Capital budgeting.

Forecasting the future

Capital resource budgeting is the
way managers of publicly held
companies fulfill their fiduciary Silver price vs. time, 1950-1995.
responsibility to maximize the
wealth of stockholders. Managers
maximize shareholder wealth by
allocating investment capital to the
most productive of competing alter-
native projects. Managers do this in
a manner that maximizes the net
present value of the firm's future
cash flow. The techniques of cash
flow analysis are the primary tools
available for selecting a corporate
portfolio of projects that meets or
exceeds the rate of return expected
by shareholders.
The reliability of cash flow analysis
hinges on the ability of managers to
forecast the future values of
individual components of cash flow.
The accuracy and reliability of
forecasting determine the soundness
of capital investment decisions and,
ultimately, determine the value of the
firm. In other countries, tax rates may be less predictable and
may change dramatically with political instability. Tax
Components of cash flow policy also enters the cash flow equation when noncash
depreciation and depletion are allowable expenses.
Net cash flow equals revenue less the cash costs of In the United States, the deductibility of interest
production, taxes, administration and investment. Al- paid on borrowed funds influences the overall capital
though the concept of cash flow is simple, in practice it structure of most corporations by reducing the relative
can become complicated. Modeling, or forecasting, fu- cost of debt vs. equity capital. The use of tax-deductible
ture net cash flows, to compare alternative investments, debt as a vehicle for leveraged buyouts of firms with ex-
requires the development of independent projections of cess borrowing capacity has resulted in some of
the future value of the various components that make history's most spectacular mergers and acquisitions.
up net cash flow. Individual components are
interrelated. But they also vary independently with Capital budget
production quantity, time, technology, market structure
and other exogenous variables. as the business plan
Production revenue is the quantity of units of pro-
duction times the average price of an individual unit. The success of any business is
Total revenue depends on unit price (marginal revenue) determined by the firm's ability to
and selection of the optimal production scale for a firm. develop and execute a realistic busi- Daniel K. Dysinger
For most mineral commodities, profits are maximized ness plan. As the primary compo- is director, The
where the marginal cost of producing one more unit just nent of the business plan, the Center for Advanced
equals the marginal revenue, or price. Revenue maximi- capital budget summarizes the
expectations of the firm for revenue, Mineral Processing,
zation is rarely consistent with maximizing profits.
The firm's production cost function varies in a non- costs, taxes, growth and market Montana Tech of the
linear manner with production quantity. Therefore, de- share and the required capital University of
velopment of accurate models of the various production investment to attain the planned
Montana, Butte, MT
cost functions is important for generating reliable cash business activity. The expected
flow estimates. An accurate cost function analysis is profitability of the firm is reflected in 59101-0991.
also fundamental for determining the optimum output the capital budget. And the level of
of the firm. The amount and types of taxes are a understanding that a firm has of its
function of governmental philosophy. In the United business is reflected in the accuracy
States, taxes are relatively stable and predictable and and execution of the capital budget.
are based on profitability

MINING ENGINEERING SEPTEMBER 1997 35

 The firm's cost of capital also depends on the accu-
racy and execution of the business plan and capital bud-
get. Each lender and investor to a firm has an expecta-
tion of return on the funds they risk. Firms that deliver
predictable and stable returns to investors pay less for
capital. Firms with unpredictable returns pay more be-
cause investors demand a higher risk premium.
Therefore, the discount rate, or weighted average
cost of capital, is related to the firm's ability to forecast
and manage its capital budget. Failure of the capital
budget through sloppy or inaccurate forecasting will re-
sult in a real cost to the firm in the form of higher costs
of capital or bankruptcy.
Capital budgeting process
Capital budgeting in the resource business involves
a predictable and systematic approach. The process be-
gins with an estimate of the inventory of units available
for production based on exploration, whether a new ore
body or an existing mine.
The next phase is based on developing an engi-
neered system for extraction and processing of the valu-
able mineral and disposal of the waste. In the engineer-
ing phase, a conceptual strategy for developing the prop-
erty is determined. It integrates the best practices of the
day with the physical realities of the site location, sup-
port infrastructure, transportation, work force, etc.
Alternative extraction and processing strategies are
screened. These identify fatal flaws and determine a
working universe of potential technologies and operating
plans. Metallurgical treatment schemes, conceptual mine
plans and order-of-magnitude capital budgets are
prepared. These further refine the information required
to make the ultimate decision: accept, reject or defer.
