Resources Policy 80 (2023) 103242

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Resources Policy
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Natural resources: Cost of capital and discounting – Risk and uncertainty

Eric Lilford
Curtin University, Department of Minerals and Energy Economics, Australia

A B S T R A C T

Notable contention remains around what discount rate should be used in the determination of the net present value (NPV) of a mining operation’s discounted cash
flows (DCF). It is typically deemed simpler to apply a single “corporate discount rate” that satisfies the targeted project’s return associated with the investment capital
outlay and some unquantified element of risk. This targeted return will ideally 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). In addition, it will also incorporate some gut-feel or indeterminate additional return factor, to account for risk, to appease the project owners and its
associated shareholders. This additional project risk being captured in a discount rate is contentious, as it generally is not quantified. 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 applied over the
life of an operating asset actually be justified? Can a single rate be equally justified for medium and long-term operations as it is for short-life 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?

1. Introduction A LoM Plan will therefore typically contain forecast figures

Captured within the Income Approach of mineral property valua­
tions is the discounted cash flow (DCF) methodology, incorporating the
net present value (NPV) tool, real options, bi- and tri-nomial analyses,
Monte Carlo simulations, sensitivity analyses and others. The Income
Approach and its sub-set of methodologies is only used for projects in
which a reliable cash flow can be determined, meaning that it can
therefore be used for existing mining operations as well as undeveloped
projects for which Reserves (JORC, 2012) and an associated life of mine
plan (LoM Plan) exists, as may be contained in a feasibility study. If no
reliable cash flow can be compiled, then either the Cost Approach or the
Market Approach may be appropriate as the valuation tool to be used.
These latter two Approaches will not be discussed in this paper, but can
be reviewed in numerous publications and research papers (Lilford,
2011), and are summarised in Table 1 below for completeness.
For clarity, an ore Reserve (JORC, 2012) can only be defined as such
in the event that the portion of mineralisation classified as a Reserve is
economically mineable using acceptable commodity price and exchange
rate forecasts, as well as accurately estimated mining and production
rates, ore grades and plant yields, operating costs, capital expenditure
and other economic factors including marketing costs, overheads, roy­
alties, duties, tariffs, etc. These represent a few of the modifying factors
necessary for the conversion of Resources to Reserves (JORC, 2012). The
implication is that, generally, a Reserve will be reflected in the devel­
opment of a LoM Plan, for which a reliable cash flow can be derived.
capturing.
• Commodity prices and exchange rates
• Mining tonnages (waste extraction and ore mining and processing
rates)
• Ore grades (above the cut-off grade)
• Factors around dilution, recoveries, efficiencies, etc
• Operating costs (per unit), working capital forecasts and mine
closure and remediation costs
• Capital expenditure and ongoing capital requirements
• Royalty rates (notably ad valorem and unit based) calculations and
possibly taxation calculations (CIT (corporate income tax), duties,
depreciation, amortisation, etc).
With the above parameters, forecasts and calculated figures known, a
periodic, likely annual, free cash flow model can be compiled and,
through using an appropriate discount rate, a reflective, static NPV can
be determined.
1.1. Levels of accuracy
Considering that a definitive feasibility study’s (DFS) LoM Plan
comes with an approximate 85%–90% confidence level (Ausimm
Monograph 27, 2012) (i.e. room for a 15%–10% error margin around
the accuracy of its inputs), it would be fair to suggest that the applicable

E-mail address: e.lilford@curtin.edu.au.

https://doi.org/10.1016/j.resourpol.2022.103242
Received 16 September 2021; Received in revised form 13 December 2022; Accepted 14 December 2022
Available online 9 January 2023
0301-4207/© 2023 Elsevier Ltd. All rights reserved.
E. Lilford Resources Policy 80 (2023) 103242

