(Mis)use of Monte Carlo simulations in NPV analysis

G.A. Davis

Abstract - There has been some confusion over the selection of discount rates when performing stochastic simulations of a project's net present value (NPV) using riskadjusted discounting techniques. Some argue that lower discount rates should be used when performing stochastic valuation simulations. This creates higher NPV values and improves the attractiveness of a project. Others argue that the discount rate should not be loweredfor these simulations. This paper exposes the source of this confusion. It demonstrates that stochastic simulations d o not remove the risk inherent in aproject and, therefore-donot improve a project's value to the risk-averse investor. Risk-adjusted discount rates should, therefore, not be adjusted downward when performing stochastic NPV simulations. Stochastic simulations are, however, shown to he useful in several aspects of project valuation. Introduction
Mineral companies have long wrestled with the fact that, at the stage of project valuation, there is significant uncertainty over many of the inputs to net present value (NPV) analyses. This uncertainty has historically been accommodated by the risk-adjusted discounting technique, where the project's net cash flows are discounted at a rate that reflects their diminished value due to their uncertainty. In generating these net cash flows, a specific or deterministic value of each uncertain input variable is assumed, resulting in a singular NPV estimate. Sensitivity analyses are then used to explore the variation in NPV as certain inputs change. The advent of Monte Carlo stochastic simulation software for the personal computer has the potential to revolutionize the method by which mineral firms are able to incorporate uncertainty into mineral project valuation. Given the impending adoption of this valuation tool by the mineral industry, this paper demonstrates the uses and misuses of Monte Carlo simulations and risk-adjusted discounting in project valuation. Under various manipulations of the
1 With a 5% standard deviation, possible recovcries range from about 75%

risk-adjusted discount rate, a sample gold project can be valued anywhere from $1.35 million to $40 million. Of course, the project has only one market value, and the objective of any valuation exercise is to arrive at this value. No valuation method, including stochastic simulations, can determine this value with certainty. Stochastic simulations do, however, give a good idea of the uncertainty associated with a project's expected value. This provides useful information when deciding whether or not to bid for or develop a property.

What is stochastic simulation?

Stochastic simulation is a rigorous computational method of project valuation that takes input parameter uncertainty into account. In a stochastic simulation, each uncertain variable is input as a probability distribution that reflects the variable's uncertainty. For example, preliminary metallurgical testing at a prospective mine might indicate that the mill recovery could be specified as a normal distribution with a mean of 85% and a standard deviation of 5%. In a deterministic setting, the expected recovery of 85% would be input into the spreadsheet and calculated the expected project NPV. In a stochastic simulation, the computer takes into account that the recovery is uncertain, as specified by the recovery probability distribution.' Correlations between various uncertain variables, such as between grade and recovery, can also be specified. The stochastic simulation obtains a value for each uncertain (stochastic) variable by sampling the specified probability distribution using a 'Monte Carlo' sampling technique, and an NPV is calculated based on these value^.^ This process is repeated for some 1000 iterations, with the result being 1000 separate calculations of possible NPVs of the project. These NPVs, when displayed graphically, yield an expected project value and an explicit demonstration of the uncertainty surrounding that value. It was possible to perform such stochastic simulations in mineral project analysis as early as 1980 using algorithms
G.A. Davis, member SME, is assistant professor with the Division of Economics and Business, Colorado School of Mines, Golden, CO. SME paper 94409. M~~~~~~~~~ April , 994, Discussion of this peer-reviewedand approved paper is invited and must be submitted, in duplicate, prior to April 30, 1995.

