Part 2 of Mining Man's Finance Basics series introduces the Discounted Cash Flow concept in an easy to understand way.
Welcome to Part 2 of Mining Man’s Mining Financial Basics Series. Today we are looking at the concept of Discounted Cash Flow, or DCF as it is commonly known. This concept builds on the idea of the time value of money, and is used extensively in financial modelling and evaluations in the mining industry.
Please go here to read Part 1 of this series where we discuss the Time Value of Money, it would be best to read this article prior to diving into Part 2.
Cash flow is the term commonly applied to either money coming in or going out of our business or mining project. Cash flow covers both incomes and costs. Using the term cash, tells us that we are focussing on real money flowing in or out – money we are actually making or spending (ie we ignore things like depreciation).
In a business or mining project, by adding together all the revenues and subtracting all the costs for particular year or period, we come up with the Net Cash Flow – the net amount of cash we are left with at the end of the specific period once all incomes are in, and all bills are paid.
Recap - Time Value of Money
To quickly recap what we discussed in Part 1, the concept of the Time Value of Money tells us that “A Dollar Today is worth more than a Dollar Tomorrow”, and the we should always look to have our income coming in as soon as possible, while our costs are pushed out as far into the future as possible.
Basically, the idea is that we should place more value or importance on dollars spent or received this year than those we will spend or receive next year.
The concept of discounting future incomes or costs (cash flows) builds on the time value or money, by giving us a way to specify how much less money is worth to us in the future compared to what it is worth to us today.
For example, how can we create a comparison between $1000 we make this year from a mine and $1000 we will make in five year’s time?
The way we do it, as we referred to in our description of time value of money, is that we discount, or reduce, the future $1000 income by a certain rate due to the fact that we don’t receive it until sometime in the future.
The rate at which we reduce the value of a cash flow over time is called the Discounting Rate. The Discounting Rate that we choose to apply to a particular mine, mining project, or asset purchase will vary from one to the other, and will depend on two key factors:
- How much return you would expect to make on your money if you put it into a similar investment or project
- How much risk there is in this project
Typically for mining projects, the discounting rate is between 8% and 20% per year. Generally the higher the risk in the project, the higher the discounting rate applied to it. Effectively we are saying that in higher risk projects, we put far less value in cash flows we will get in the future compared to those we will get today.
Discounted Cash Flow
To get the Discounted Cash Flow from a particular year in the future (in order to compare it to other years), we reduce the cash flow by the Discounting Rate for each year that it needs to be brought back.
So if our discounting rate is 12%, and the cash flow we are analysing is $1000 five years into the future, we will reduce that $1000 by 12% five times to get what it is worth today. The formula would be 1000/(1+0.12)5.
By discounting the cash flows from all the future years of the mining project, we are now able to compare them on a common base, and even add them all together to get a project’s total value over its life. We couldn’t do this by just adding the cash flows from every year together, as we already know that money’s value changes with time. So by discounting them back for future risk and return requirements, we now have all our cash flows at a common base – today’s value.
Hopefully this post gives you a good overview of the concept of Discounting Cash Flows. We’ll be talking more about how mining companies use this concept in future articles, but for now it’s just important to understand how time and value are related, and how we apply a percentage reduction in value over time.
Click here to read Part 3 in the series - Net Present Value
Any questions, please feel free to post them in the comments section below.