PAPUA NEW GUINEA UNIVERISTY OF TECHNOLOGY

MINING ENGINEERING DEPARTMENT

PRIVATE MAIL BAG, TARAKA CAMPUS,
LAE 411, MOROBE PROVINCE, PNG
Ph: 4734671:

COURSE FACILITATOR
DR KAEPAE KEN AIL (PHD)

SESSION 2
OPERATING AND CAPITAL COSTS AND FINANCING TECHNIQUES

FEB 27TH 2023

 OPERATING AND RECURRENT MAINTENANCE COSTS
Can be classified as:
• Fixed Cost (FC), incurred irrespective of the level of production or

• Fixed costs can be in form of maintenance of equipment and parts and stripping
of a push-back plan for mine expansion can involve capital expenditures the
require depreciation. These can be recognised under the Allowable Capital
Expenditure (ACE) items.

• Variable Costs (VC) are directly proportional to the level of production

• Profit and loss (P/L) Statement recognises the VC comprising of:

- Recurrent operating and maintenance costs,
- Depreciation and amortisation expenses
- Interest on debt capital recognised under thin capitalisation rules
 CATEGORISES OF RECURRENT COSTS

Operating and maintenance costs (incurred during production period)

Fixed (constant): - Licenses, indirect costs, property, land and acquisition fee and taxes
- Fixed overheads, wages, salaries, payroll taxes
- Fixed services (equipment and logistic contracts)
- Interest expenses
- Depreciation (non-cash) expenses

These depend on the intensity of the mine or oil and gas project designs and financial arrangements

Variable Costs: - Mining (drill & blast, load and haul)

- Milling (crushing, grinding, floatation)
- Service and admin costs

Generally, a mining sector project will continue to operate as long as the contribution margin (i.e.,
the difference between the price and variable cost per unit) is zero or positive.
PROJECT MODELING AND EVALUATION WILL ALOW BETTER CHOICES
AND FACILITATE VALUE CREATION STRATEGIES
 CAPITAL INVESTMENT COSTS

Capital costs are required to establish the mine to a productive capacity

- Required to bring a mining, oil and gas project to a production state

- Required for working capital (when a project is not yet generating revenues)

RECURRENT OPERATING AND MAINTENANCE COSTS

- Operating costs required for producing the commodity to a stage where it is marketable

- Mostly linked to production activities

- Both cost categories may require equity and debt capital financing mechanisms, especially
important at the initial development and production stages (e.g., working capital)
 CAPITAL INVESTMENT COST
Pre-production stage:
- Exploration & feasibility study and these are amortised

- Mine access: Stripping and shaft sinking development

- Mine: Mine equipment, site preparation, construction of workshops, power and water facilities, mine
office, store, road improvements, water supply, accommodation camps, towns, etc.

- Mill: - Crushing, grinding, flotation and drying facilities, tailing disposal, dam etc.

- Working capital – support 3 – 6 months of operation

Production stage: replacement or upgrading and non-current maintenance of equipment

- major modification of mine plans, capacity expansion, conversion from open pit
to underground mining

Closure stage: Salvage, site rehabilitation

Capital investment cost appears as Assets in the Balance Sheet (B/S) as these are capitalised
 THE AMOUNT AND TIMING OF CAPITAL FLOWS

Are influenced by:

• The mining method and design (e.g., open pit or underground) depending on the nature of the
deposit

• The scale of operations and the degree of capital intensity and automation

• The extend to who underground development must precede the ore extraction (e.g., the
difference between block or crater caving or selective sublevel stopping methods).

