1

Project Economics: Concepts and Financial Modeling

Training

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

Mining Tax Regimes- Range of Taxes and Non-Tax Instruments-Overview

2

3

Profit based Tax -– tied to profitability and preferred by the investor

• On Dividends for foreign shareholders- common and encourage re-investment in the country

• Most states apply a standard national corporate rate in the range of 20% to 35% of profits

Withholding Tax on Dividends

Windfall Profit Tax(Variable Income Tax, Additional Profit tax, Super profit tax)

Corporate Income Tax

• Profit taxes on a sliding scale linked to measure of return, taking into account change in prices and costs

Resource Rent Tax

• Triggers in after a threshold real rate-of-return (RoR) on investment has been achieved by the project.

• Generally between 20% to 50%

Investment Credit/ Capital allowance

• A percentage of the capital expenditure that is tax deductible

Loss and Carry Forward

• An accounting technique that applies the current year's net operating losses to future years' profits in order to reduce tax liability

4

Production-based taxes– not tied to profitability and disliked by the investor

Royalty

• 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

Export Tax • Applied on FoB value of mineral exports - like another royalty• Used to encourage beneficiation and sale to local market

Import Duty• Should be an industrial development instrument • Exemption should only be applied to capex to encourage

local manufacturing of consumables (operating costs)

Withholding Tax on Interests

• to discourage abusive recourse to debts (for instance under the form of shareholders’ loan to the project)

Value Added Tax • Captures portion of value-added – full exemption when product is exported- discouraging local market

Sliding Scale Royalty • Royalty rate increases with increase in prices

5

Non tax instrument

Signature Bonus• Up front payments for the right to develop- can be deductible

Production sharing • Production is shared after deduction of some or all production costs- Common in petroleum industry- (not common in mining)*

State Equity Participation

Surface fee/ license fee ($/Ha)

• Limiting exploration and mining areas to economic targets Low enough to encourage exploration

• 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

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)

* 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)

Corporate variables

• Fixed costs (land, buildings, construction and equipment )

• recurring expenses,(salaries, admin. cost , consumable, fuel)

• Calculated as a unit cost * production quantity

Capital Expenditure (Capex)

Depreciation and Amortization (D&A)

Operating Costs (Opex)

• 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

6

Revenues• Price * Production• Production profile (company feasibility studies)• Price : Market forecast

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)

• 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• The IRR 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.

Underpinning concepts of cash flows forecast

Net Present Value (NPV) and Internal Rate of Return (IRR)

Discounted Cash Flow (DCF)

Discount Rate “r“• 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

7

These concepts need to be understood for financial modeling and importance of timing when determining fiscal policies

2011 2014 2030

Unit price

120

150

200

300

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

Market Variables : How to forecast prices during life of mine (20-40 years)?

Time 8

9

Modeling will always be based on market forecast that linearize the volatility of commodity market

A good fiscal regime accomodates different volatilitiesThe fiscal modeling helps to find out the different options and tax policies

( IMF World Economic Outlook)

Linear forecast on the long term

10

Choose between real prices and nominal prices

Definitions

• Nominal Price definition : An unadjusted rate, value or change in value. Reflects the current situation and 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

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

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 - AssumptionsLife 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$/tCapital Expenditure for 2-year exploration: $100 million/yearCapital 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 2019Closure 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%

Modeling exercise - questions1- Based on those assumptions, input the market variablesa) 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 numbersFill in the grey cells of production and short term real prices-> 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 variablesOn 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

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

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+a Y+b X+a Y+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

Modeling exercise – questions- continued