FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 1.1 Date of Report: June 26, 2007 The Management Discussion and Analysis ( MD&A ) should be read in conjunction with the unaudited interim consolidated financial statements for the nine months ended, and the audited consolidated financial statements for the year ended August 31, 2006. All dollar figures stated herein are expressed in Canadian dollars, unless otherwise noted. This discussion includes certain statements that may be deemed forward-looking statements. All statements in this discussion, other than statements of historical facts, that address future production, reserve potential, exploration drilling, exploitation activities and events or developments that the Company expects are forward-looking statements. Although the Company believes the expectations expressed in such forward-looking statements are based on reasonable assumptions, such statements are not guarantees of future performance and actual results or developments may differ materially from those in the forwardlooking statements. Factors that could cause actual results to differ materially from those in forward-looking statements include market prices, exploitation and exploration successes, continued availability of capital and financing and general economic, market or business conditions. Investors are cautioned that any such statements are not guarantees of future performance and that actual results or developments may differ materially from those projected in the forward-looking statements. 1.2 Overall Performance Capstone Mining Corp. ( the Company ) is a mining company with a primary focus to operate, expand and explore the Company s 100% owned Cozamin copper-silver-zinc-lead mine located in Zacatecas, Mexico that achieved commercial production in September 2006. The Company s shares are listed on the Toronto Stock Exchange ( TSX ) under the symbol CS. The Company had an operating profit of $20.3 million and earnings of $16.2 million during the nine months ended, compared to operating profit of $Nil and a loss of $1.6 million in the nine months ended 2006. During the nine month period ended, the Company realized revenues of $28.2 million from sales of 7.9 million pounds of copper, $6.2 million from sales of 3.4 million pounds of zinc, $1.9 million from sales of 2.1 million pounds of lead and $5.9 million from sales of 432,000 ounces of silver in concentrates. The average price for sales of copper, zinc and lead during the nine months were US$3.21/lb, US$1.79/lb, and US$0.84/lb respectively. Work continued during the quarter on the expansion of the mill to 2,200 tpd at the Cozamin mine with construction on schedule and budget. All major components have been installed and are being tested in operation. The expansion project will increase the production capacity of the Cozamin mine by greater than 100%, from 12 million pounds to 26 million pounds of copper per year by 2008. The Company sold all of its silver production from the Cozamin mine in Mexico over a 10 year period to Silverstone in consideration for an upfront payment of US$44 million of which US$20 million was received in cash and US$24 million in 19,155,310 special warrants of Silverstone which are convertible into common shares of Silverstone at no additional cost. Silverstone will pay for each ounce of refined silver from the mine the lesser of US$4.00 per ounce of silver and the prevailing market price per ounce of silver. The Company has completed 58 underground definition drill holes that total 18,200m of NQ core. An additional 2,300m of drilling distributed between 8 holes are planned for this program. A surface exploration drilling program totaling 4,800m of PQ and HQ core in 5 holes has been completed. Initial results from these drill programs were released on March 22, 2007. These data indicate that Capstone will be able to increase all resource categories at Cozamin in concert with the current construction program that is planned to more than double daily production from the mine and plant. The definition drilling program is planned to be completed by the end of July and all results released to the public by the end of August.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 Cozamin Mine Third Quarter 2007 Highlights Copper Zinc Lead Copper in concentrate produced during the quarter was 3.5 million pounds of copper, 25% higher than the previous quarter. Copper concentrate sales for the quarter were 5,947 dry metric tons ( DMT ), containing 2.9 million pounds of copper, an increase from the 4,524 DMT sold during the previous quarter. The average price for sales of copper in the quarter was US$3.62/lb. Copper concentrate inventory at was 3,842 DMT, an increase in inventory from the 2,559 DMT of concentrate on hand at the end of the previous quarter. Silver in the copper concentrate produced during the quarter totaled 142,000 ounces, 28% higher than the previous quarter. Zinc in concentrate produced during the quarter was 1.6 million pounds of zinc, 33% more than the previous quarter. Zinc sales for the quarter were 1,949 DMT, containing 1.5 million pounds of zinc, an increase from no sales during the previous quarter. The