Table 1 effect, a coin-toss, 50 : 50 outcome). If the company has underestimated

Valuation approaches and associated valuation methodologies (Lilford, 2011).
APPROACH METHODOLOGY DESCRIPTION
Cost Historical cost Meaningful historical costs
incurred, less outstanding
obligations
Appraised value Only considers meaningful
previous exploration expenditure
and costs and committed future
costs
Income DCF NPV performed on determined
free cash flows at appropriate
discount rate(s)
Gross contained metal value Financial derivative. Mitigates
(typically inappropriate) unknown factors and builds in
decision flexibility. Tonnes x
grade x price
Decision tree Applying probabilities to yes/no
alternatives
Statistical or probabilistic Probability factors applied to
theoretically derived NPV
Market Market capitalisation per unit Market value divided by total
(e.g. ounces, tonnes) resource units (e.g. ounces,
tonnes)
Market capitalisation per Market value divided by annual
annual production unit (e.g. production units (e.g. ounces,
ounces, tonnes) tonnes)
Comparable transactions Transaction over properties with
similar attributes reflect a similar
value
JV terms or option agreements Participation or earn-in
expenditure by incoming party to
secure equity/ownership in the
project
Geoscience factor Kilburn or Lilford TEM (techno-
economic matrix), using location,
grade, geology and other factors
Rules of thumb Rudimentary, back of envelope
determination
its capital cost by 100 basis points (being 1%) and assumes a capital cost
of 9%, the project shows a positive NPV9 of approximately $1 million.
This provides a relatively attractive return on investment. However, if
the company assumes that its cost of capital is 1% higher than originally
assumed, the same project shows a negative NPV11 of around $1 million
and it is likely to be abandoned, as shown in Table 2.
The above example shows the potential impact of the importance of
applying the correct discount rate to a set of cash flows.
Decisions on investment are not made around a NPV alone, and
generally investors and financiers will also look at some form of return
on the investment, such as an internal rate of return (IRR), before
committing any funding for the capital development of the project
(Cortazar et al., 2001).
2. Reminder on discount rates
A discount rate is a discounting factor, or series of factors, that
captures the pre- or post-tax cost of debt, cost of equity and, if appli­
cable, the cost of preferential shares (Belli et al., 2001). When these
funding costs (debt, equity and preference shares) are pro-rated ac­
cording to their relative weightings and then summed, the summed
result is a weighted average cost of capital (WACC).
To calculate a WACC, the typical convention follows the formula
below (from Smith, 1995):
WACC = repe + rdpd + rppp (1)
where.
re, d, p = the calculated cost of equity (%), debt (%) and preference
shares (%), respectively,
and.

pe, d, p = the proportions, or weightings, of each of equity funding,

discount rate should be at least this accurate too. So it must be asked
debt funding and preferred stock funding, respectively.
then, why do we tend to expend very little time and effort in determining
the appropriate discount rate that should be used in a DCF NPV model,
The summation of these funds provides the upfront (initial) and
when discount rates themselves, as reflective of the cost of capital, can
potentially the ongoing funding amounts (development and operational
be calculated to some fair degree of accuracy?
capital) reflected in the corporate capital structure of the company or in
A company will spend tens of millions of dollars over many months
the asset under consideration. The sum of the weightings must equate to
and probably even years, on exploration, metallurgical studies, infra­
1.00 (i.e. pe + pd + pp = 1.00) (Brennan and Schwartz, 1985).
structure (logistics, electricity and water) and social (ESG – environ­
The preference shares or stock are a specific equity instrument
mental, social and governance) studies and more, to define a mining and
available in some jurisdictions that carry a different cost to ordinary
processing plan and regime that can be used to gauge the economic
equity. Since preference shares are not a widely available funding in­
attractiveness of the project. For the same study, the company then
strument globally, they will be excluded from any further discussion in
simply dictates the preferred discount rate to be used, based on nothing
this paper.
more than a “gut feel” or else some derivative of a desired return or a
The cost of equity itself as used in the WACC calculation is typically
hurdle rate needed to justify the upfront capital investment (Belli et al.,
determined by applying the capital asset pricing model (CAPM).
2001; Laughton and Jacoby, 1991b; Van Horne, 1977).
The cost of equity, using the CAPM methodology, can be calculated
as follows (Mullins, 1982):
1.2. Numerical example
CAPM = re = f + Rβ (2)
Assume an initial investment (capital outlay) of $20 million occurs in where.
a new project that promises to produce positive annual, post tax cash
flows of $3.25 million for 10 years. If the cost of capital is 10%, the re = expected return (or “cost”) on the listed shares (or asset)
NPV10 of the project (the value of the future cash flows discounted at
that 10%, less the $20 million investment) is essentially break-even (in

Table 2
Simplistic Real Terms NPVs, in $’mill, from a 10 year cash flow.
Discount Rate Year 0 1 2 3 4 5 6 7 8 9 10

10% -$0.03 20 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25
9% $0.86 20 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25
11% -$0.86 20 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25 3.25