to about 95%. 2 Technically, stochastic simulationsneednot be Monte Carlo simulations. A stochastic simulation is a series of iterations drawing input variables from specified probability distributions. The Monte Carlo technique is one method of drawing randomly from each of these distributions.
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written for large computers (Barnes 1980). However, treatment of uncertainty was largely impaired by the absence of commercially available software and personal computers. Even with the advent of personal computers in the 1980s. estimating the effects of uncertainty on project values was limited to sensitivity analyses, conducted by manually running multiple NPV calculations while varying input parameters individually (Glanville 1985). But these were simply what economists call comparative static results, where the interdependence of uncertain events was not modeled. For example. it was difficult to consider linkages between grade and recovery when assessing the sensitivity of a project's value to ore grade. Thus. grade would be varied and the effect on NPV would be calculated, but the recovery would be left unchanged. The resulting sensitivity analysis would not be a true reflection of the effects of changing grades on the value of the project. Other pioneering work in valuation under uncertainty involved modeling the value afforded to the project by managerial flexibility, such as the ability to temporarily suspend operations during periods of low product prices (Palm. Pearson, and Read 1986; McKnight 1988). But such analysis was laborious and allowed the consideration of only limited aspects of uncertainty. And, for accurate results, upwards of 1000 runs are required, making the data handling aspects of uncertainty modeling almost prohibitive. In 1984. the stochastic simulation package "@Risk" became commercially available for use with Lotus spreadsheets on IBM personal computers. A similar package for Excel, "Crystal Ball." was introduced in 1988. Commercially available mine prefeasibility software packages are now able to provide Monte Carlo simulation results in a somewhat primitive manner. While the petroleum industry has been quick to adopt these tools to project valuation, the mining industry has been less receptive. Cavender (1992) discussed the first application of stochastic simulation to mining in MINING' ENGINEERING. His paper spawned three published comments (Le Bel 1993: Malozemoff 1993 and Smith 1993)and two replies (Cavender 1993a, 1993b). There appeared to be a considerable amount of confusion over the interpretation of the output from stochastic project zvaluations. In teaching the use of these stochastic simulation packages, this author has found similar confusion to exist in the classroonl.

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Fig. 1 - Distribution of project NPVs using an 8% discount rate.

Where the confusion begins

Cavender first calculated the risk-adjusted NPV of a small open-pit gold project using traditional deterministic riskadjusted discounted cash flow techniques. in real dollar terms.? He estimated the project's value to be $1.35 million. Although he reported normal discount rates to be from 14% to 15%. the real discount rate used by Cavender for this project was 16%, "since the project is assumed to exhibit a substantial degree of risk." After specifying probability distributions for six of the project's uncertain input variables, Cavender then performed a Monte Carlo simulation, creating a histogram of possible project NPVs (Fig. 1). In performing this simulation, Cavender noted: "An 8% discount rate was used in the stochastic model
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since the majority ofthe risk was explicitly identified in the simulation." As a result, he naturally obtained a higher expected risk-adjusted NPV than he did in the deterministic calculation. The mean value from the stochastic simulation was about $22 million (Fig. I ) vs. the original estimate of $1.35 million. The obvious question then becomes. what is the expected market value of this property? There are two estimates, $1.35 million at a 16% discount rate, and $22 million at an 8% discount rate. Has performing a stochastic simulationcreated value for the project by reducing project risk? Le Be1 (1993). commenting on Cavender's calculations, notes the fault with this reasoning; "Project risk cannot explicitly be addressed through the use of distributions, but rather by actions like the following: introducing a gold hedge program to reduce or eliminate the gold price risk; entering into a contractual arrangement to secure assets; securing contractor bids for various operating functions; or obtaining political risk insurance. . . In fact, knowing that the deterministic (traditional) NPV calculation (16% discount rate) yields a value of $1.35 million, would someone pay $20 million for this project?" Cavender replied to Le Bel: "Simulation . . . allows the analyst to expldre every possible combination of inputs and to weight the resulting outcomes according to the relative probabilities of these inputs. In the deterministic calculation of net present value, uncertainty has been recognized, instead, through adjustments to the discount rate. The deterministic [discount] rate, therefore, should not be applied to cash flows that already reflect risk" (Cavender, 1993b). Both parties at face value appear to have a reasonable argument. Yet neither treats project risk correctly. The confusion comes from the interpretation of project risk and the resultant ad hoc adjustment to the discount rate.

