-4 summary of the more populur mineral valuation techniques being used by the mining industry, with examples of their

various interrelationships Some of the older methods may be in error when compared to modern methods of finuncial analysis.

A Critical Examination of Mineral Valuation Methods in Current Use

John J. Dran, Jr. and Henry N. McCarl
School of Business University of Alabama

The academic community and the larger and more sophisticated mining companies have largely rejected the older mineral valuation methods such as the Hoskold and Morkill concepts and replaced them with "discounted cash flow" (DCF) techniques. The relevancy and usefulness of the older methods have been questioned primarily on the basis of their underlying assumptions that mining companies do not have numerous alternative investments and must use sinking funds deposited at market or "safe" rates of return to recover the purchase price of mineral reserves. The ability to reinvest in numerous (often nonmining) alternative business ventures, the changing purchasing power of the dollar, corporate income and other taxes, depreciation and depletion allowances, and modern financial management practice all militate against the continued use of the older valuation methods, especially for the larger mining companies. Small mining companies and individuals still use these methods largely out of habit and familiarity.

In the Hoskold method, estimated future annual earnings (i.e., cash flows) are divided into two parts for the determination of the present value of the mineral reserve. These parts are ( 1 ) an annual sinking fund designed to recover the purchase price (discovery cost) of the reserve at the time of its depletion, and ( 2 ) the remaining cash available annually to the investor. Mathematically: where A is the annual earnings or cash flows to the investor, S is the annual sinking fund necessary to recover the purchase price of the mineral reserve, and R is the remaining net cash flows to the investor. The amount that the investor must set aside annually to recover his purchase price is a function of the rate o E interest that the sinking fund will return. The Hoskold method assumes that this fund is invested in a "non-speculative" manner at a "safe" rate of return, 7 . This could mean short term U.S. government securities or any investment with an assured "risk-free" interest rate. It is possible to determine the annual amount necessary to recover the purchase price in n years by the equation: S-s- =P nlr (2) where s - is the amount to which an annuity of $1 nlr will accumulate at the end of n years at a rate of interest r (read s angle n at r ) , and P is the purchase price of the property to be recovered at the end of n years.
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The Hoskold Mineral Reserve Valuation Method The Hoskold method was developed prior to the evolution of modern accounting practices and before the days of the corporate income tax. At the time of its development, annual earnings of the firm were represented by the difference between cash revenues and cash expenses and were not subject to taxation by the government. Thus, earnings at that time were equivalent to what is today known as cash flow.
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It may be shown mathematically that:

By assuming that the present value of the property (V,) not only represents the maximum amount that the investor would be willing to pay but also that he does, in fact, pay this amount, then

and by substitution of Eq. 3 and 4 into Eq. 2 the annual amount of the sinking fund is determined as :
T7

If the sinking fund is used for reinvestment in another mineral reserve when the given mineral property is depleted then the remaining net cash flows ( R ) available to the investor become a perpetual annuity. Because mining is a speculative venture the investor requires a "speculative" rate of return, r', on his investment. The equation for the present value of an annuity of R dollars at an interest rate, r', is:

The Morkill method, like the Hoskold method, is based upon a division of the estimated annual earnings into sinking fund contributions and net cash flows to the investor. However, although the net cash flows to the investor are valued on the basis of a "speculative" interest rate r', the sinking fund payments are non-interest earning contributions. In addition, the annual sinking fund contributions in the Morkill approach are not fixed over time but instead begin at an amount equal to A - Vpr' and increase over the life of the reserve at a rate equal to the speculative interest rate. Since the estimated annual earnings remain constant, each increase in the sinking fund must be accomplished by a reduction of an equal dollar amount in the annual net cash flows to the investor. Because the sinking fund contributions are growing at a rate r', the fund will increase in size in the same manner as if the ai~nualcontributions were constant and the fund was earning an interest rate of r'. Thus at the end of n pears the sinking fund will total:

Assuming ( 1 ) that the sinking fund will be used to recover the purchase price of the property at the where a Z r , is the present value of an annuity of $1 for n yeais at the rate of interest r' (also known as the Inwood coefficient), which as n goes to perpetuity becomes : time of depletion of the reserve (i.e.,

2 S = P),
i=l

11

and ( 2 ) that the investor purchases the reserve at its present value ( i.e., P = Vp), then:

vp= r'

(7)
Solving Eq. 11 for V, gives us:

Thus the required annual net cash flows necessary to obtain a rate r' are determined to be:

R = V,

. r'.