2
E. Lilford
f = risk-free rate of return, being the pre-tax yield on a government
bond
R = risk premium of market returns over the long term risk-free rate,
being the stock’s return in excess of the market’s return.
β = beta or volatility factor for the share, being that share’s coeffi­
cient of systematic risk (Hull, 1989).
The beta or volatility or systematic risk of a company reflects the
volatility of that company’s listed equity relative to the market’s vola­
tility as a whole. This is the beta that is used in the CAPM (Van Horne,
1977).
On the other side of beta or systematic risk, the unsystematic risk can
be adequately diversified away (theoretically diluted) through holding a
sufficiently diverse portfolio of market investments (Mullins, 1982). In
the mining sector, unsystematic risk will include varying production
rates, grades, recoveries, operating costs, capital expenditure and other
measureable inputs, which can typically be mitigated against or at least
can be quantified using tools other than through CAPM or/and WACC in
order to be addressed.
For systematic risk, a listed company with a beta coefficient of
greater than 1 reflects a company that has a non-diversifiable risk that is
higher than the whole market’s average risk. What this actually means is
that this particular listed entity (company) has more systematic risk, or
has a higher share price volatility, than a wider portfolio of risky assets.
Alternatively, a beta coefficient for a company that is less than 1 will
reflect that company having a lower-than-market non-diversifiable risk,
which manifests as stock volatility being less than the market’s volatility
as a whole.
Simplistically, the beta coefficient of a listed company reflects its
systematic risk, which is that specific component of total risk that cannot
be obviated, diluted or removed just by holding a diversified portfolio of
investments. A company’s beta is a measure of the company’s overall
risk that cannot be removed or diversified by merely holding a portfolio
of investments (Dixit and Pindyck, 1994).
The volatility or beta coefficient of a company is a measure of the
sensitivity of that company’s value to the various economic inputs that
influence all risky assets’ values, incorporating interest payments and
inflation rates, economic growth, exchange rate impacts and other in­
fluences, as appropriate.
Unfortunately, betas derived from the market co-exist with certain
limitations (Lilford, 2010), including that betas.
• are derived from historical variances, which may not be accurate as
forecasts, notably over the long term;
• vary as the market varies and not independently of it;
• indicate the volatility of a share price and not of a specific asset (so
we tend to use proxies to determine the betas for unlisted assets or for
subsidiaries of listed companies);
• are variable over time, and therefore CAPM will vary over time too;
and
• cannot reflect a perfect or close-to-perfect correlation (cannot yield β
= 1) because resources-based betas vary due to unique commodity
price cycles, independent of the whole market.
2.1. Current practice
If we accept that the WACC is an appropriate measure of the total
cost of funding, and also recognise that the equity component of WACC
can be derived through the application of the CAPM, which is turn in­
corporates a country’s sovereign risk (reflected as the risk free rate or
yield on a government bond, pre- or post-tax) and an attributable market
volatility (the beta), as well as a market risk premium, then why is an
additional project risk premium often added to the resulting weighted
cost of capital to determine a final discount rate?
The generalised answer to this is that the market risk premium does
3
Resources Policy 80 (2023) 103242
Fig. 1. Discount rates and WACC, incorporating risk and uncertainty.
not capture the inherent project risk of an operation and hence an
additional risk premium is typically added to the WACC (Sorentino,
1993). It is suggested that this market risk premium does not actually
capture a specific project risk factor that can be added to the WACC, but
is more accurately a reflection of overall project risks and uncertainty
relating to the resources sector in general. Risks, specifically, may be
factored into an analysis, potentially through applying probabilities or
some other tool to generate a likely outcome, since risks are generally
the unsystematic risks referred to in Mullins (1982).
Risks can be broken down further into being either tangible or
intangible, or risks may actually manifest as an uncertainty, where un­
certainty is a sub-set of risk. Naturally, uncertainties may be either
tangible or intangible too (Maybee et al., 2022).
The following figure (see Fig. 1) outlines the additional factors that
would then need to be included in a WACC to present as an acceptable
discount rate (i.e. WACC + Risk + Uncertainty).
3. Increased accuracy calculating discount rates
There is a significant difference between the absolute cost of capital
(as captured by variable or dynamic WACCs), project risk and project
uncertainty, with the latter often being attributed the reasons for justi­
fying a discount rate higher than WACC. This then suggests that the
WACC, risk factors and uncertainty factors should not simply be added
together to create a single discount rate for the determination of a NPV,
let alone to obtain a single discount rate for the life of the project. This
needs to be discussed further.
Discount rates that are derived using WACC must recognise the
variability of the WACC itself over time. Since the “W” in WACC is the
weighting applied to debt and equity, it is intuitive to recognise that the
“W” will vary over time as debt levels vary, which is driven by debt
principal repayments and potentially further debt draw-downs if a
revolving debt facility exists with the lender, and further recapitalisation
of the project occurs (varying the capital portion of the project, which is
largely further equity investments). That is, as the principal amount of
debt is fully repaid and equity levels change due to recapitalisation (i.e.
capital growth after less than 100% of distributable income is paid out as
dividends), the WACC will trend towards the risk free rate over time
(Lilford et al., 2018).
Corporate strategy and accompanying policies for many companies
lock in a targeted gearing (debt-borrowing) rate and therefore will strive
to achieve a sustainable, pre-determined long-term debt-to-capital level
(ratio), defined as the targeted gearing ratio, which can readily be
justified by the fact that debt is nearly always cheaper than equity and
therefore it is cheaper for a company to borrow (debt) money to achieve
capital growth than to use (retained or raised) equity. If a targeted
E. Lilford Resources Policy 80 (2023) 103242

Table 3
Cash flows showing static NPV at a real, 3.81% discount rate, of $188.9mill.
Year 0 1 2 3 4 5 6 15 16

