Project Economics: Concepts and Financial Modeling Training

1. Project Economics: Concepts and Financial Modeling Training

2. Mining Tax Regimes- Range of Taxes and Non-Tax Instruments-Overview • Profit- Based taxes • Corporate income tax (plus withholding tax) • Resource rent taxes • Windfall profits tax • Production-based taxes: • Royalties Ad valorem, Unit-Based/production volume • Sliding scale royalties • Import duties • Export taxes • Withholding tax on loan interest and services • VAT • Non-tax instruments: • Signature bonuses • Surface fees • License fees • Production sharing contracts • State equity participation Adapted from Paul Jourdan- UNDP Training

3. Profit based Tax -– tied to profitability and preferred by the investor • Corporate Income Tax • Most states apply a standard national corporate rate in the range of 20% to 35% of profits • Investment Credit/ Capital allowance • A percentage of the capital expenditure that is tax deductible • An accounting technique that applies the current year's net operating losses to future years' profits in order to reduce tax liability • Loss and Carry Forward • Withholding Tax on Dividends • On Dividends for foreign shareholders- common and encourage re-investment in the country • Windfall Profit Tax • (Variable Income Tax, Additional Profit tax, Super profit tax) • Profit taxes on a sliding scale linked to measure of return, taking into account change in prices and costs • Triggers in after a threshold real rate-of-return (RoR) on investment has been achieved by the project. • Generally between 20% to 50% • Resource Rent Tax

4. Production-based taxes– not tied to profitability and disliked by the investor • Imposed on value of mineral sales (ad valorem) or on production volume (unit based). • Could be based on value at mine, at port (FoB value), or at destination (CIF value). • Defining the base is as important as defining the rate (where possible, useful to define the base by reference to transparent price indices) • Front-loaded, giving tax revenues from first production • Royalty • Sliding Scale Royalty • Royalty rate increases with increase in prices • Applied on FoB value of mineral exports - like another royalty • Used to encourage beneficiation and sale to local market • Export Tax • Should be an industrial development instrument • Exemption should only be applied to capex to encourage local manufacturing of consumables (operating costs) • Import Duty • Withholding Tax on Interests • to discourage abusive recourse to debts (for instance under the form of shareholders’ loan to the project) • Captures portion of value-added – full exemption when product is exported- discouraging local market • Value Added Tax

5. Non tax instrument • Signature Bonus • Up front payments for the right to develop- can be deductible • Limiting exploration and mining areas to economic targets Low enough to encourage exploration • Surface fee/ license fee ($/Ha) • Capital Gain Taxes • Should be considered for sale of exploration licenses before mineral production- (imposed on difference between the sale price and total allowable exploration spent) • Production sharing • Production is shared after deduction of some or all production costs- Common in petroleum industry- (not common in mining)* • Higher share of economic rent and increase govt. influence on companies’ decisions • Can be costly for paid-up equity and creates potential conflict of interest as regulator & player • Investors prefer government’s role as regulator & tax collector, with equity <15% • Many forms : Paid-up equity on commercial or concessional terms, Carried interest, Tax exchanged for equity (reduced tax liability), Equity in exchange for provided infrastructure, Free equity • State Equity Participation • * In Mining: costs are front loaded and higher so not enough marginal production to share from beginning + marketability of minerals in local market more difficult (PSC in Coal in Indonesia, Egypt, Poland), in Tin (Indonesia)

6. Corporate variables • Price * Production • Production profile (company feasibility studies) • Price : Market forecast • Revenues • recurring expenses,(salaries, admin. cost , consumable, fuel) • Calculated as a unit cost * production quantity • Operating Costs (Opex) • Capital Expenditure (Capex) • Fixed costs (land, buildings, construction and equipment ) • Depreciation and Amortization (D&A) • Accounting mechanism to spread out the capital expenditure over many years-> tax deductible and investment incentive • Retained Earning • The percentage of net income not paid out as dividends, but retained by the company to be reinvested in its core business or to pay debt. • % of net income paid as dividend is called dividend payout ratio • Financial Interests • Interest payments on debt are treated as costs and are generally tax deductible • Debt financing increases the indicator of profitability of the project (the Internal Rate of Return)

