HERE’S AN EXAMPLE OF HOW THIS BECOMES DANGEROUS:
Recently a prominent North American s i l v e r a nd gold r oy a l t y c ompany announced the acquisition of a gold two separate gold streams from Vale for a combined value of around $2.03bn, of which $1.9bn is cash.
I made the calculation using a $1 700/ oz spot gold price increasing by around 2% per annum (the slope of the gold forward curve) over more than 25 years, and worked out that my best-case production scenario was an IRR of around 7.5%.
The deal was around 16% of the current size of the company and would extend the company’s debt position significantly, so a very material transaction. Using pretty standard methods, I calculated the company’s cost of capital at 7%-9%, so a marginal transaction from a theoretical “value accretive/value destructive” perspective.
Stressing the gold price and production within normal bounds easily took my IRR to 5.4%. Management was incensed by the notion that this looked to be a marginal deal. “It was a competitive process” I was told (ie there were other bidders), “these are world-class assets”.
When I asked what they thought their cost of capital was, I was told “way below 5%, all analysts use these numbers”. Enough said.
Safe to say t he share price went nowhere, which seemed to confirm that the deal was neither hugely accretive nor dilutive, but I found the discussion very instructive.
I battle to take seriously anyone running a public mining company who thinks its cost of equity or cost of capital is 5% or less, let alone uses this as a return hurdle rate for a mining project.
Even though mining royalty deals have less risk attached than mining project