Risk as incomplete information

Risk, as used by Cavender and Le Bel, refers to the upside and downside uncertainty over revenues and costs that will dissipate as the mine is developed and brought into operation. In a risk-aversion paradigm, the more variable or uncertain a project's cash flows, the more risky it is. Given two otherwise equivalent projects, the riskier project (the project with more initial uncertainty in its operating parameters) would be less desirable to risk-averse investors. even if its 'expected' operating parameters and value are identical to those of the less risky project. To incorporate this aversion to uncertainty into the valuation process, it is common to use risk-adjusted discounting. This discounts the net cash flows from the more uncertain project at a higher rate. Its 'risk-adjusted' NPV is thuh lowered, signaling that it is less desirable. Cavender chose u
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3 Readers arc referred to the original article, page 1263. for a description of the minerat project. A "risk-adjusted" NPV is used in this paper tq describeanexpectedNPV that has beenadjusted downwards for investors aversion to risk. It is thus the value of the property to risk-averse

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16% discount rate for this risky project, vs. what he noted are more normal rates of 14% to 15%. Before moving to stochastic methods of exploring project risk, the implications of the risk-adjusted method of valuing uncertainty are examined. Consider two gold properties, A and B, located adjacent to each other, bisecting a homogenous ore body. The projects are thus identical, but assume that project A is riskier than B, in the sense of uncertain valuation parameters. Why might this be so? Output price uncertainty is surely the same for both projects, as are input costs and input quantities. Tonnage throughput will also be equally uncertain for both projects, given that both are located in the same political system and subject to the same environmental and meteorological forces. Grade, recovery and reserves should also have the same expected values for each project, with the same uncertainty. But, to illustrate a p6intT assume project A's expected grade, recovery and reserve values are less certain because $X less in-fill drilling and metallurgical testing has been performed by project A's engineers. In other words, based on work to date, the expected grade, recovery and reserve potential for project A are the same as those for project B, but they have a wider variance. Even though both projects are expected to produce the same yearly cash flows-and overall NPV, project A's cash flows and hence NPV is at this point less certain. According to Cavender and others (Sandri 1985), project A is 'riskier' and worth less.4 An investor could reduce the additional uncertainty of project A's cash flows by spending $X on an in-fill drilling program and metallurgical testing, just as B has already done. Since the projects are identical, except for this drilling program, this drilling expenditure by A will provide information that subsequently makes project A identical to project B in terms of uncertainty, and hence identical in value tothe riskaverse investor. Thus, project A should, before the drilling program, be exactly $X less valuable than project B. Using risk-adjusted discounting, it would be lucky indeed if the discount rate for project A was adjusted upwards by just enough to reduce its value below that of project B by $X. This is a major problem with risk-adjusted discounting. If the uncertainty in project A's grade, recovery and reserves were modeled using Monte Carlo simulation instead of performing the in-fill drilling program, would this improve the information on A's recoverable metal? That is, does it reduce the uncertainty over these operating parameters, as did in-fill drilling? Of course not. It simply shows what the resultant rangeof uncertainty in the NPV of project A is likely to be, as demonstrated in Fig. 1. Since stochastic modeling does not change any aspect of the project's uncertainty, the same risk-adjusted discount rate should be used in the Monte Carlo simulation of project A's value that was used in the deterministic calculation. Project A is still worth $X less than project B to the risk-averse investor. Contrast this with Cavender's approach, where under Monte Carlo simulation property A will now be worth the same as property B. This is because the incremental uncertainty of project A has been recognized, in Cavender's view, directly in the spreadsheet cash flows of the simulation analysis. Therefore. it is no longer necessary to adjust A's discount rate upwards for its additional riskiness, even in this
4 One referee suggested that since project A's upside reserve potential was

risk-adjusted discounting paradigm. To model all of the uncertainty associated with a project's variables in a stochastic simulation, probability distributions would be entered for each of the uncertain parameters that are used in the valuation calculations. According to Cavender's reasoning (1993a), with all of the uncertainty modeled, we should then use the real risk-free rate, say 4%, as the discount rate in the stochastic calculation of NPV. This means that, if it was possible to model all of the uncertainty in Cavender's gold mine example, the expected NPV of the mine would rise to around $40 million. Does this make the market value of the mine $40 million'? No. In fact, at this stage, the true value of the mine remains uncertain. Stochastic analysis has only helped to understand the degree of uncertainty surrounding the expected value. What has become evident through this analysis is that, in a risk-adjusted discounting framework, it is incorrect to reduce the risk-adjusted discount rate when stochastic NPV simulations are performed.

