Financial Risk Analysis and Real

Option
Valuation of Mining Projects
Sensitivity Analysis and
Monte Carlo Simulation
Dr. Pietro Guj

LEARNING OBJECTIVES
To gain some familiarity with how to
carry out:
Sensitivity and
Scenario analyses and
Monte Carlo simulation

COMPUTER SOFTWARE

The exercise will use, besides Excel,

the Decision Toolworks risk
analysis add-in software, including:
Sensit, for Sensitivity analysis, Spider

and Tornado diagrams

Risksim for Monte Carlo simulation
and
Treeplan to construct decision trees

This software is copyright3 to Prof.

M.R. Middlelton of the University of

KEY REFERENCES
Sensit and Treeplan are useful
and functional professional tools
Risksim is ideal for teaching Monte
Carlo simulation, but its
functionality is lower than that
ofsophisticated risk analysis
packages like @risk and Crystal
Ball
http://www.decisiontoolworks.com
web page contains instructions for
the use of this software 4

SENSITIVITY ANALYSIS ON THE

FOREVER HOPEFUL GOLD MINE
Sensitivity analysis and Monte Carlo
simulation will be carried out using
the simple nominal dollars version
model of the Forever Hopeful Gold
mine
This is in the Excel file: Sensitivity
Forever Hopeful 2011

THE NOMINAL BASE CASE SPREADSHEET

SHOULD BE BUILT INTERACTIVELY
YEAR

GROSS SALES REVENUE ($ million)

55.29

57.52

59.84

62.25

64.76

67.37

OTHER REVENUE (Salvage)

12.00

Less:
ROYALTY @ 2.5%
OPERERATING EXP. ($ million)

-15.48

Depreciation
Interest expenses
PROFIT BEFORE TAX ($ million)

-1.44

-1.50

-1.56

-1.62

-1.68

-16.18

-16.92

-17.69

-18.49

-19.33

-8.20

-8.20

-8.20

-8.20

-8.20

0.00

0.00

0.00

0.00

0.00

0.00

31.70

33.22

34.81

36.45

38.15

12.00

0.00

Less:
TAX @ 30%

-9.51

-9.97

-10.44

-10.93

-11.45

-3.60

PRODUCTION PROFIT AFTER TAX ($ million)

22.19

23.26

24.36

25.51

26.71

8.40

8.20

8.20

8.20

8.20

8.20

0.00

Addback:
Depreciation
Working Capital

-2

2.39

CAPEX

-41.00

NET CASH FLOW - NCF - ($ million)

-43.00

30.39

31.46

32.56

33.71

34.91

10.79

0.882613

0.779005

0.687559

0.606849

0.535612

0.472738

Discount Factor
PRESENT VALUE OF NCF ($ million)

-43.00

26.82

24.50

22.39

20.46

18.70

5.10

CUMULATIVE DCF ($ million)

-43.00

-16.18

8.33

30.72

51.18

69.87

74.97

Periods to break even

NPV

3 GOLDEN RULES TO ENSURE A

MODEL IS INTERACTIVE
1. Never type a number in the algorithms of a
model. Refer to numbers in the assumptions
table
2. Crosscheck the figures of a model column
under different assumptions using a pocket
calculator
3. Construct the model including inflation
(nominal dollars) and excluding inflation (real
dollars) getting the same NPV result

SENSITIVITY ANALYSIS
Sensitivity analysis highlights the effect
on the outputs of the model, (e.g. on
the NPV, IRR etc.) of changing the
value of any of input one at the time
This will direct the focus of future
investigations
on
getting
better
estimates of those inputs to which the
project is most sensitive, thus achieving
maximum information value

SCENARIO ANALYSIS
Scenario Analysis highlights the
effect on the model outputs of
combinations of inputs designed to
portray possible and realistic
scenarios either optimistic or
pessimistic
Scenario analysis provides a
quantitative idea of the robustness
and upside possibility of the project
9

LIMITATIONS OF SENSITIVITY AND

SCENARIO ANALYSES
These techniques are as good as
the flexibility of the model to adjust
to large changes (say 10 to 20%)
in inputs
Most models have linear
relationships to production volumes
and do not optimise the project in
terms of marginal revenue and
costs
10