At each stage in the process, many assumptions,
rules of thumb and estimates are required to develop a
mathematically based picture of what an operating mine
will look like. These parameters are based on vendor
quotes, historical and experiential data, scale factors and
other engineering methods to develop the most robust
engineering model possible. The accuracy of the model
depends on the talent and knowledge of the estimating
team and the inherent bias of the organization.
FIG. 2
Linear regression of inflation at T vs. Inflation at T-1.
2 SEPTEMBER 1997 ... MINING ENGINEERING
The product, or output, developed in this process
is pure information. The informational value is deter-
mined by the future correlation of the model
predictions with the operating and financial results of
the final physical asset. On the strength of this
argument, the market value of the firm is ultimately
equal to the value of the information developed in the
capital budgeting process.
Accuracy and precision in capital budgeting is one
of the most important functions of management. Ulti-
mately, the net present value of the company is deter-
mined by the value of the information contained in the
discounted cash flows of the capital budgeting process.
Management can increase the value of the company by
refining techniques to anticipate the market price
structure, operating costs, general and administrative
costs, taxes and other components that determine
future cash flows.
Decay in the value of information with time
Investment of funds in mineral production is long term
and risky. Capital requirements for greenfield in-
vestments can exceed several hundred million dollars.
The investment horizons can extend from 10 to 30
years. Capital budgeting for mineral investment,
therefore, requires forecasting the components of cash
flow far into the future.
The reliability of any forecast declines with time.
Capital markets reflect the increasing uncertainty over
time by demanding a higher rate of return to assume
long-term risk. The yield on government bonds,
society's proxy for a risk-free asset, increases with time.
This reflects the risk premium demanded by investors
for assuming the time risk. The risks associated with
uncertain future states of the world are incorporated
into capital budgets through the market-determined
discount rate.
Designers, engineers and financial analysts are
aware that forecast accuracy varies between the indi-
vidual components of cash flow. Equipment prices, la-
bor, and environmental costs and metal prices are less
certain next year or five years from now.
In addition, the accuracy of forecasting individual
components is not necessarily equal. For instance, oper-
ating cost estimates may be more accurate than com
modity price estimates. Because the
internal uncertainty in capital bud-
geting models is determined by the
cumulative uncertainty of the indi-
vidual components, each component
must be scrutinized equally.
Forecasting techniques
Theoretical concepts can explain the
importance of minimizing the
forecast variance. But they do not
provide the how. No one technique
has ever been shown to exactly
predict the future. The best that can
be expected of financial forecasting
is to quantify the probability of
occurrence of potential future states
of the economy and the impact on
the future cash flow of the firm.
The most useful forecasts are
unbiased and quantitatively repre-
 sent the downside investment risk. FIG. 3
Returns above budgeted, due to un
expectedly strong market Markov inflation model vs. actual data.
conditions or other random
events, are a pleas~uit surprise
that may increase the value of the
firm. The impact of below-
expected returns can potentially
result in bankruptcy or other
financial reversal that limits the
firm's ability to operate. For this
reason, forecasting techniques
that quantify the probability of
downside risk, while positioning
General price equilibrium
of markets
Many market price structures
can be viewed from the aspect of a
continuum. The price oscillates
around a general, market-clearing
equilibrium price for significant
periods of time. Daily or weekly
hiccups are not really predictable.
the short run, they can be described FIG. 4
by a log-normal distribution of re Comparison of the multivariate model fit with actual silver prices vs. time.
turns. This is the basis for
valuing call and put options
where the option premium is
priced to cover the probability
that the market price will exceed
the strike price before the option
expires.
Over longer, or mid-run, periods,
prices tend to follow identifiable
trends that are not randomly
distributed. Mid-run commodity
price trends are linked to specific
market circumstances. These in-
clude overproduction, the onset of
booms or recessions, listing as a
toxically challenged material and
acceleration or deceleration in the
inflation rate. Price changes are not
randomly distributed. But they are
related to the elasticity and shifts
of the supply and demand function.
Understanding and planning for
price changes during the mid-run is
the short run. As time increases, fewer and fewer of the greater capability.
internal and external variables that influence the market
price are fixed. Four separable trend periods are identified in Fig. 1.
In the long run, price prediction becomes even less It presents the yearly average silver price ($US/oz) from
dependable. Mid-term trends reverse, new technology is 1950 through 1995. As a first approximation, the trends
assimilated, governments and laws change radically, are 1950 to 1966, a time of relative price stability; 1967
wars occur and generations change. The probability of to 1978 - a period of steadily increasing silver price;
correctly predicting prices and costs declines as time in- 1979 to 1980 - a period of speculation; and 1980 to 1995
creases. - a period of steadily declining prices.