Risk as uncertainty in operating environment

But this is not the only use of the term risk. For example, a potential gold mine in Papua New Guinea (PNG) is considered 'riskier' than an identical mine situated in Nevada. In this case, more risk means greater exposure to external forces. External risk includes uncertainty over expropriation, weather, labor supply and logistics. The major impact of these factors on yearly cash flows and mine value is by potentially reduced mill throughput. In this case, the parameters other than throughput for the PNG and Nevada projects may be equally uncertain, but the additional uncertainty over throughput in the PNG project makes it the riskier of the two. Again, intuition states that investors would pay less forthe PNG project. In this case, it is not because of higher uncertainty over mill throughput (as with Mine A above), but because of the potential for throughput shortfalls. The expected value of the PNG project is lower. Unfortunately, this conclusion is usually reached by increasing the discount rate. The following example shows why this is unlikely to provide a correct estimate of the project's diminished value and how stochastic simulations can help. Assume that the mine in PNG will be designed to process 3.6 Mt/a (4 million stpy) of ore. However, if the mine is expropriated or shut down by local events, the actual output will be zero. Assume that there is a 50% chance of this happening (a very 'risky' project). There are three ways to model the mine's production. The first, and most common, is to use the design value of 3.6 Mt/ a (4 million stpy). That is, in performing an NPV analysis of this project, 3.6 Mt/a (4 million stpy) is the throughput parameter that is used in the spreadsheet. But. since it is known that this will give expected cash flow values that are too high, the discount rate is arbitrarily increased to above the rate that would be used for the Nevada mine, say from 15% to 20%. Even though the 20% discount rate serves to reduce the ultimate value of the PNG mine. it does so in a convoluted and imprecise manner. It penalizes late cash flows more then early cash flows. This is only appropriate if the chance of operating at 3.6 Mt/a (4 million stpy) decreases over the life of the mine. And, even if this were the case, it is unlikely that the reduction in expected output will decline at the same exponential rate implied by the increased discount rate. It is also unlikely that the analyst will be able to determine how much to increase the discount rate to adjust the NPV for the
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greater, it may be more valuable. This contradicts the assumption of riskaverse investors made here, but given the "psyche" of mineral investors. may hold in some cases.
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Trmd Chart Forecast: Mstrlbutlon of NPVs @ 7.6% Frmency Chart 998 Trlds Shown
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Fig. 2 - Distribution of project NPVs using a 7.60h discount rate.

Fig. 3 - Confidence interval for yearly cash flows ($000).

downside uncertainty in annual output. A second, better method, of dealing with this heightened production uncertainty is toexplicitly model the fact that the expected throughput in any one year is 1.8 Mt (2 million st) (0.5 x 4 + 0.5 x 0) and use the 15% discount rate. The expected NPV of the project will be suitably reduced, not because a higher discount rate was used, but because the downside aspect of political risk is explicitly incorporated into the spreadsheet. The third way to model this risk is to model output as a probability distribution, with a50% probability of 3.6 Mt/a(4 million stpy) and a 50% probability of zero output. A Monte Carlo simulation is then run using the 15% discount rate. The resulting expected NPV will be the same as in method two, but will now reflect the uncertainty in the operating environment. The stochastic simulation is preferable to method two. This is because it makes explicit the uncertainty in the project's expected NPV. which method two does not do. The correct way to model the downside of output 'risk' in foreign projects is by using stochastic probability analysis and the appropriate unintlated discount rate, or using the expected output value in a single, deterministic NPV calculation using this same discount rate. This will provide more accurate results than arbitrarily increasing the discount rate for foreign projects.

@ is the market premium for risk.