Revenue $‘mill 102.4 136.0 154.2 165.3 159.8 217.4 226.1

Costs $‘mill 66.6 87.7 105.8 116.0 112.2 159.6 166.0
Op Profit $‘mill 36.3 48.3 48.3 49.3 47.7 57.8 60.1
Capex $‘mill 44.4 16.5 10.3 7.1 5.7 4.5 3.9 2.2 0
Tax $‘mill 8.8 12.3 12.2 11.9 11.3 15.9 16.6
Cash Flow $‘mill − 44.4 − 16.5 17.1 28.8 30.4 33.0 32.5 39.7 43.5
Real Cash Flow $‘mill − 44.4 − 15.9 15.9 25.6 26.0 27.1 25.7 22.0 23.2
Values $‘mill NPV0% 282.9 IRR 30.1%
$‘mill NPV3.81 188.9

gearing rate is considered, then the WACC must trend down to this
weighted pre-determined, geared cost-of-funding level. Succinctly, this
is because the weighting “W” reflects the ratio of debt to total capital,
which changes periodically and often as debt principal levels vary and as
capital levels change (recapitalisation and capital growth from retained
cash flows without raising additional equity from new equity issues to
the markets).
This known variability in the weighted cost of funding over time is
seldom, if ever, reflected in the discounting of medium to long-term cash
flows, and is overlooked altogether in the evaluation of short-term cash
flows.
Unfortunately, it is often deemed too difficult or confusing (or time
consuming) by industry practitioners to consider using a variable (dif­
ferential) discount rate over mid-to long-term cash flows. Consequently,
a single discount rate incorporating both the cost of capital and some
factor for risk and uncertainty is typically and incorrectly used over the
life of the periodic cash flows.
Since this additional risk and uncertainty factor currently has no
accurate mathematical or econometric derivation, there is no deter­
minable correlation that exists between the WACC and the discount rate
ultimately used by practitioners in the NPV calculation.
Compounding matters, an attempt may be made to motivate the
inclusion of an additional percentage premium into the WACC to cap­
ture technical and techo-economic risks and uncertainties arising within
the project (Sorentino, 1993). The percentage premium added here also
typically does not have any quantifying methodology or mathematical
derivation that supports it. Rather, it is simply an additional discounting
factor added on to the derived, static (single-period) WACC.
Simplistically, the resultant discount rate is often referred to as a risk
adjusted discount rate (RADR), being:
RADR = WACC + Xr (3)
where.
Xr = additional risk and uncertainty percentage above WACCand,
from the discussion above:
Xr = Rr + Ur (4)
where.
Rr = (quantified) risk
Ur = (quantified) uncertainty
specifically into the area of intangible uncertainty as captured in dis­
count rates.
3.1. Risks and uncertainties
There are a number of risks and uncertainties associated with the
evaluation of a mining project’s LoM cash flows that are not appropri­
ately, if at all, accounted for in a discount rate. In brief, the risks and
uncertainties associated with a discount rate may include.
• the volatility or beta varying over time as markets vary;
• a static or single-period WACC being applied to cash flows covering
multiple periods;
• a varying cost of debt over time as LIBOR/BBSW (London Inter Bank
Offer Rate and Bank Bill Swap Rate, respectively, being base lending
rates) and funding margins vary;
• the debt: capital ratio varying over time as debt repayments (or
further principal drawdowns) occur, impacting the debt-weightings
or “W” in the WACC;
• the capital amount varying as recapitalisation and capital growth
occurs, impacting the debt: capital ratio over time;
• the unlevered and then re-levered beta not being adjusted as debt
levels change, equally so when a proxy company is used, over time,
and the risks and uncertainties associated with the business of min­
ing itself and its cash flows may include.
• variable tonnages, grades and recoveries against forecasts;
• variances to forecast operating costs and ongoing capital
expenditures;
• unquantifiable environmental, social and governance (ESG) impacts;
• market variances (prices, exchange rates, etc)
• any other continuously changing project risk and uncertainty,
collectively incorporated in Xr.
In the first set of listed risks and uncertainties above, the debt to
capital ratio changes over time as well as the additional inconsistencies
can be addressed through the following discussion and solutions.
To capture the ever-changing factors that alter a RADR, we have,
from equations (1) and (3) (Lilford et al., 2018):
RADR = repe + rdpd + rppp + Xr (where Xr = Rr + Ur) (5)

and from (2), and assuming that preference share funding is not avail­
The overarching assumption here is that this premium, Xr, reflects
able, and noting that rd is a pre-tax cost of debt (the post-tax cost of debt
the risk and uncertainty premium above the WACC acceptable to the
is calculated by rd(1-t), where t is the applicable tax rate in that
investor or lender providing the equity and/or debt, respectively, to
jurisdiction):
fund the project.
Consequently, this additional premium Xr will only include those RADR = pe(f + Rb) + rdpd + Rr + Ur (6)
technical risks and uncertainties not already captured in the WACC
which, by definition, implies that Xr may be a significant addition. and at periodic, specific points over time:
The analysis and derivation of Xr, and specifically Ur, from an RADRi = pei (fi + R(bi)) + rdipdi + Rri + Uri (7)
intangible perspective, presents an opportunity for further research,
where i represents the specific period.