(8) which is the standard Morkill formulation. The combination of a sinking fund which earns no interest yet grows at a rate equal to the speculative rate of return, with a net cash flow to the investor which decreases by the amount of increase in the sinking fund contributions and is valued at the speculative rate of return, obscures the underlying foundations of the Morkill formulation. Eq. 12 may be better understood by dividing both the numerator and denominator of the right side by the quantity (1 r')-". This gives us:

Substituting Eq. 5 and 8 into Eq. 1 and solving for the present value of the mineral reserve we find that:

which is the familiar Hoskold equation based upon uniform annual income.
The Morkill Method of Valuation Another traditional method for valuation of mineral reserves is the Morkill technique.' This method has been found particularly applicable in determining the value of the reserves to the land owner on the basis of estimated royalty payments to be received by himn2
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JULY 1974

The bracketed term in Eq. 13 is nothing more than the mathematical formulation for the present value
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of an annuity of $1 for n years at an interest rate f which may be expressed as a,,r, (and is also known as the Inwood coefficient). ~ h u the s Morkill formula reduces to:

changes that have occurred in taxation and accounting practices since the time of their formulation, both methods may be reduced to:

the present value of an annuity of A dollars for n years at an interest rate r'.
The "True" Difference Between the Hoskold and Morkill Equations It is appropriate for us to examine the Hoskold and Morkill methods in order to point out the "true" differences (as opposed to any superficial differences) between these approaches. In comparing Eq. 9 and 12 the most obvious difference is the lack of a "safe" rate in the Morkill formulation. In the mining industry of the 19th and early 20th century the small mine or single-mine company was dominant, and attitudes toward continual reinvestment were quite different from those held by the major mining and mineral companies of today. Most businessmen would agree that in this context, the assumption of two rates of return is quite unrealistic for firms in today's economy. In general cash flows which do not provide direct returns to investors are reinvested, not in a bank or other "safe" investment, but instead are put back into the business and thus should be accorded the "speculative" rate r'. When this adjustment is made to the Hoskold method, Eq. 9 becomes:

where C is annual cash flow (assumed constant over the life of the mineral reserve). Thus both methods represent discounted cash flow techniques with slightly different underlying assumptions. Due to th,e changes in our accounting and taxation systems these assumptions have become obsolete. This has rendered the Hoskold and Morkill formulas, without compensating adjustments, inappropriate for current investment analysis.
The Discounted Cash Flow Technique of Colby and Brooks Colby and Brooks (CB) have presented a method for valuing mineral resources which they . ~ their specify as a discounted cash flow m e t h ~ d In paper, they give considerable attention to defining cash flows within the scope of current accounting and taxation procedures. Based on the assumptions that annual cash flows are constant over the life of the project, and that all capital improvement occurs at the time of valuation of the reserve, the CB equation for the present value of a mineral reserve may be written as:

Multiplying both the numerator and denominator of the right side of Eq. 15 by the term [ ( 1 r')" -1 1 gives:

which reduces to:

Eq. 17 may be immediately recognized as the Morkill equation, thus indicating that the only real difference between the Hoskold and Morkill formulations is the Hoskold assumption of a "safe" rate of return. After accounting for the difference of the assumption of a safe rate, it is apparent that both methods simply discount the annual earnings over the life of the mineral reserve. It may be noted again that at the time of the formulation of these methods, in the days prior to corporate taxation, depreciation and depletion allowances, annual earnings represented cash flows to the investor. After the proper adjustments to compensate for the
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where K is the capital improvements occurring at the time of valuation, and r' is the risk adjusted discount rate. The equation simply states that the present value of a mineral reserve is equal to the present value of the cash flows which the reserve will generate over its life less any initial capital costs necessary to exploit the reserve. The discounted cash flow approach as used by CB is an accepted method of asset valuation and as such requires no further comments. Other aspects of their paper as well as certain interpretations of the CB approach found in recent literature deserve comment. Focusing on the CB paper, it is important to point out an unnecessary assumption stated by CB which may serve to restrict the application of their method. They assume that funds for the exploitation of the mineral reserve are provided entirely by equity financing4 This assumption appears to limit the discounted cash flow technique to those firms which are not financially leveraged. Such an assumption is unnecessary. Manufacturing firms with debt in their capital structure have for years used the discounted cash flow method for the valuation of industrial investment opportunities. There is no reason why financially leveraged mining firms cannot utilize the same method. The discounted
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cash flow equation remains the same whether used by a firm financed entirely by equity capital (all equity) or by a firm with debt in its capital structure. The only difference in the use of this equation between firms that are financially lever~ged and those which are not is in the determination of the rate at which cash flows are discounted to the present. For the all-equity firm, the discount rate is simply 1 1 the required rate of return on equit) c'ipital. 1 financial terminology this is known as the cost of equity capital and is equivalent to what is know11 as the speculative or risk rate in the literature regarding mineral reserve valuation. On the other hand, for the financially leveraged firm, the rate at which cash flows are to be discounted to the present is determined on the basis of a weighted cost of equity capital and debt capital. The procedure for this determination of the weighted cost of capital will not be discussed here. However, many references regarding this calculation may be found in the literature pertaining to corporation finance and capital budgeting5 It has been stated that the CB nlethod "does not attempt to determine the 'in-place' value of the mineral deposit as much as it does to determine total efficiency and value of an actual or hypothetical ~ p e r a t i o n . "It ~ should be pointed out that the value of a mineral reserve is inherently dependent upon the efficiency of the operation b ! . which that reserve is exploited. In other words, if one firm has an operation which is highly efficient and which enables it to evploit the reserve at a much lower cost than any other firm, then that firm will place a higher value on the reserve than will be placed on the reserve by other firms. Thus, this "limitation" of the Colby and Brooks method is not a restriction on the use of their method but rather an economic fact of life. Another "limitation" that has been attributed to the CB method is that "when purchasing a possible reserve, the producer himself, never . . . . . . . . uses ~ the fact that a such a method of ~ a l u a t i o n . "If method has never been used before is construed as a limitation on that method and an argument against its use, then any new method is handicapped because of the simple fact that it is new. This criticism of the CB approach is entirely unfounded. It has also been contended that the CB method is "more applicable to operating properties than to giving value to a piece of mineral land."8 In fact the discounted cash flow approach as put forth by Colby and Brooks is applicable to both valuation of operating properties and valuation of unexploited mineral resources. There exist only hvo differences between the alternate applications of the CB method. When applying the discounted cash flow method to unexploited mineral reserves

it is necessary to (1) estimate the time at which the reserve will be put into use, and ( 2 ) to estimate the capital equipment costs that will be required at this time. For valuation of operating properties these estimates are unnecessary. A final comment with respect to interpretation of the CB paper is that Colby and Brooks in the development of their valuation equation (Vp = C a,,,, - K) have assumed that all capital improvkments K occur at the present time. Since use of the equation without recognizing the assumption can result in an incorrect valuation, it is suggested that whenever the valuation equation is reproduced this assumption be explicitly specified. If the assumption that all capital expenditures occur at the present time does not hold true, a correct valuation may be obtained by interpreting the variable K in the equation to represent the present value of all capital improvements.

The Transportation Advantage Discounted Cash Flow Method

A recent development in the valuation of mineral resources has been termed the transportation ad. ~ approach to discountvantage DCF m e t h ~ dThis ing cash flows developed by Dunn, Hudec, and Brown emphasizes differences in transportation costs among alternative mineral producing properties. Placing the emphasis of property valuation on transportation cost can be especially useful in those situations where the value of the mineral resource per unit of volume is especially low. In these cases, transportation costs comprise a relatively high proportion of the producer's total costs and therefore deserve particular attention. The originators of the transportation advantage approach assume that unit production costs and prices do not vary among different potential mineral reserves, and therefore the only relevant factor in deciding which of several resource locations to exploit is the cost of transporting the output from each reserve to the market. Based upon this reasoning the basic transportation advantage equation has been formulated as : lo

VP = t

Q a,,,.