Risk in the portfolio sense

What is left is deciding on an appropriate discount rate. The problems with adjusting the discount rate on an ad hoc basis for risk have already been discussed. Portfolio Theory. properly applied, provides a reasonable alternative. According to Portfolio Theory, a fully diversified investor is not concerned with the variance or uncertainty of returns from a particular asset. Instead, the investor cares about the effect of any investment on the risk (or variance) of hisher entire portfolio. From this, the Capital Asset Pricing Model (CAPM) states that the risk-premium in the discount rate for any project depends only on the project's beta (P) (Brealey and Myers 1991). Roughly speaking, beta is a measure of the degree of covariance between the value of the project and the market return. The discount rate for any project is then calculated from the CAPM as, where ri is the appropriate discount rate for project i. rs is the risk free interest rate, pi is the project's beta, assumed to be constant over the life of the project, and
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Using an expected short-term real risk-free rate of 4%. a typical market premium for risk of 8% (Brealey and Myers 1991), and a beta of 0.45 for gold projects (Guzman 1991), the real discount rate for Cavender's gold project should be about 7.6%. Using this in the stochastic simulation, the expected project value, then, is $26.1 million, with a spread of-$100 million to $150 million (Fig. 2). If the beta of this project is likely to be greater the 0.45, where the NPV of the project is for some reason more strongly tied to the business cycle than the average gold project, then a higher discount rate should be used and the value of the project to the diversified investor would decrease. But there is nothing in Cavender's analysis to suggest that the beta of his 'risky' gold project will be other than 0.45. Thus. there is no reason to believe that a higher discount rate should be used. In the CAPM, risk in the sense of initially uncertain input parameters has no direct bearing on the discount rate of a project. Under the portfolio definition of risk, all that matters is the covariance of the NPV with movements in the market. This is taken care of by the beta term in the CAPM. Given this, securing contractor bids for various operating functions, which reduces the uncertainty of operating expenses, is unlikely to reduce the beta of the project. This is because these cash tlows are unlikely to be correlated with market movements in the first place. Also, hedging gold price risk at the level of the mine does not provide value to the investor, since the investor can costlessly go short in the futures market if the mine does not (Black 1976). Gold price hedging is no reason to lower the beta and hence the CAPMcalculated discount rate. Thus, Le Bel's recommendation that discount rates be reduced if operating costs and price risk are 'hedged' is correct in the risk-adjusted discounting sense. But it is incorrect under the portfolio definition of risk. Having defined risk in this sense, the valuation of project5 A and B are reexamined. According to the portfolio definition of risk, project A's discount rate should be higher only it' its value has a stronger covariance with the market than project B's. More accurately, r~ will only be higher than r~ if PA is greater than PB. From the description of the two projects, this is impossible. Thus, the same discount rate should be use for both, and the two projects have the same expected market value. This applies regardless of whether a stochastic or deterministic valuation model is used." Let us return to the idea of political risk. According to the CAPM, unless a foreign operation's value is more correlated
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5 Project A may be worth less than project B to the undiversified invesror. but since that investor will not be successful in his or her bid for A. rht\ will have no impact on the observed market value of A.
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with the market than an operation in Nevada, its project beta should be the same as that of the Nevada mine. That is, the twoprojects' discount rates should be the same. Can political risk affect a foreign project's beta? Possibly. Consider a worldwidecrisis that causes markets to plunge. That same crisis may cause political instability in the foreign country, and the cash flows from the foreign mine may drop to zero. Cash flows and markets being strongly correlated, higher betas are found and, hence, higher discount rates are being used for foreign operations. But this adjustment should not be made due to downside uncertainty in operating environment per se. Instead, as much of this uncertainty as possible should be incorporated into the cash flow analysis. Stated another way, the discount rate might justifiably be adjusted upwards for foreign projects, but Portfolio Theory determines how much. The downside uncertainty in operating throughput for a foreign operation should be modeled within the cash flow spreadsheet. This gives aforeign project a lower NPV. The lower NPV should not be created by an arbitrarily elevated discount rate. According to Portfolio Theory, initial parameter uncertainty has no direct bearing on the discount rate that should be used in either deterministic or stochastic NPV calculations. The discount rate should depend only on the systematic fluctuations of the project's value over time, as determined by the project's beta. All other quantifiable elements of uncertainty should be modeled directly into the spreadsheet by probability distributions or their expected (deterministic) values.

modeled as a random walk. with or without a trend. This more closely resembles the way output prices move during a project's life. Managerial decision rules can then be modeled, such as temporary shut-downs when prices are low. This replicates the option value that operational flexibility provides to a project, an exciting field of real asset valuation that is just beginning to be applied to mineral property valuation (Bjerksund and Ekem 1990).