4
E. Lilford Resources Policy 80 (2023) 103242

Table 4
Cash flows showing a dynamic (differential) NPV ($216.9mill).
Year 0 1 2 3 4 5 6 15 16

Diff Disct Rate % 3.81 4.21 3.05 2.30 2.17 2.06 1.16 1.16
Cash Flow $‘mill − 44.4 − 15.9 15.9 25.6 26.0 27.1 25.7 22.0 23.2
Disct Factor 1.000 0.963 0.924 0.897 0.877 0.858 0.841 0.732 0.724
DCF $‘mill − 44.4 − 15.3 14.7 23.0 22.8 23.2 21.6 16.1 16.8
Progressive NPV $‘mill − 44.4 − 59.7 − 45.1 − 22.1 0.5 23.5 44.8 190.8 216.9

With equity and debt levels changing over time, and also with their
ratios changing as a collective funding solution totalling a certain % of
the company’s capitalisation, we have:
pe + pd + prc = 1
where prc = weighting of reinvested capital, where reinvested capital
excludes operating and replacement expenditure, and therefore (modi­
fied from Lilford et al., 2018):
RADRi =
ei
(fi + R(bi)) + rdi
di
+ Rri + Uri
ei + di + rci ei + di + rci
To then apply an appropriate, variable RADR to each periodic
(specific) cash flow, we must apply:
1 RADRi+Rri+Uri
RADRindexi = x aims to expunge all debt and remain debt free in the future, which will
1+RADRi+Rri+Uri 1+(RADR+Rr+Ur)(i+1)
x
(RADR+Rr+Ur)(i+1)
x…x
(RADR+Rr+Ur)(n− 1)
1+(RADR+Rr+Ur)(i+2) 1+(RADR+Rr+Ur)n
(10)
Table 3 below shows the resultant NPV of a generic cash flow when
applying a single (static) discount rate (WACC) over the life of the cash
flows.
The first or upper half of Table 4 below simply repeats the static NPV
calculation, but uses a discount factor rather than through the use of
Excel’s “ = NPV(x%,range)” function. The static value, or check value,
can be seen in the “Progressive discounted” row at Year 16 (i.e.
$188,881).
Considering the previous discussion and applying the associated
formulae, periodic cash flows for a minerals project can be discounted at
different periodic rates, importantly on a compounding basis, over the
life of the project. The discount factor in the table below shows the
variable (differential) periodic discount rates.
Table 4 shows the progressive cumulative NPV over each duration of
the life of the cash flows, with the whole-of-life cash flow NPV being the
sum of the periodic values. An important consideration in the above
table is that the variable (differential) discount rate falls over time to a
low of 1.16% (occurs in Year 15 of the full model, and is shown in Year
16 in Table 4), which is the after-tax risk free rate. However, the
applicable discount rate should not fall below the sum of the risk free
rate plus the debt costs associated with the targeted gearing rate (target
debt as a percent of total capital), being 30% in this example. Therefore,
the minimum discount rate that should be applied at any point in time
cannot be less than the sum of the weighted total sovereign risk
(representing the cost of residual equity) and the weighted cost of debt,
collectively being the floor WACC (or minimum WACC).
The above paragraph also alludes to the finite nature of an ore body.
If, with certainty, the ore body will be depleted over a certain period of
(8) time assuming existing mining rates are sustained, then the outstanding
(remaining) debt balance must be repaid over the period with at least
2–4 years of zero payments at the end of the LoM. So if the remaining life
of the ore body is, say 16 years, and the debt term is 8 years (with rolling
draw-downs), we will maintain a gearing ratio of 30% up until Year 6
(9) and then allow free cash flows to reduce the gearing until the debt is
fully repaid by year 14. The final 2 years, year 15 and year 16, provide
the financier a margin of comfort in case the debt is not successfully and
fully repaid over the final 8 year term.
In the event that the company’s targeted gearing rate is zero (i.e. it
be the case at least 2–4 years before the mine finally closes), then it can
be argued that the cost of capital will reduce over time, but will never
fall below the sovereign risk rate. In the discussion above, then, once the
debt is fully repaid in year 14, the final 2 years’ cost of capital will be the
after-tax risk free rate alone.
As stated previously, if uncertainty associated with the project is to
be captured in a discount rate or in an uncertainty factor, it can be done
separately from the WACC rate, as shown in Table 5 below. In this table
below, the inclusion of risk and uncertainty is factored into the final one
third of the table.
From Table 5, the split between the cost of capital (WACC), which
varies over time, and the additional discount factor associated with
project risk and uncertainty (Project Risk Discount Rate in Table 5) is
clearly distinguishable. From the above tables, the following summary
holds:
NPVproject at static WACC: $188.9 million.
NPVproject at variable WACC: $197.1 million.
NPVproject at variable WACC plus 0.1%pa risk/uncertainty: $187.2
million.
This means that the value of the additional 0.1%pa risk or uncer­
tainty alone is approximately $10 million, or 5.02% of NPVdynamic.
3.2. Factored risk and uncertainty and component parts
Some project risks and uncertainties, separate from WACC, can be
factored into a minerals project’s cash flows using tools including Real
Options, Probability Distributions (decision trees), weighted sensitivity
analyses, and other methods. However, these additional tools often