SENSITIVITY ANALYSIS
1. Manual changes to the model or
2. Tabulating in Excel the result of
progressive quantum or percentage
changes in a single input or
3. Observing the effect of changes in one or
more inputs, both in tabulated and
graphical form (Spider and Tornado
diagrams), using the add-in Sensit from
the Decision Toolworks folder in the class
CD. This program can be opened while in
Excel and when opened, will show in the
Tool Excel (2003) or Add-in menu Excel
(2007)
11

SENSITIVITY USING TABLE

FUNCTION
Paste the relevant
Output cells

Leave this cell blank and link

it to the grade input cell

Headgrade
g/t Au

1 - Select table
except titles and
2 - Use Table
function from Data
Menu

3.4
3.5
3.6
3.7
3.8
3.9
4
4.1
4.2
4.3
4.4

NPV
$M
74.97
56.11
59.88
63.65
67.43
71.20
74.97
78.74
82.52
86.29
90.06
93.83

IRR
%
68.76%
55.68%
58.33%
60.96%
63.57%
66.17%
68.76%
71.34%
73.90%
76.46%
79.00%
81.53%
12

TWO-INPUTS SENSITIVITY
MATRIX USING TABLE
Headgrade
g/t Au
74.97
3.4
3.5
3.6
3.7
3.8
3.9
4
4.1
4.2
4.3
4.4
4.5

943.94
46.09
49.57
53.04
56.52
60.00
63.48
66.95
70.43
73.91
77.39
80.87
84.34

963.94
48.59
52.15
55.70
59.25
62.80
66.35
69.90
73.45
77.01
80.56
84.11
87.66

983.94
51.10
54.72
58.35
61.97
65.60
69.22
72.85
76.47
80.10
83.72
87.35
90.97

1003.94
53.60
57.30
61.00
64.70
68.40
72.10
75.80
79.50
83.19
86.89
90.59
94.29

Gold Price US$/oz

1023.94 1043.94
56.11
58.62
59.88
62.46
63.65
66.31
67.43
70.15
71.20
74.00
77.85
74.972
78.74
81.69
82.52
85.54
86.29
89.38
90.06
93.23
93.83
97.08
97.61
100.92

1063.94
61.12
65.04
68.96
72.88
76.80
80.72
84.64
88.56
92.48
96.40
100.32
104.24

1083.94
63.63
67.62
71.61
75.61
79.60
83.59
87.59
91.58
95.57
99.57
103.56
107.55

1103.94
66.13
70.20
74.27
78.33
82.40
86.47
90.53
94.60
98.67
102.74
106.80
110.87

1123.94
68.64
72.78
76.92
81.06
85.20
89.34
93.48
97.62
101.76
105.90
110.04
114.19

1143.94
71.14
75.36
79.57
83.79
88.00
92.21
96.43
100.64
104.86
109.07
113.29
117.50

13

SENSITIVITY USING SENSIT

SensIt 1.30 Academic
One Input, One Output

Headgrade (g/t Au)

3.4
3.5
3.6
3.7
3.8
3.9
4
4.1
4.2
4.3
4.4
4.5

NPVasfunctionofheadgrade

19-Jan-11
8:48 AM
est Feb 11.xls
se case'!$B$7
se case'!$E$5

100.00

NPV
56.11
59.88
63.65
67.43
71.20
74.97
78.74
82.52
86.29
90.06
93.83
97.61

85.00

95.00
90.00

80.00

NPV

Date
Time
Workbook
Input Cell
Output Cell

75.00
70.00
65.00
60.00
55.00
3.3

3.5

3.7

3.9

4.1

4.3

4.5

Headgrade(g/tAu)

14

SPIDER DIAGRAM

15

INTERPRETATION
Rising slope indicates positive
correlation between NPV and input
The steeper the slope the more
sensitive the NPV is to the input, e.g.
revenue components (price,
headgrade, exchange rates etc.),
CAPEX and operating costs
Inputs plotting over each other are
perfectly correlated, e.g. price, grade,
recovery
16

TORNADO DIAGRAM

17

INTERPRETATION
Minimum and Maximum possible input values
should be selected such that there is a low (say
2%) probability of the input falling below or
above them respectively, i.e. at the 2th and 98th
percentile
The Tornado diagram re-orders inputs in
decreasing sensitivity, e.g. price, headgrade,
exchange rate, diluted reserves.