7. Underpinning concepts of cash flowsforecast • The rate used to determine the Present Value (PV) of future cash flows. • Discounting concept: Money available now is worth more than the same amount of money available in the future because it could be earning interest • Discount Rate “r“ • PV=( 1/ (1+r)^n) –> Future CashFlow are discounted • the farther the cash flow in the future (the bigger n), the smaller is the present value (PV) of the cash flow • Sum of all the negative and positive DCF over the life of the project • TheIRR is the discount rate that makes the net present value of all cash flows from a particular project equal to zero. • NPV and IRR serve to rank projects . The higher the better. • Discounted Cash Flow (DCF) • Net Present Value (NPV) and Internal Rate of Return (IRR) These concepts need to beunderstood for financialmodeling and importance of timing whendetermining fiscal policies

8. Market Variables : How to forecast prices during life of mine (20-40 years)? • Short term prices and historical prices will be easily available: • For metals: • http://www.metal-pages.com/metalprices/free-charts/ • http://www.kitcometals.com/ • For energy and metals • http://www.consensuseconomics.com/download/Energy_and_Metals_Price_Forecasts.htm • For energy, metals and non- metals • http://www.infomine.com/ • For coal and steel • http://www.worldcoal.org/ • http://www.worldsteel.org/ Long term prices forecast require analysis about the international market : Is the current boom/ bust in short term prices sustainable ? Is the market demand-driven or supply-driven? Is the historical price average valid to forecast long term prices? Which big exporter or importer countries make the price ? Sources: www.worldcoal.org, www.worldsteel.org/, www.iea.org, www.consensuseconomics.com, IMF World Economic Outlook ; http://www.imf.org/external/pubs/ft/weo/2010/01/ Technical report, press articles, bank analysis release Unit price 300 200 150 120 2011 2030 2014 Time

9. Modeling will always be based on market forecast that linearize the volatility of commodity market Linear forecast on the long term ( IMF World Economic Outlook) A good fiscal regimeaccomodatesdifferentvolatilities The fiscal modelinghelps to find out the different options and taxpolicies

10. Choose between real prices and nominal prices Definitions How to convert? Real Price ( Year n) = Nominal Price ( Year n)* 100 / Price Index ( Year n) with 100 as base year Real discount rate = Nominal Discount Rate – Inflation Rate • Nominal Price definition : An unadjusted rate, value or change in value. Reflects the current situationand doesn't make adjustments to reflect inflation, which provide a more accurate measure in real terms (investopedia.com). • Real Price definition : Nominal prices adjusted for inflation What matters is consistency! Either all nominal or all real! But Real values capture better the reality and eliminate the increase in prices and costs that are due to pure inflation

11. Sensitivity analyses at the core of Financial Modeling • Sensitivity analyses : • give a clear indication of what government and investors can expect according to market and project conditions • help the Government better understand a fiscal regime’s tolerance of risk • What happens if prices go up by 15%? Down 15% ? • What happens to Government revenues if project costs (e.g., fuel charges) unexpectedly increase? • help calculate trade-offs, interaction of fiscal elements and evaluate options For all these reasons, financial modeling is a crucial tool in negotiation and investment policy making