where t is the transportation advantage expressed as the differential cost per unit of output between two alternate sites, and Q is the estimated annual production in units of output ( a constant). The solution of this basic equation results in the calculation of the difference in present values of two alternative reserves rather than the present value of either, as the use of the term V, in the equation implies. Thus, the transportation advantage method determines the relative valuation of two alternative sites rather than an absolute valuation as determined by other discounted cash flow approaches.
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Strong reservations must be expressed regarding the use of a relative value approach. First, although such an approach indicates whether the purchase of one piece of property, would be favorable when compared with another piece of property, it does not indicate whether purchase of either would be economically justifiable. In order to determine whether the purchase of any asset is justifiable it is necessary to determine an absolute value against which the potential purchase price may be compared. Secondly, despite the fact that a relative value approach does not indicate economic justification, the transportation advantage method has been misinterpreted to imply such justification or a lack thereof. For example, it has been stated that when "the transportation advantage of one deposit over another is approximately zero . . . . it is difficult to justify paying prices much higher than normal land prices in the area."" The analysis preceding this statement in the original article compares two alternative deposits but makes no comparison of the value of either deposit to area land prices. Thirdly, not only may relative value analysis be misinterpreted to imply absolute value analysis, but also relative and absolute value calculations can be improperly combined to give meaningless results. This occurs when such combinations result in omission of important cash inflows and/or outflows. It must be kept in mind that in the transportation advantage method, cash flows pertaining to production costs and revenues are assumed to be the same for alternative mineral reserves and thus are omitted from the relative value calculations. Likewise transportation costs common to alternate sites are netted out in the calculation of the transportation advantage. These cash flows must be added back when absolute values are desired. In two adaptations of the transportation model purporting to show absolute values, these essential cash flows have been omitted.12 In addition to the general difficulties associated with the relative value approach as stated above, there are two additional specific criticisms of the final form of the transportation advantage model.13 First, the model includes the annual interest payment made as part of the annual cash flows. The purpose of a present value analysis is to determine if the annual cash flows from the investment itself justify the use of funds which are not free but for which some rate of return is required. Since the required rate of return is included in the discounting procedures it is therefore inappropriate to include them again as part of the cash flows. This would be "double counting."14 The second objection relates to the use of the land price as one of the cash flows in the transportation advantage model. The objective of a present value equation is to determine the maximum price
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that you would be willing to pay for the land. The inclusion of the land price as a cash flow on the right side of the transportation advantage equation simply inflates the present value by that amount. Thus, the equation indicates that the higher the land price, the higher the present value and the higher the maximum price a potential purchaser would be justified in paying. This is incorrect. The price of the land should be excluded as a cash flow in the transportation advantage equation. Conclusions 1) In both theory and practice, a discounted cash flow approach to mineral reserve valuation should be used. 2 ) The development and application of present value equations for mineral reserve valuation must be based upon economic and financial theory. Valuation of mineral reserves like valuation of any asset is more than simply plugging numbers into an equation. There are many pitfalls for the unwary. 3) It is important that land valuation be carried out on an absolute basis rather than attempted on a relative basis. If the final objective is to determine the relative values of two potential sites this can always be accomplished by comparing absolute values. 4 ) There should be no objection to focusing attention on transportation costs where these are important cash flows. However, transportation cash flows should not be emphasized to the exclusion of other cash flows. All relevant cash flows must be taken into account in valuing mineral reserves. References
1 Parks, R. D.. Examination and Valuation of Mineral Property, 4th ed., Addison-Wesley Publishing Co., Reading, Mass., 1957; pp. 350-53 or Raymond, C. L., "Valuation of Mineral Property, Economics of the Mineral Industries, E. H. Robie, ed., AIME, New York, 1964, p. 133. ZDunn, J. R.. Hudsec. P. P., and Brown S. P., "How Valuable Are Mineral Resources." Rock Products, S'ep. 1970, p. 85. 3Colb~. D. S., and Brooks, D. B., "Mineral Resource Valuation for Public Policy," Information Circular 8422, 1969, U.S. Bureau of Mines. 1 Colby and Brooks, 1969, p. 16. Weston, J. F., and Brigham, E., Essentials of Managerial Finance, 2nd ed., Holt, Rinehart and Winston, New York, 1971, pp.

% D u n ,et al., and Dunn. J. R., "Valuation of High Bulk-Low Value Mineral Deposits" Paper presented a t 1972 SME Fall p. 1. Meeting, Birmingham. ~ i a . , 7 Ibid., p. 86 and p. 8, respectively. 8 Dunn. 1972. D. 8. ~ u n n~ ; u d e i and . Brown. 1910 and Dunn, 1912. 10 Dunn, 1972, p. 12. l1 Dunn, 1972, D. 12. l a The adaptations are found in Dunn, Hudec, and Brown (1970), P. 86 and Dunn (19721, P. 16. The more recent version of the model by Dunn (correcting a typographical error) may be written as: Vp = (A-T-Ir) An r v + IP-R) + HVn where V, is present value of the reserve, A is transportation advantage times annual production (expressed as tQ in Eq. 20), Ir' is annual interest on present land price a t risk rate r', T is annual property taxes. P is present land price, R is present value of the rehabilitation cost, H is estimated land resale value, and V n = (1 + r')-= = present worth of a single payment factor. In this equation the relative cash flow term, A, is combined with absolute cash flow terms (for example, T ) in an attempt to assign an absolute value (V,) t o the reserve. This combination omits all cash flows of production and revenue as well as transportation cash flows which are common to the alternative sites being examined. "The model in equation form is shown in Ref. 12. "Bierman Harold J r . and Smidt Seymour The Capital wo r k :1971. pp. 114Budgeting kci is ion. &d ed.. ~ a c ~ i l l a n , ' N e ~

243-fi8. --. .-

115.

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