18

SCENARIO ANALYSIS
Test potential project performance
project by building two or more extreme
but realistic scenarios including:
A pessimistic set of assumptions to test
the robustness of the project to
combinations of adverse circumstances
and
An optimistic one to see how much blue
sky there would be if favourable
circumstances prevail
19

SCENARIO ANALYSIS
The Excels Scenario function
provides a facility to build, save,
edit and merge various scenarios
Its use is very simply a matter of
following the dialog box prompts
It is important to save the base
case as a scenario
20

10

SCENARIO DISPLAY

21

SCENARIO SUMMARY

22

11

MONTE CARLO SIMULATION:

PROBABILITY DISTRIBUTION OF INPUT VALUES
Most inputs are uncertain but one may
have some idea as to how their values are
likely to distribute, i.e. the probability with
which various values may occur
Little can be done about reducing the
uncertainty of some (exogenous) inputs
(e.g. price and exchange rate),
but information gathering may reduce the
uncertainty of other (endogenous) inputs,
e.g. critically located drilling can reduce the
uncertainty of grades and reserves
23

TYPES OF DISTRIBUTIONS
Depending on the nature of the input
its probability distribution may be:
Discrete or continuous
Symmetrical (e.g. rectangular, triangular,
normal) or
Asymmetrical/skewed (e.g. triangular,
log-normal etc.)

12

MONTE CARLO RISK SIMULATIONS

Using the base case one can carry out a simulation
by:
Inputting the probability distributions (not the singlepoint, expected estimates) of possible inputs
Sampling input variables simultaneously and
randomly, but according to their respective
probability of occurrence, during thousands of
iterations of the model, thus generating thousands
of possible scenarios
Resulting in the model outputs being not just
expected values but also probability distributions of
all possible outcomes surrounding expected values.
25

MONTE CARLO SIMULATION

Random sampling from probability distributions of inputs over a large number of
iterations

Expected (mean) NPV

PROBABILITY
DISTRIBUTION
OF POSSIBLE NPVs

Generates a probability distribution of all possible values surrounding the expected

value of the simulated output, e.g. NPV
26

13

PROBABILITIES CAN BE
Independent:
But not mutually exclusive:
Can be added: P(A or B) = P(A) + P(B) or
Multiplied: P(A&B) = P(A) * P(B)

Or mutually exclusive and collectively

exhaustive: P(A) + P(B) = 1

Bayesian or Conditional:
P(A given B) = [P(A) * P(B given A)] / P(B)
27

PROBABILITY ESTIMATES CAN BE

Objective:
Classical, when they can be determined
by stringent mathematical models or by
Rigorous experimental tests generating
reliable frequency distributions of
occurrence

Or Subjective:
When determined by our professional
judgement and experience, in many
ways based on our intuition of relevant
frequency distributions
28

14

DETERMINING SUBJECTIVE
PROBABILITY ESTIMATES
Subjective probability estimates are
generally determined using :
Expert interviewing techniques and
Delphi techniques

29

PROBABILITY DISTRIBUTION OF INPUT VALUES

Many inputs (e.g. commodity prices,

grades etc.) have skewed log-normal
distributions, in which the logarithm
(ln(X)) of possible values (X) distribute
normally
The distribution is characterised by its
mean and standard deviation
These statistics can be derived from
historical time series (e.g. for
commodity prices from KITCO or the
LME)
30

15

GOLD PRICES
The Excel file KIGAM Gold statistics.xls shows
how to derive the mean () and SD () of the daily
gold prices (X) over the last two years (till
December 31, 2010)
Note that to do this one makes use of the normal
mean () and SD () of the logarithms of the
prices (ln(X))
These statistics of the logarithms are then
translated back to those of the values using the
formulae as shown in the following slide
31

LOGNORMAL STATISTICS
Mean (X) = exp( + 0.5)
Variance (X) = = 2 * (exp( - 1) or = exp(2 +
2) exp(2 + )
Standard deviation (X) = square root()
Mode (X)= exp( - )
Median(X) = * exp(-0.5) or exp(
Where:
X = value of variable
= mean of ln(X)
= standard deviation of ln(X)
32

16

SIMULATED GOLD PRICE

33

TRIANGULAR DISTRIBUTION
Analysts often make use of a triangular
distribution as a proxy for the lognormal
distribution
A triangular distribution is characterised by
the following parameters:
maximum,
minimum and
most likely (mode) values
The mean is:
Mean = (min + most likely + maximum)/3
34