Summary
Stochastic simulation of uncertainty in project valuation allows mining companies to numerically and graphically depict the effect of operational uncertainty on project cash flows. It does not create value by allowing the use of a lower project discount rate. Nor does it remove any of the risk of a project, no matter how risk is defined. It simply allows companies to input more information into their NPV analyses and make decisions based on more completely modeled information. At a low cost in time and effort, stochastic simulation increases the amount of information available when making difficult project evaluations. A few benefits have been listed here. Project analysts will discover other advantages to stochastic simulations as simulations become more widely used. +

References
Barnes. M.P 1980. Computer-Assfsted MineralAppraisaland Feasibility, SME, Linleton. CO. Bjerksund, P., and Ekern, S.. 1990. "Managing investment opportunities under prlce uncertainty. From 'last chance' to 'wait and see' strateg~es." Financial Management, Autumn 1990, pp. 65-83 Black, F., 1976. "The pricing of commodity contracts," JournalolFinancial Economics.Vol. 3. pp.167-179. Brealey, R.A., and Myers, S.C.. 1991. Principles olcorporate Finance, 4th Edibon, New York: McGraw-Hill. Inc Cavender, 8.. 1992. "Determination of the optlmum llfetlme of a mining prolect using discounted cash flow and option prtcing techniques," MfnfngEngineering, Vol. 44. No. 10, pp. 1262-1268 Cavendar, B.. 1993a, "Determination ofthe optimum l~fetimeof a mining project uslng discounted cash flow and option pricing techn~ques:Reply to Malozemotfand Smith." Minfng Engineering. Vol. 45. No. 3, pp. 293-294. Cavender. B., 1993b. "Determination of the optimum lifetime of a mining project using discounted cash flow and option priclng techniques: Reply to G. Le Bel," Minmg Engineering, Vol. 45. No. 11, pp. 1411-1412. Glanville, R, 1985, "Optimum production rate for high-gradellow-tonnage mines," Finance for the Minerals Industry, C.R. Tinsley. M.E. Emerson and W.D. Eppler, eds., SME, L~nleton, CO, pp. I I4-125. Guzman. J., 1991, "Evaluating Cyclical Projects.' Resources Policy 17, Vol 2, pp. 114123 Le Bel, G. 1993, "Determination of the optimum llfettme of a mining project using discounted cash flow and optton pricing techniques: Discussion." Mfning Engfneering,Vol 45, No. 11, pp.1409-1411. Malozemotf. P. 1993, "Determination ofihe optlmum lifetime of a mining project uslng discounted cash flow and option prtcing techniques: Discussion.''MinfngEngineering, Vol. 45, No. 3, p. 292. McKnight, R.T. 1988. "An empirical methodology for the valuat~on of risky gold cashflows;' Gold Mining 88. C . 0 Brawner, ed. SME, Littleton, CO, pp. 120-137. Palm, S. K.. Pearson, N.D. and Read. J.A., Jr, 1986. "Option pr~cing: A new approach to mlne valuation." CIM Bulletin. May. Sandri. H.J , Jr. 1985, "Mineral Industry acquisition analysls." Finance lor the Minerals Industry. C.R. Tinsley, M.E. Emerson and WD. Eppler, eds SME. Littleton. CO, pp. 383389. Smith, L.D. 1993, "Determinat~onof the optimum lifetime of a minlng project uslng discounted cash flow and option prlcing techniques: Discussion,'' Mining Engineering, Vol. 44, No. 10, p. 293.

The value of stochastic simulation

Performing a stochastic simulation of the expected value of a mineral property provides information on several fronts. First, when using the correct discount rate, the simulation gives us a better estimate of the expected project NPV than a deterministic analysis. This is because the uncertainties modeled may have nonnormal and/or correlated distributions. Explicitly modeling these distributions creates a more informed expected NPV value. Second, the variance in possible NPV outcomes, as typically presented (Figs. 1 and 2), shows the uncertainty surrounding the NPV point-estimate. It allows the determination of the probability that the NPV in any given project will be greater than zero, or any other specified limit. For Fig. 2, the simulation package shows that there is a 70.1% probability that, given the project uncertainties modeled, the NPV will be greater than zero (this is not shown in Fig. 2). Third. the uncertainty in project NPVs can be compared. Andchoosing between two otherwise similar projects may be made easier once the variance in the expected NPV values is modeled. Another value of stochastic simulations comes when seeking debt financing for a project. The output from a stochastic simulation allows us to determine the probability of the yearly net cash flows being sufficient to fully repay debt. The probable cash flows for the gold mine example are shown in Fig. 3. This output may make debt financing easier and less costly. This is because the lender will be able to more confidently design project debt parameters. Finally, instead of modeling a single output price for the duration of the project, the actual evolution of prices can be

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