Table 5
Cash flows showing a static, dynamic and a combined dynamic-with-risk NPV ($187.2m).
Year 0 1 2 3 4 5 6 15 16

Diff Disct Rate (30% geared) % 3.81 4.21 3.22 3.22 3.22 3.22 3.22 3.22
Cash Flow $‘mill − 44.4 − 15.9 15.9 25.6 26.0 25.7 21.8 22.0 23.2
Disct Factor 1.000 0.963 0.924 0.896 0.868 0.841 0.814 0.612 0.593
DCF $‘mill − 44.4 − 15.3 14.7 23.0 22.6 22.8 20.9 13.5 13.8
Progressive NPV $‘mill − 44.4 − 59.7 − 45.1 − 22.2 0.5 23.2 44.2 183.3 197.1
Project Risk % 0 0 0.1 0.2 0.3 0.4 0.5 1.4 1.5
Risk Disct Factor 1.000 1.000 0.999 0.997 0.994 0.990 0.985 0.901 0.887
Risk-adjusted DCF $‘mill − 44.4 − 15.3 14.6 22.9 22.4 22.5 20.6 12.2 12.2
Progressive NPV $‘mill − 44.4 − 59.7 − 45.1 − 22.2 0.2 22.8 43.4 175.0 187.2
Progressive IRR % − 55.51 − 14.67 3.99 14.37 20.13 29.97 30.13

5
E. Lilford
Fig. 2. Changes in unit value per change in unit input.
require either specialised software (expensive) or otherwise significant
time and expertise to incorporate.
Dynamic or differential discounting has been discussed in detail in
Lilford et al. (2018), which includes differentiating the absolute, vari­
able cost of capital from project risk and uncertainty. However, it is this
latter risk or uncertainty that requires more attention, especially if
project risk and uncertainty are distilled into a single or variable dis­
count factor. In Table 5, this uncertainty factor was included as an
additional 0.1% each year from Year 2 onwards. But what should this
factor actually be?
To answer this, we need to ask and answer the questions “so what are
the typical risks and uncertainties that a mining project is exposed to
that are not captured in a WACC, and will these factors vary over time in
a similar way to how WACC varies over time?”
Typically and as stated previously, the risks and uncertainties that
should be considered in an operation’s cash flow include.
• tonnage risks (can LoM tonnage rates be realistically achieved)
• grade variations (including dilution)
• plant recovery uncertainties (and throughput targets)
• cost variations and capex over- or under-estimations
• market movements (commodity price and exchange rate) not
captured in WACC already (Note: CAPM incorporates volatility
which is largely, but not solely, driven by the volatility or variability
of the commodity price, in the local currency, and hence also capture
exchange rate volatility)
• other operating uncertainties (mine closure costs, environmental
aspects, ESG, etc)
That is, there is a need to separate out the pure cost of funding as
determined by a WACC from project risk and uncertainty associated
with technical and techno-economic parameters, which may also be
variable over time.
Giving some thought to risk and uncertainty over time, it would seem
appropriate that these parameters will increase over time, since fore­
casts become less accurate the further out they are projected. So over the
short term, forecasts may be considered to be fairly accurate over the
parameters listed above, whereas these same parameters become likely
to vary from the forecast figures as time elapses.
The value of an operating assets is dependent on revenue (tonnes,
grades, recoveries, sales, etc), where revenue is driven by commodity
price and exchange rates. The volatility of commodity prices and ex­
change rates are, to some extent, captured in the CAPM where the beta
(volatility) largely reflects the variability of the stock against the market
as a whole. Stock volatility is obviously affected by changes in
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Resources Policy 80 (2023) 103242
commodity price, amongst other factors. In addition, commodity prices
are often mean-reverting, so the short term volatility is offset to some
extent by the reversion to a long-term trend. This naturally excludes the
occurrence of global events that shift the reversion altogether (Global
Financial Crisis, Covid-19, etc).
Operating costs and capital expenditure (capex) provide for two
areas of significant risk and uncertainty over time as well. In addition,
while modelling in nominal money terms captures inflationary effects in
forward-looking costs and capex, real increases (or decreases) in these
factors are seldom included. Once again, these aspects form part of the
“additional risk and uncertainty” added to a discount rate, despite being
weighted in a sensitivity analyses too.
3.3. Proportional changes
Every mining project exhibits a different relationship between its
NPV-variability against its changing input parameters. One project’s
value will reflect a different percentage change, as measured by its NPV,
when compared with another project, despite the varied input param­
eter(s) being changed by the exact same amount.
Stated differently and by way of an example, if the relevant com­
modity price is changed by 10% for one project and its resultant NPV
changes by, say, 2%, then for a different resources project mining the
same or different mineral, that same 10% change in commodity price
may impact its NPV by, say, 5% or by a different amount. This is a
Proportionality Constant.
This of course assumes that there is no hedging in place as, intui­
tively, one cannot sensitise the hedged position. In addition, many
commodity producers hedge some of their production, so the variability
(volatility) of that company is dampened. That is, hedging impacts the
volatility of the project, as reflected in its Beta. To calculate the CAPM
(cost of equity) then, the applicable Beta must firstly be “unhedged”, in
the same way that a gearing Beta is firstly ungeared, as explained
previously.
It becomes important then that we recognise that each project be­
haves differently under similarly changing conditions. The change in
NPV per unit (e.g. NPV per tonnes milled, NPV per ounce sold, etc) will
differ from one project to another to reflect the analysis of the same
variation in input (e.g. price per tonne, price per pound, working cost
per tonne, grade, etc).
The above means that a different Proportionality Constant (PC) ex­
ists from one operation to another, as well as a different PC from one
varying input to another. The following graph (see Fig. 2) shows three
sensitised inputs on a base model used in this analysis, being commodity
price, operating costs and tonnes mined.
E. Lilford Resources Policy 80 (2023) 103242