Silver has markets as both an industrial metal and as
Silver market 1950-1995 a monetary substitute during inflationary periods. The
nominal silver price has been found to be statistically
The silver market provides an opportunity to test
correlated with both the consumer price index (CPI) and
some forecasting techniques. This analysis is not meant
the rate of inflation.
to be exhaustive. Many more refinements can be made
Simulation models can be derived. They take advan-
and several other techniques applied that may provide
MINING ENGINEERING SEPTEMBER 1997 37
FIG. 5
Simulated inflation and silver price.
T% "
in the future under randomly generated states of the
economy.
A statistically significant linear correlation exists
between the silver price and the CPI. However, the price
data is poorly represented by a simple linear correlation.
Other correlated factors must be included that explain
the obvious divergence of the data from the linear $/oz
vs. CPI trend line. The addition of other factors is re-
ferred to as multivariate modeling. It provides a better
overall fit with the real world data. It also enhances the
ability to forecast the impact of future states of the
world on the price of silver.
Multivariate regression analysis indicates that the
price of silver at any point in time also depends on the
rate of change of the CPI or the level of inflation in the
economy. The future cash flow from a silver producing
operation depends on the future price of silver. So fore-
casts for capital budgeting must take potential inflation
into account.
Unfortunately, forecasting future inflation or defla-
tion is difficult. Inflation is caused by several economic
mechanisms, or decisions, that impact the management
of growth of the money supply. From deficit spending
during times of war or to ease the effect of oil supply
shocks, inflation can be traced to monetary factors.
However, natural economic equilibrium constraints
function in the money markets, as in other markets.
This limits the duration and magnitude of sustainable
inflationary episodes.
Figure 2 compares historical inflation data from
1950 to 1995 (points) with a correlation generated from
a Markovian process model (solid line) in which inflation
in period, t, is linearly correlated with inflation in
period, t-1. The Markov correlation can be combined
with a Monte Carlo procedure to develop conditional,
random estimates of the future path of inflation.
Figure 3 compares the actual inflation data and a
Markov-Monte Carlo simulated inflation, seeded with
the 1949 inflation rate, from 1950 to 1995. The data
demonstrate that exact predictions of inflation are not
possible. However, multiple simulations of randomly
4 SEPTEMBER 1997 MINING ENGINEERING
generated inflationary paths, based
on the statistical distribution of his-
torical data, can be used to evaluate
the sensitivity of capital budgeting
outcomes. For example, the simple
1950 to 1995 Markov-Monte Carlo
simulation would have indicated
that the high inflation rate and
silver price of the late 1970s was
not sustainable. Firms that invested
money in silver production in the
late 1970s and early 1980s, based
on a market price of 32 cents/g
($10/oz), have likely lost a lot of
money.
Combining models
to simulate the future
A simple, multivariate model was
constructed to correlate silver prices
with several economic indicators.
These included the rate of inflation,
the nominal level of the CPI and a
d
1970s and early 1980s. i bl t model
A real-world dj would
t f th
also
incorporate variables such as the elasticities of supply
and demand, inventory levels, consumption
expenditures and other variables that have known
correlations with the silver price. The multivariate
analysis of historical data from 1915 to 1995 resulted in
a functional model capable of predicting silver price with
an adjusted RZ of 96 % for the period. The fit of the
model is shown on Fig. 4, which compares the actual
price data with the calculated data.
The Markov-Monte Carlo inflation model and the
multivariate model can be combined to simulate likely
future states of the economy and the potential effect on
the future price of silver. The top line of Fig. 5
represents one potential scenario of inflation for the
next 25 years. It is derived from the Markov-Monte Carlo
inflation model seeded with 1995 inflation data. The
bottom line of Fig. 5 presents the projected silver price
based on the above potential inflation projections.
If the actual future values of inflation and price are the
same as predicted, it will be accidental. However, the
simulations represent unbiased projections of potential
states of the future. These are consistent with historical
experience and conditions of market equilibrium.
Multiple simulations can be generated to provide cases
for sensitivity analysis, to identify fatal scenarios and
quantify the potential downside risk for capital bud-
geting decision making. Worst- and best-case scenarios
can be identified. Alternative planning for various situ-
ations can be stimulated. Unbiased estimates of future
cash flow also can be provided.
All economic entities use financial forecasts to raise
capital, plan operations and make investments. Ulti-
mately, the value of the company is determined by the
value of the budget information and its correlation with
the actual state of the economy in the future.
Simulation can provide glimpses of the most likely
future and quantify the probability of the occurrence of
individual states and the range of potential states.
Management must interpret the results, plan for
contingencies and maximize the net present value for
the owners of the firm.