average price for sales of zinc in the quarter was US$1.70/lb. Zinc concentrate inventory at was 1,820 DMT, a decrease in inventory from the 2,140 DMT of concentrate on hand at the end of the previous quarter. Silver in the zinc concentrate produced during the quarter totaled 6,000 ounces, 10% higher than the previous quarter. Lead in concentrate produced during the quarter was 0.6 million pounds of lead, 20% more than the previous quarter. Lead concentrate sales for the quarter were 502 DMT, containing 0.7 million pounds of lead, a decrease from the 978 DMT sold during the previous quarter. The average price for sales of lead in the quarter was US$0.94/lb. Lead concentrate inventory at was 120 DMT, a decrease in inventory from the 213 DMT of concentrate on hand at the end of the previous quarter. Silver in the lead concentrate produced during the quarter totaled 30,000 ounces, 10% lower than the previous quarter.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 Third Quarter Production Results The following table is a summary of the operating statistics for the current quarter (Q3 2007) compared to the previous quarters (Q2 2007 and Q1 2007). Q3 2007 Q2 2007 Q1 2007 Total tons mined 131,325 100,620 90,281 Tons of ore milled 112,277 95,439 93,055 Copper grade (%) 1.65 1.58 1.5 Zinc grade (%) 1.65 1.45 1.8 Silver grade (g/t) 71 68 72 Lead grade (%) 0.6 0.53 0.7 Copper recovery (%) 85.7 84.5 85.3 Zinc recovery (%) 43.0 42.6 49.3 Silver recovery (%) 68.1 67.5 74.6 Lead recovery (%) 48.0 49.0 60.3 Copper production (million DMT lbs) 3.5 2.8 2.7 Zinc production (million DMT lbs) 1.6 1.2 1.9 Silver production ( 000 ounces) 174 149 161 Lead production (million DMT lbs) 0.6 0.5 0.9 Note: Silver reports to all concentrates. Labour There was 1 minor lost time accident during the quarter. The number of personnel at the end of the quarter was 515 compared to 359 at the end of the previous quarter due to expansion construction and exploration activities.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 Third Quarter Actual Sales Compared to Current Production Forecasts The current forecasted copper, zinc, lead and silver production for fiscal 2007 is estimated to be 13 14 million pounds of copper, 8 million pounds of zinc, 3.5 million pounds of lead and 700,000 ounces of silver. Actual sales and costs for the first 3 quarters and production forecast for the fourth quarter are tabulated below. Q1 (A) Sales Q2 (A) Sales Q3 (A) Sales Q4 (F) Production Copper (million lbs) 2.9 2.1 2.9 4.0 Zinc (million lbs) 1.9 Nil 1.5 1.9 Lead (million lbs) Nil 1.4 0.7 0.9 Silver ( 000 ounces) 120 169 143 245 Copper production costs, net of by product credits, per lb of copper Off property costs for transport, smelting and refining per lb of copper Total cash costs of production per lb of copper US$(0.04) US$(0.02) US$0.20 US$0.20 US$0.48 US$0.41 US$0.41 US$0.41 US$0.44 US$0.39 US$0.61 US$0.61 Market Trends Copper prices have been increasing since late 2003. Copper prices averaged US$1.30/lb in 2004, US$1.67/lb in 2005 and US$3.05/lb in 2006. Copper prices retracted in the first couple of months of 2007 but have since begun to increase, averaging US$3.02/lb to. Zinc and lead prices have also been increasing since 2003. Zinc prices averaged US$0.47/lb in 2004, US$0.63/lb in 2005 and US$1.48/lb in 2006. Zinc prices appear to have stabilized in 2007, averaging US$1.61/lb to. Lead prices averaged US$0.40/lb in 2004, US$0.44/lb in 2005 and US$0.58/lb in 2006. Lead prices have continued to increase in 2007, averaging US$0.86/lb to.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 1.3 Selected Annual Information The following financial data is selected information for the Company for the most recently completed financial years: Aug 31, Aug 31, Aug 31, 2006 2005 2004 Total revenues $ - $ - $ - Loss before discontinued operations and other items 3,510,600 2,465,764 1,323,133 Basic and diluted loss per common share before discontinued operations and other items 0.06 0.07 0.07 Loss for the year 3,217,627 2,287,205 2,443,545 Basic and diluted loss per common share 0.05 0.06 0.12 Total assets 66,161,151 19,035,348 9,405,440 This financial information was prepared in accordance with Canadian generally accepted accounting principles ( GAAP ) and reported in Canadian dollars. 1.4 Results of Operations The consolidated earnings for the nine months ended was $16,159,516 or $0.20 per share. This compares to a loss of $1,616,995 or ($0.03) per share for the same period in 2006. The Company reported revenues of $42.2 million (2006 - $Nil). Revenues consisted of copper concentrate sales of $28.2 million, zinc concentrate sales of $6.2 million, lead concentrate sales of $1.9 million and silver in concentrate sales of $5.9 million. Cost of sales for the period was $11.2 million (2006 - $Nil), treatment and transportation charges were $7.2 million (2006 - $Nil), royalty charges were $913,209 (2006 - $Nil) and depletion was $2.6 million (2006 - $Nil). The increased general and administrative expenditures for the nine months ended compared to the same period in 2006 are due to the Company attaining commercial production as well as an unrealized foreign exchange loss related to deferred revenue. Glencore International AG purchases the concentrates produced by the Cozamin mine pursuant to the terms of a written contract. The Company has also agreed to terms with Trafigura Beheer B.V. to purchase additional copper concentrates from the expansion pursuant to the terms of a written contract.