• Capital costs generate current expenses on:

- a non-cash accrual basis e.g., deprecation and amortisation

- cash basis, e.g., interest expenses of the capital investment were funded with debt or
opportunity cost of equity capital if funded by out-off pocket money (or equity)

• The capital cost must be recovered through capitisation (is not an expense) at a shortest
possible timing.
 SOURCING CAPITAL COSTS
Mine development is a risky business and therefore, it requires an understanding of how these
activities are financed.
 Investment decision: allows easier comparison and choose projects on the basis of their inherent
merits assuming a 100% equity ownership and neglect the first instance of financing
arrangements.
 Financing decision: to determine ways of enhancing returns on a shareholder’s equity from a
project, which the investment decision analysis has indicated to be potentially attractive. This is by
funding it in a most advantageous way from a leverage and tax-shield point of view, compatible to
an acceptable increase in financial risk.
 Portfolio decision: to optimise corporate objectives through integrated investment strategies with
potential synergies (joint venture operations, farmin/farmout, contract mining) and advantageous
mine designs (e.g., satellite ores feed to an existing mill in the area). Also two or three gas fields
use a single pipeline and a LNG condensing plant.

These decisions must be considered separately and successive steps taken to obtain the correct
decision variables from an evaluation. Here, we only focus on the financing decision. Large
resource companies have credit-worthy advantage over smaller companies and have little difficulty in
raising capital in financial markets. There are different types of debt capital required for financing
resource projects.
 SOURCING AND SECURING FINANCIAL CAPITAL

1. Conventional debts finance such as:

i) long-term loans or debenture issues etc., secured by a “senior” claim on the firm’s assets and
protected by coverts generally limit further ability to borrow, or

ii) short to medium-term loans, bank overdrafts and financial leasing agreements, or

iii) gold loans and advance sale contracts of the operation to be financed for a gold mine and other
precious metals such as diamond and platinum.

2. Project finance secured, at least partially by the fortunes of the specific project ideally reducing
the exposure to risks (no or limited recourse) of the parent holding company.
- e.g., the Newcrest’s Lihir gold mine guarantees securing the capital for Wafi-Golfu project, but
the new mine’s capital cost must not be tied to the existing mine.
3. Quasi-equity and hybrid instruments such as:

Limited-resource finance may include various forms of operating leases (contract mining),
convertible and non-convertible long to medium-term, unsecured and zero- coupon notes, and
preference share issues. These are secured by subordinate claims on the firm’s assets.

The seniority of their claims (e.g., Newcrest), lenders do not bear much risk. The risk is borne by
the project itself and ultimately the shareholders. As such, the real long-run cost of fully secured debt
financed (RD) to large corporations, on average relatively low; of the order of 4.5% or 3%. Interest
futures, swap to other securitisation, e.g., hedging mechanisms allow stabilisation of interest rate risk
and often at a low cost. The risks of financing a resource project is reduced by farmin/farmout, JV
operation, and contract mining.

The term of a loan must ideally match the life of an investment that is going to be financed. Short-
term debt such as bank overdraft should be used to finance working capital or short-term obligations
(e.g., school fee). Medium to long-term debt capital should be used to finance a mine
development, equipment, land and other long-lived capital equipment at a preferably lower interest
rate. Never use long-term loans for financing short-life assets or obligations (e.g., bride price).
1. Debt facilities

(a) Trading banks to secure long-term production assets and mine development

- Overdrafts to finance fluctuations in working capital at the initial stage of a resource project
operation

- Bill acceptance and discount facilities for working capital and medium term needs rolled over for
every 30 to 180 days at interest rates slightly higher than that of the overdrafts.

- Term loans (3 to 10 years) for long term capital expenditure. Interest rates slightly vary from 0.5%
to 1.0% above the current overdraft rates

(b) Merchant banks

- Bill acceptance and discount facilities

- Term loans up to a maximum of 5 years at a floating rate indexed to commercial bill rates or the merchant
bank’s own prime rate

- Financial leasing for large capital equipment with lives of 10 to 20 years at a cost generally below the
commercial loan rates
(c) Gold and commodity-linked loans
are generally for up to 5 years. The lender provides bullion which is either held or converted into
cash. Loan repayments are also in form of physical gold (typically 20 to 30% of mine production).

The lending fee expressed in US$ typically ranges from 1 to 3% p.a. in addition to a guarantee fee
of 0.5 to 2.5% calculated daily on the basis of the market value of the outstanding gold loan. The
structure of a gold loan is given in Figure inserted (next page).