Table 6
Differential discount values with sensitivities converted to uncertainties and risk.
Year 0 1 2 3 4 5 6 15 16

Diff Disct Rate (30% geared) % 3.81 4.21 3.22 3.22 3.22 3.22 3.22 3.22
Cash Flow $‘mill − 44.4 − 15.9 15.9 25.6 26.0 25.7 21.8 22.0 23.2
Disct Factor 1.000 0.963 0.924 0.896 0.868 0.841 0.814 0.612 0.593
DCF $‘mill − 44.4 − 15.3 14.7 23.0 22.6 22.8 20.9 13.5 13.8
Progressive NPV $‘mill − 44.4 − 59.7 − 45.1 − 22.2 0.5 23.2 44.2 183.3 197.1
Cost inc 10% DF % 4.68 4.68 4.68 4.68 4.68 4.68 4.68 4.68
Risk Disct Factor 1.000 0.955 0.913 0.872 0.833 0.796 0.760 0.504 0.481
Risk-adjusted DCF $‘mill − 44.4 − 14.6 13.4 20.0 18.8 18.1 15.9 12.5 6.8 6.6
Progressive NPV $‘mill − 44.4 − 59.0 − 45.7 − 25.7 − 6.9 11.3 27.2 112.6 119.3
Tonnes less 10% DF % 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00
Risk Rate 1.000 0.990 0.980 0.971 0.961 0.951 0.942 0.861 0.853
Risk-adj DCF $‘mill − 44.4 − 14.5 13.1 19.4 18.1 17.2 15.0 5.9 5.6
Progressive NPV $‘mill ¡44.4 ¡58.9 ¡45.8 ¡26.4 ¡8.3 8.9 23.9 100.9 106.6
Grade less 10% DF % 3.30 3.30 3.30 3.30 3.30 3.30 3.30 3.30
Risk Rate 1.000 0.968 0.937 0.907 0.878 0.850 0.823 0.614 0.595
Risk-adj DCF $‘mill − 44.4 − 14.0 12.3 17.6 15.9 14.7 12.3 3.6 3.4
Progressive NPV $‘mill − 44.4 − 58.4 − 46.1 − 28.5 − 12.7 2.0 14.3 69.4 72.7
Progressive IRR % 3.79 29.97 30.13