17

TRIANGULAR DISTRIBUTION
If the mean (expected) price for gold is
estimated at US$1024/oz between a
minimum of US$681 (2% percentile)
and a maximum of US$1476/oz (98%
percentile), then, the most likely
(modal) price is:
(681 + most likely + 1476)/3 =
US$1024/oz
Mode = Most likely = US$915/oz
35

GOLD PRICE INPUT USING THE

TRIANGULAR DISTRIBUTION

Mode = US$915

Min = US$681

Mean = US$1024

Max = US$1476

36

18

TRUNCATED DISTRIBUTIONS
Although most inputs are skewed,
some (e.g. exchange rates) are fitted
by the normal distribution well
However, the normal distribution has
tails that run to +- infinity, which is
unrealistic
To overcome this difficulty distributions
can be truncated to minimum and
maximum realistic values 37

MONTE CARLO SIMULATION

SOFTWARE
Risk simulation software like
Risksim and the more sophisticated
@risk and
Crystal Ball

allow us to sample at random and

simultaneously from the probability
distributions of various inputs through
the use of specific functions, e.g.:
Randlognormal or
Randtriangular or
Randnormal etc.

38

19

MONTE CARLO SIMULATION:

PROBABILITY DISTRIBUTION OF INPUT VALUES

Using the Forever Hopeful model we

could input probability distributions for:
Gold prices
Exchange rates
Head grade
Recovery
Mining and milling costs
Capital costs etc.
39

DISTRIBUTIONS CAN BE INPUT

PROGRESSIVELY
if the base case inputs were the expected or mean
values of the various distributions , then after a
large number of iterations the mean of the output of
a simulation (e.g. NPV) should generally be close
to that of the base case,
Differences indicate discrepancy between the base
case inputs and their distributions which need to be
addressed
By inputting a few parameters at the time and
comparing the output of simulations one can
identify where a discrepancy may have occurred
and rectify it
40

20

MONTE CARLO SIMULATION

provides not only an expected value (e.g. NPV = $76.18 M), but a full
distribution of all possible NPV outcomes and their related probability of
occurrence. The greater the number of trials (in this example 30000) the
smoother the distribution of results

41

MONTE CARLO SIMULATION

Simulated mean = A$76.18

42

21

MONTECARLO SIMULATION

Infinitesimal chance
that NPV>A$283M

About 54% probability that the

NPV<than expected (<A$76.18M)

Infinitesimal
chance that
NPV<0

43

INTERPRETATION
From the cumulative chart one can see that there
is less than 0.05% chance that the NPV will be
negative and 54% chance that it will be lower than
the expected value of $ 76.18 M
However even if the NPV is negative it does not
mean that the cumulative cash flows from the
project would be negative. It only means that the
project may not be as profitable as we expected
On the up-side there is an infinitesimal chance that
the NPV may be as high as $ 283 M

22

CORRELATION AND AUTOCORRELATION

In our simulation we assumed that:
Every input was independent of each
other (i.e. no correlation) and
Inputs of successive years were
independent of previous years values (i.e.
no autocorrelation)

In reality this is often not the case (e.g.

correlation between price of gold and
exchange rates, grades and recovery,
tonnages and unit costs etc.)
If measurable these correlations can
be included with sophisticated software
45

INVESTMENT DECISIONS
The risk analysis tools used in this session:

Help highlighting and quantifying the risk

inherent in a project
Do not provide rules to managing risk
Investment based on the mean or expected value
(i.e. $ 74.97 M from the base case or $ 76.18 M
from the Monte Carlo simulation) assumes a riskneutral approach to the decision
In later sessions we will see that investors are in
fact risk-averse and influenced by the underlying
chance of making a loss, particularly if the latter is
significant in relation to their wealth46

23

RISK MANAGEMENT
The combination of the severity of potential
impacts of possible events and their related
probability
of
occurrence
are
the
fundamental elements in formulating a riskmanagement policy as to whether:
Bear the risk
Hedge or insure against it if possible
Shift it to another party through
contractual arrangements or at the limit
Reject the project
47

CONCLUSIONS
Modern risk analysis software makes it easy to:
Test the sensitivity of project performance to
changes in single or multiple inputs
Convert base case models, built under assumed
certainty, to probabilistic ones
Fit probability distributions to input data and
sample them randomly and simultaneously over a
very large number of iterations in simulations
Generate not just single-point but distributions of
possible results leading to better knowledge of the
risk of a project, better investment decisions and
strategies to how to manage risk
48

24

THANK YOU

25