Borrowing enhances gearing and increases the expected return on equity, but also increases its
variability or risk imperilling the interest and loan repayment ability.
High gearing (debt capital higher than equity capital) can lift the expected return on equity, but
also increases the cost of debt through high interest accumulation if price falls.
As the debt/equity ratio of the borrowing firm increases beyond the industry average, the lender
(banks) become exposed to financial risks of default and higher rates of interests. That is, the
marginal cost of capital of the firm increases rapidly. This in turn limits the capacity of the firm to
borrow and increases its average cost of capital with further borrowing.
It must be emphasised that a 75% loan financing refers strictly to the initial capital costs for mine
development and overburden stripping.
The loan periods are 5 to 7 years and the mine lives must range from 10 to 20 years. As a
result, the average level of debt over the life of the mine is much lower (probably of the order of
40%). Sometimes thin capitalisation rules apply to restrict the debt/equity capital composition.

Mining developments historically were funded largely by equity capitals.

Since the early 1960s, however, many mines, especially those selling high-volume products
such as iron ore and coal that were mined by massive open-cut operations have been
substantially financed by debt capital.

This in some cases exceeded in the initial stages by 75% of the total capital required. Security
has risen mainly through the negotiation of sales contract, either at a fixed price subject to
annual or other periodical price negotiations (e.g., Pilbara iron ore agreements) or at a floor
price (Bougainville copper contracts with Japanese smelters) or a fixed price with annual or
periodical increases or lowest long-term average prices.
 FINANCIAL STRUCTURE OF RESOURCE COMPANIES
A firm is said to be creditworthy when it has large asset base (cash, operating projects
and technology). It can source low cost source of debt finance than the cost of equity
finance. The cost of debt (RD) is reduced since interest expenses are deducted before
determining the taxable income.
As a result, the rate of return on equity (ROE) fund by higher debt component (D) is
higher than a project financed entirely with equity component (E). This is called financial
leverage. As a result, resource companies tend to secure higher debt capital (gearing) to
benefit from interest expenses as well as pay reduced tax revenues. However, host
governments restrict the 100% use of debt capital using thin capitalisation rules to ensure
the interest deductible before tax is not excessive.

The combined opportunity cost of financing structure of a mining project is measured by a

rate known as Weighted Average Cost of Capital (WACC). It is suitable discount rate if
the project risk is similar to that of the firm, and project is funded by a combination of debt
(D) and equity (E) capital.

The WACC is a suitable discount rate instead of the debt interest rate or the cost of equity
(RE). In a DCF model, if the model is applying 100% equity finance assumption, the
discount rate should be the cost of equity or the minimum average rate of return (MARR)
determined by the project developer.
Weighted Average Cost of Capital (WACC)
= E/(D+E) + D/(D+E) * RE * (1-t) * i

Where RE = expected return on common stock,

D = portion of debt component in capital finance
E = portion of capital finance comprising of equity finance
‘ t = effective tax rate of the host country
‘ i = nominal interest rate of the debt capital

RE = Cost of equity
RC = Weighted average
corporate cost of funds
RD = Cost of debt

D/E
 Example: Calculate the discount rate given the following information for resource project:

 Risk free rate of return is 4.5%, Beta is 1.5%

 Global mining industry rate of return is 7%
 Assume financial capital cost is sourced from 50% commercial loan with 15% interest rate
and
the other 50% comes from debt financing
 Effective tax rate is 30%.

Step 1: RE = RF + beta * (RM – RF)

=4.5% + 1.5%* (7%-4.5%) = 8.25%

Step 2: WACC = E/(D+E) + D/(D+E) x RE x (1-t) x i

= [50/(50 + 50] * 8.25%* (1-0.3) * 15%
= 9.38%

This shows that the WACC will decline as the percentage of debt increases from zero upwards.
However, it reaches a plateau and start rising again when suboptimal debt levels are reached
indicating 100% debt increases the cost of capital and thus expose the project to financial risk
(see Figure in previous slide). WACC is ONLY applied when a project is funded by a
combination of debt and equity capital.