In this specific example, it is apparent that any percentage change in
the commodity price impacts the unit NPV in a similar manner to a
similar percentage change in the mining (tonnage) rate. This is only
possible since, as the tonnage changes, so does the divisor (if the NPV
was not unitised, the commodity price changed NPV would be signifi­
cantly greater than the NPV for a similar percentage tonnage change).
Naturally, an increasing operating cost will decrease the NPV (unit or
absolute), and further impact taxes once profitability is compromised.
Conducting a sensitivity analysis is well-known to all. However, the
benefits of a sensitivity analysis are brought into question when we
acknowledge that it reflects a static operation, being one in which
nothing else (tonnes, grades, yields, etc) varies while we sensitise eco­
nomic (prices, exchange rates, costs, capex, etc) or technical inputs.
Stating the obvious, the cut-off grade should change if we change
(sensitise) the price, or costs, or other economic parameter, which in
turn will impact on our mining rate (tonnes), process recovery, pro­
cessing rates and costs, and numerous other determinants included in
the LoM Plan, which collectively will impact the NPV.
It is for this reason that this paper puts forward a proposed partial
solution, being to correlate the relationship between each varying
parameter, and then determine the effective discount rate or factor, and
gauge the impact that this has on the project. This discount factor impact
must then be modelled separately from the WACC so that it can be
independently assessed as a risk or an uncertainty, and not merely
hidden in the discount rate (as shown in Table 5).
In the model used in this analysis and partially presented in the
previous tables, the following table, Table 6, presents the relationship
held between the sensitised input value and the calculated discount
factor that this variation, whether through the input parameter or the
discount factor, would have on the NPV of the project. For ease of
reference, the NPV of the project was determined to be $197.1mill using
dynamic discounting.
To clarify this, if we accept the base calculated variable WACC and
then factor in a cost increase uncertainty (10% increase), a risk of the
tonnage rate being 10% lower than forecast, and a risk that the grade
may actually be 10% below the LoM determined grade, then we can
separately determine the impacts of each of these risks and uncertainties
on the value of the project. In this example, and on a cumulative basis.
• a 10% increase in the operating cost will result in a NPV of
$119.3mill. This translates into an additional discounting factor of
4.68% over the LoM;
• a 10% reduction in the annual tonnes mined will result in the NPV
being $106.6mill, translating to an additional 1.00% on the discount
factor;
• a 10% grade reduction will result in the NPV falling to $72.7mill,
being an effective or equivalent increase in the static discount rate of
3.30%.

Fig. 3. Cumulative differential discount values with sensitivities converted to uncertainties and risk.

7
E. Lilford
Fig. 4. NPV variation due to “sensitised discount rate”.
The progressive NPVs highlighted in Table 6 above are shown dia­
grammatically below (see Fig. 3).
From the above Table 6, and shown graphically in Fig. 3, we can
quickly compare the value impacts of each of the sensitised parameters
by comparing the Progressive Value of each variation. The difference
above the WACC rate is shown for each of the sensitised cases in Fig. 4
below.
Intuitively, the question will be asked as to if we can calculate the
impact of a 10% reduced grade (or any other input parameter), why
should we bother converting it to an equivalent discount factor (DF)?
The reasons are many, but most importantly.
• changing the input (e.g. grade) will likely and should change the LoM
Plan and hence the whole NPV model. This is something no-one does
in a sensitivity analysis;
• accepting that differential discounting is more accurate than static
discounting, and modelling the cash flows as shown in the example
used, the probable variation in the grade (or other uncertainty) is
likely to be further out in the mine’s life and not from Year 1. This
modelling convention allows for the grade-uncertainty to be factored
into the cash flow at any point in time. It also allows for increasing
(non-static) uncertainty with time, so that the grade discounting
factor can also be variable (differential) from one period to the next;
and
• each input that is varied or sensitised, can be individually tracked to
determine its impact on the NPV at any point in time.
4. Summary and conclusion
From the above discussions, it can be appreciated that conventional
DFC NPV modelling remains a useful evaluation tool for mining project
decision-making. It is generally a preferred tool that is used by many
valuation practitioners, despite its many limitations.
Importantly for a mining company, investor or other stakeholder,
after the company has spent tens of millions of equity dollars on various
studies including a definitive study, they tend to diminish the value of
the study somewhat by incorporating a discount rate or discount factor
that has not been accurately determined and is merely a reflection of
what has always been done in the past. Very little time or effort is spent
on ensuring the most accurate discount factor possible is used.
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Resources Policy 80 (2023) 103242
In addition to this, companies typically incorporate a single discount
factor in the analysis over the full life of the project, irrespective of
whether the investment is a short-, medium- or long-life project, and
irrespective of whether debt: capital and equity: capital ratios change
over time (which will occur, since debt will be repaid periodically and
completely at some future point).
Other than stating that differential or dynamic discounting is war­
ranted Lilford et al. (2018), the findings in this paper suggest that a
preferred way of incorporating risk and uncertainty into a discount
factor is to disaggregate the risks and uncertainties from a single dis­
count factor and then itemise each risk and/or uncertainty and model its
impacts separately. These factors can be correlated with a discounting
effect and hence allow the valuation practitioner to select an appropriate
risk-and-uncertainty-adjusted discount factor associated with that risk
or uncertainty. This adjustment factor can then be added to the WACC,
over each period, so that a dynamic WACC incorporating varying risks
and uncertainties in a DCF NPV calculation becomes defendable.
In addition, this paper clearly shows how simple it is to disaggregate
the various components of a discount rate into its WACC, risks and un­
certainties, so that any individual reviewing the valuation metrics can
readily ascertain which components of risk and uncertainty are attrib­
uted greater value (being negative value in this case) and should
therefore be given greater attention in the various studies.
Author statement
This paper is my own, original work and is not being funded by any
party whatsoever. This paper has not been submitted elsewhere for
publication.
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