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 1.5 Summary of Quarterly Results The following financial data is selected information for the Company for the eight most recently completed financial quarters: Feb 28, Nov 30, Aug 31, 2007 2007 2006 2006 Total revenues $ 16,695,086 $ 10,594,538 $ 14,929,191 $ - Earnings (loss) before discontinued operations and other items 4,461,686 3,637,145 6,289,639 (1,720,838) Basic and diluted earnings (loss) per common share before discontinued 0.05 0.04 0.08 (0.03) operations and other items Earnings (loss) for the period 5,808,500 3,835,338 6,515,678 (1,600,632) Basic earnings (loss) per common share 0.07 0.05 0.08 (0.03) Total assets 134,546,930 78,400,485 73,783,574 66,161,151 Feb 28, Nov 30, Aug 31, 2006 2006 2005 2005 Total revenues $ - $ - $ - $ - Loss before discontinued operations and other items (903,872) (238,116) (647,774) (1,206,514) Basic and diluted loss per common share before discontinued operations and other (0.01) (0.01) (0.01) (0.03) items Loss for the period (793,978) (203,495) (619,522) (1,126,045) Basic loss per common share (0.01) (0.01) (0.01) (0.03) Total assets 68,877,045 40,666,742 20,386,527 19,035,348 This financial information was prepared in accordance with Canadian GAAP and reported in Canadian dollars. 1.6 Liquidity As at, the Company s cash increased by $14,865,764 to $37,707,358. The Company s working capital was $47,793,767 (August 31, 2006 - $22,832,165). The increase was primarily due to the Company selling its silver as well as having revenue during the nine months. Revenue from sales of copper, silver, zinc and lead, along with current cash balances will provide sufficient working capital for the Company to complete its 2007 expansion and exploration programs as well as carry out its day to day obligations. The Company had no long-term bank debt in either period. The Company received $125,198 in proceeds from the exercise of warrants, $49,252 from the exercise of agent s options and $80,499 from the exercise of stock options for the nine months ended.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 1.7 Capital Resources When the Cozamin project achieved commercial production for six months, a US$1,000,000 cash payment or the equivalent value in the Company s common shares was to be paid to Grupo Minero Basis, S.A. de C.V. At 2007 the Company paid the commercial production obligation by issuing 679,080 shares of the Company for a value of $1,181,600. The Company has completed the spin-out of its Silver exploration properties (which are the Copala, Claudia, Promontorio, Montoros and Martha projects). Silverstone Canada assumed all the rights and obligations relating to the option to purchase a 90% interest in the Silver exploration properties. 1.8 Off-balance Sheet Arrangements There are no off-balance sheet arrangements. 1.9 Transactions with Related Parties During the nine months ended, a management company controlled by Darren Pylot, President, CEO and a director of the Company, received $15,833 per month from September 2006 to March 2007 and $18,333 per month from April to May 2007 (2006 - $15,000 per month from September 2005 to February 2006 and $15,833 per month from March to May 2006) to perform the presidential and managing director duties on behalf of the Company. This management company was paid a $47,500 (2006 - $20,000) bonus during the year. The Company charged $9,000 (2006 - $15,000) rent and $13,500 (2006 - $7,500) for administrative services to a public company with a director in common. Also, the Company charged $11,250 (2006 - $Nil) rent and $7,875 (2006 - $Nil) for administrative services to a public company with directors in common. 1.10 Third Quarter During the Third quarter the Company continued successful production at its Cozamin copper-silver-lead-zinc mine. Construction continued on the expansion of the mine capacity and the exploration program continued with both on budget. The Company sold all of its silver production from the Cozamin mine in Mexico over a 10 year period to Silverstone in consideration for an upfront payment of US$44 million of which US$20 million was received in cash and US$24 million in 19,155,310 special warrants of Silverstone which are convertible into common shares of Silverstone at no additional cost. 1.11 Proposed Transactions The Company has budgeted US$6 million for phase 4 surface exploration and phase 5 underground infill drilling programs at the Cozamin project in 2007 in order to expand our reserves and resources. The Company has also budgeted US$15 million for the expansion of the mine to increase capacity. The Company has the required funds in order to complete its expansion and exploration programs. There are no proposed asset or business acquisitions or dispositions, other then those in the ordinary course, before the board of directors for consideration.
