confidence interval reduces).
No windfall tax With windfall tax
600 600
Corporate income tax cash flow ($ million)

Corporate income tax cash flow ($ million)

500 500

400 400

300 300

200 200

100 100

0 0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40
Project time (year) Project time (year)
Expected CIT cash flow (no WFT) 10% confidence bdy 90% confidence bdy Expected CIT cash flow (with WFT) 10% confidence bdy 90% confidence bdy

Slide 17
2 October 2007
Corporate income tax
uncertainty profile and risk adjustments

• Corporate income tax uncertainty increase with time because of

lower grades and increased profit uncertainty.
• Large increase in the last year is due to the write off of a residual
depreciation balance.
• RO RDF negatively mirrors cash flow uncertainty variation and
recognizes effect of windfall tax on corporate income tax uncertainty.
• Corporate income tax cash flow under RO is higher value than DCF
because the former uses smaller effective risk adjustments.

Slide 18
2 October 2007
 Corporate income tax
risk adjustments (DCF vs. RO)

No windfall tax With windfall tax

300% 1.0 300% 1.0

RO price discounting RO price

only discounting only

N e t c a s h flo w R IS K d is c o u n t fa c to r
240% 0.8

N e t c a s h flo w R IS K d is c o u n t fa c to r
240% 0.8

RO risk discounting
factor (price+ 2%

C a s h flo w C o V ( % )
general risks)
C a s h flo w C o V (% )

180% RO risk discounting 0.6 180% 0.6

factor (price+ 2%
general risks)

120% 0.4 120% 0.4

DCF risk discounting

factor

60% 0.2 60% 0.2

Corporate income tax
Corporate income tax cash flow risk DCF risk discounting Equity cash flow risk
risk profile
profile (CoV) profile
factor
0% 0.0 0% 0.0
0 5 10 15 20 25 30 35 40 0 5 10 15 20 25 30 35 40

Project time (year)

Project time (year)
Slide 19
2 October 2007
Windfall tax cash flow
uncertainty profile

• Windfall tax cash flow uncertainty increases as copper price reverts

to a long-term equilibrium – which is less than effective windfall tax
threshold. It becomes less likely to produce the excess revenue
necessary to trigger a windfall tax.

Slide 20
2 October 2007
Windfall tax cash flow
risk adjustment (DCF vs. RO)

• RO RDF negatively mirrors with the uncertainty change in windfall

tax cash flow
• DCF overestimated the value of windfall tax because it applies a
smaller effective risk adjustment.
300% 1.0

Equity cash flow risk

Net cashflowRISKdiscount factor

240% profile (CoV)
0.8
CashflowCoV(%)

180% 0.6
RO price
discounting only

120% 0.4

60% 0.2
RO risk discounting
factor (price+ 2%
general risks) DCF risk discounting
factor
0% 0.0
0 5 10 15 20 25 30 35 40
Project time (year)
Slide 21
2 October 2007
Sensitivity analysis for RO NPV
(varying general risk discounting rate)

• To incorporate other possible risks, a range of general risk

adjustments can be applied to the RO method (in addition to price
and time discounting).
• For the equity cash flow, RO produces a higher value than DCF in
most cases.
Sensitivity Analysis for R O N PV
R O N PV for individual stakeholders
(price uncertainty adjusted at the source, tim e discounting factor =3% )
($ m illion)
C orporate Incom e
G eneral risk adjustm ent Equity R oyalty W indfall T ax
0% 7332.7 512.1 1070.2 2060.2
1% 6011.8 430.6 910 1684.6
2% 4936.5 364.5 779.4 1385.1
3% 4056.3 310.5 672.2 1143.1
4% 3332 226.1 583.4 947.3
D C F N PV for individual stakeholders
O verall discounting factor
8% 3631.8 271.8 1064.2 994.5
Slide 22
2 October 2007
Concluding comments
and future work

• Oyu Tolgoi project has a higher value with RO valuation than the
conventional DCF approach.
– RO approach recognizes reversion in copper prices and adapts its risk
adjustment accordingly.
– DCF risk adjustments implicitly assume cash flow uncertainty grows at a
constant rate.
• Equity and government cash flow streams have a wide range of
uncertainty characteristics, which produces a variety of risk
exposures.
– RO reflects the variation of uncertainty in its risk adjustments.
• This analysis can also help with valuing long-life oil sand projects
and the value impact of possible Alberta royalty increases.

Slide 23
2 October 2007