12. Modeling Exercise - Assumptions Life of mine/ contract: 37 years Coal Production: Max of 10 Million tons per annum (Mtpa) reached in year 5, linear ramp-up till Year 5 – sharp production decline within 2 years (at the end of the life of the mine) Long term real Price: 100$/t Short term nominal prices : Y-2: 90 $/t, Y-1: 80 $/t , Y+1: 95$/t (Y-2 and Y-1 are the 2 years of development phase and Y+1 is the first year of prod.) US CPI Price Index: Y-2-Base year : 100 Y-1 : 105 Y+1 :110 Operating real Cost (real terms) : 50$/t Capital Expenditure for 2-year exploration: $100 million/year Capital Expenditure for development: $2 billion spread linearly over 5 years (2 years of development phase and first 3 years of production) Sustaining/ Replacement capex: $10 million/ year from year 2019 Closure Cost: $5 million/year over 2 years (at the end of the life of the mine) Royalty: 3% Corporate Tax: 30% Withholding tax on dividends: 20% Free equity share : 10% Dividend payout ratio: 20%

13. Modeling exercise - questions 1- Based on those assumptions, input the market variables • On the “P&L Cash Flow sheet”: Observe the number of phases : when shall you start inputting production numbers? Observe the unit in column B : it tells you to limit the number of “0” while inputting numbers Fill in the grey cells of production and short term realprices -> Remember the production timeline of a mining project seen in the fiscal training! b) on the “Assumptions & Analysis” sheet, input : • a long term price and check the impact on line 8 of “P&L Cash Flow” sheet • a unit operating cost and check the impact on line 13 of “P&L Cash Flow” sheet -> While checking the “impact”, have you observed how the “Assumptions & Analysis” and “P&L Cash Flow” worksheets are interrelated? c) On the Capex spreadsheet, input • the initial capex ( don’t forget the closure costs) and sustaining capex (purple cells) -> What is the type of depreciation schedule that you are observing? 2- Based on those assumptions, input the tax variables On the “Assumptions & Analysis” sheet, input: • A dividend payout ratio and a % of free state equity- check the impact on line 77 and 81 of “P&L Cash Flow” sheet • a % of royalty rate, % of corporate income tax rate, % of withholding dividend tax rate and respectively check the impact on line 18, 40 and 82 of “P&L Cash Flow” sheet

14. Modeling exercise – questions- continued 3- Based on your own assumptions and experience, on the “Assumptions & Analysis” sheet, input : • the 3 debt parameters ( Debt maturity<=10) and check the impact on “Debt and Equity” sheet • a real discount rate and check the impact on cell C4, C49 and C84 on “P&L Cash Flow” sheet 4- a) What is the government take observed in “Assumptions & Analysis” sheet, cell F9? b) What is the project IRR observed in “Assumptions & Analysis” sheet, cell K7? c) What is the tax profile? Do you observe different timelines for different taxes? Question 5 – Question 7: Realizing the usefulness of a model: testing the impact of different assumptions 5- Play with different corporate variables and tax rates and observe the impact on the government take, IRR on the “Assumptions & Analysis” sheet – Can you observe the same government take and IRR for different fiscal packages? 6- Observe the sensitivity analysis on the “Assumptions & Analysis” sheet for the NPV of the project and government revenues for a range of discount rate 7- Observe the sensitivity analysis on the “Assumptions & Analysis” sheet for ranges of dividend payout ratio and the state equity

15. Modeling exercise – questions- continued • 8- Resource Rent Tax (RRT): add the IRR threshold, rate, and incremental changes (of RRT and IRR) in the ‘Assumptions & Analysis’ sheet • check the impact on the government take • observe the 2 sensitivity analyses (F9 to update the tables on PC and “Recalculate all “ on mac) • observe “progressivity of the RRT” graph • Which threshold, tax rate and incremental change makes the system progressive ? (check on the sensitivity analysis – F9 to update) • Reminder: a RRT kicks in after a certain IRR threshold and then the RRT rate will increase in parallel to the IRR increase – In our example, we have 2 tranches of increase – those 2 tranches are called “ incremental change” : • Rate IRR • X Y (Y being the IRR threshold ) • X+aY+b • X+aY+b +b (a and b being the “incremental changes”) • 9 – Build a new tax into the model : • - for instance a withholding tax on interest • 10 – Build a sensitivity analysis understanding the impact on IRR on • - A range of Opex/ Long term price