"Further Evaluation TechniquesSensitivity analysis Previously the evaluation of investmentopportunities has been based on a single point,expected value estimates of relevant economiccharacteristics. The expected value estimates aremade on the basis of limited information. As such adegree of uncertainty is associated with each of theexpected values, based on the reliability of theinformation available at the time of evaluation. Inorder to compare and select between investmentalternatives the possible effects of theseuncertainties also need to be analysed. The starting point for examining the effects ofpossible variations in the values of the inputs on thedecision criteria is to undertake a sensitivityanalysis. Sensitivity analysis measures the effect ofa given change in a input value on DCF criteria.Examples include changes in price, rate ofinflation, taxation regime etc. By varying one inputcharacteristic at a time one is able to assess therelative effects on decision criteria, as such asensitivity analysis is used to define thecharacteristics to which a decision is mostsensitive. These characteristics can then be givenspecial attention in the assembling of information,estimating and subsequent risk analysis. Sensitivity analysis can therefore be used to definecritical or strategic variables that should befocussed on in subsequent risk analysis. It can alsobe used to answer a number of other questions. Itcan also be undertaken to assess the effect ofmultiple variables. Sensitivity analysis is an important bridge betweenconventional analysis and risk analysis. However itshould be noted that sensitivity analysis does notevaluate risk, to do this estimates of the probabilityof risk need to be undertaken. Appendix 4 containsa paper that discusses mineral and metal prices andtrends in these, a good example of how to look atrisk factors. Effects of InflationInflation can have serious implications on theresults of discounted cash flow analysis andintroduce serious errors. Perhaps the worst casescenario from an engineering viewpoint is forprojects that have a high capital input at thebeginning of the project and long lead times priorto positive cash flows being realised and paybackbeing achieved. Classical examples of this type ofproject include mining projects and large-scale civilengineering infrastructure projects. Inflation appears to be a relatively simple conceptand it is, the difficulty is how is it measured andhow can the effects of inflation be taken intoaccount. A fuller description of the effects ofinflation can be found in Gentry. D. W and O’Neil.T. J. (1984) “ Mine Investment Analysis”, SME,Littleton, CO, the following present methods bywhich inflation can be simply accounted for. To account for inflation one needs to convert futureincome and expenditure streams to a constant valueas required in DCF techniques, to achieve this thefollowing formula can be applied in order todetermine the effective interest rate or cost ofcapital; i ? i ? i ? i ? i e i c i c where i ? effective interest rate or inflation adjusted interest rate e i ? cost of capital c i ? rate of inflation iAs an alternative, as reported in Noakes. M andLanz. T (1993) “Cost Estimation Handbook for theAustralian Mining Industry”, AusIMM Monograph20, AusIMM, Melbourne, the following can beapplied:cost index now Cost Now? (cost then)?cost index thenSeveral sources of information regarding costindexes for various industries exist, withinAustralia the best source is the Australian Bureauof Statistics (ABS). Depending on the industry andspecific sub-branch of the industry underconsideration research should be undertaken todetermine the best source of inflation statistics andinformation. Operating costsThe main emphasis within these notes so far hasbeen on the estimation and analysis of fixed andvariable capital costs with little emphasis onoperating costs except a discussion on how theycan be incorporated into the overall economicanalysis of a project. The method of estimatingoperating costs is quite different to that ofestimating capital costs, as very few short cutsexist. Operating cost estimates are intimately tiedinto the technical element of a project and need tobe determined with these elements in mind. Usecan be made of factors or indices but care should beexercised as some elements such as fuel costs andlabour costs do not always follow typical inflationfactors. Another factor to note is that if a project isinsensitive to capital expenditure, very common inthe mining and civil engineering industries andcommon in the case of other engineering industries,an accurate financial analysis of the project isperformed with only operating costs beingestimated and modelled because of the intrinsicaccuracy of the operating cost estimationprocedure. How can operating costs be determined? Table 22lists possible sources of cost information for themining industry, direct equivalence for otherindustries can be applied. Table 22: Sources of cost information. (after Runge (1998))Source CommentOperating mines Definitions and cost allocations vary from company to company.with similar plant Usage data (eg, litres of fuel used per hour, tyre life) are moreuseful from mine to mine than are direct cost data (eg, fuel costper operating hour, tyre cost per operating hour).Manufacturers Cost data may not be consistent from manufacturer tomanufacturer but should be reliable across machines from thesame manufacturer. Manufacturers are usually a good source ofdata for regular repair and overhaul costing, but are generally lessknowledgeable than mine sites for wear items such as life ofropes, tyres etc and maintenance due to breakdowns andaccidents. Manufacturers sometimes provide contracted prices foroperating costs.Consultants, Consultants are adept at mine to mine comparisons and atindustry cost identifying anomalies in components of cost. Consultants costsservices are probably the most appropriate source with new equipment andin new applications of existing equipment.Government and These sources are appropriate for broad indications on costs. Theindustry standardised forms used to collect cost data are sometimesauthorities inappropriate and the information is frequently dated.A company’s Internal costs are a valuable source of information. Past historyown operations may not be a reliable guide if the new application differs from thepast. Some cost accounting systems use fairly arbitrary rules forthe allocation of costs not specifically collected on individualitems of equipment.Contractor For such items as explosives, tyres etc these sources are probablyquotations the most reliable costs.Rules and These can provide very reliable estimates once enough studiesformulas have been cross checked against actual costs. Typical factors influencing operating costs include:Supply costs? ? Job conditions? ?Risk AnalysisProject investment decisions are made underconditions of uncertainty. These uncertainties willdepend on the type of project being evaluated. Asan example mining projects can suffer a highdegree of uncertainty due to factors such as mineraldeposit characteristics, market prices, operating andcapital costs, government policy etc which willonly become fully known with time. "