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 1.12 Critical Accounting Estimates N/A 1.13 Changes in Accounting Policies N/A 1.14 Financial Instruments and Other Instruments Cash is not subject to currency risks. The Company does not believe it is subject to any significant credit risk although cash is held in excess of federally insured limits, with a major Canadian banking institution. Taxes receivable due from the Mexican government are denominated in Mexican Pesos and the note receivable, commercial production obligation and equipment lease obligations are denominated in US Dollars, which are subject to currency risks arising from the fluctuations in the Mexican Peso and the US Dollar. The Company s other financial instruments consist of goods and service tax receivable (which are included in taxes receivable), receivables, due from Silverstone Resources Corp., due to related parties and accounts payable and accrued liabilities. In management s opinion, the Company is not exposed to significant interest, currency or credit risks arising from the financial instruments. The fair value of these financial instruments approximates their carrying values. 1.15 Other MD&A Requirements Disclosure of Outstanding Share Data: Number of Shares Amount Contributed Surplus Authorized Unlimited common shares, without par value Issued Balance, August 31, 2006 80,830,512 $ 75,119,115 $ 1,134,665 Issued for commercial production obligation 679,080 1,181,600 - Issued for warrants exercised 94,969 125,198 - Financing fees recovered - 4,024 - Agent s options exercised 54,722 65,268 (16,016) Issued for stock options 80,000 105,571 (25,072) Bonus and long term shares 194,500 389,000 - Stock-based compensation - - 290,181 Balance, 81,933,783 $ 76,989,776 $ 928,941
FORM 51-102F1 MANAGEMENT DISCUSSION & ANALYSIS MAY 31, 2007 1.15 Other MD&A Requirements (cont d ) The following stock options were outstanding at : Number of Options Exercise Price Expiry Date 25,000 $ 0.45 September 15, 2008 75,000 0.75 March 22, 2009 100,000 0.75 June 11, 2009 120,000 0.95 January 12, 2010 382,500 1.05 March 1, 2010 100,000 0.95 April 20, 2010 95,000 1.10 January 23, 2011 1,077,500 1.57 March 9, 2011 20,000 1.40 June 14, 2011 10,000 1.65 September 8, 2011 560,000 1.88 March 14, 2012 2,565,000 At, the following share purchase warrants were outstanding: Number of Shares Exercise Price Expiry Date 243,697 $ 1.25 December 15, 2007 113,825 1.30 December 15, 2007 4,138,248 1.40 December 21, 2008 4,495,770 1.16 Internal Disclosure Controls and Procedures We have evaluated the effectiveness of our disclosure controls and procedures and have concluded based on our evaluation that they are sufficiently effective to provide reasonable assurance that material information relating to the Company is made known to management and disclosed in accordance with applicable securities regulations. Other information Additional information relating to the Company, including the Company s AIF is on SEDAR at www.sedar.com.
INTERIM CONSOLIDATED FINANCIAL STATEMENTS (Unaudited Prepared by Management) MAY 31, 2007
INTERIM CONSOLIDATED BALANCE SHEETS 2007 August 31, 2006 ASSETS Current Cash $ 37,707,358 $ 22,841,594 Marketable securities (Note 4) 304,394 - Receivables 5,368,818 280,761 Due from Silverstone Resources Corp. 694,693 - Note receivable 168,024 - Taxes receivable 2,564,741 2,431,839 Inventory (Note 5) 5,798,865 1,402,392 Prepaid and advances 801,244 165,295 53,408,137 27,121,881 Property, plant and equipment (Note 7) 45,910,836 35,668,619 Investment in Silverstone Resources Corp. (Note 6) 32,643,715 - Note receivable (Note 8) 259,571 - Taxes receivable 2,244,471 - Mineral properties 80,200 3,370,651 LIABILITIES AND SHAREHOLDERS' EQUITY $ 134,546,930 $ 66,161,151 Current Accounts payable and accrued liabilities $ 4,131,937 $ 1,811,714 Commercial production obligation - 1,150,000 Equipment lease obligations 1,479,181 1,315,750 Due to related parties (Note 9) 3,252 12,252 5,614,370 4,289,716 Deferred revenue (Note 10) 49,894,491 - Equipment lease obligations (Note 11) 532,332 1,244,485 Asset retirement obligation (Note 12) 1,727,888 1,673,554 57,769,081 7,207,755 Shareholders' equity Capital stock (Note 13) 76,989,776 75,119,115 Contributed surplus (Note 13) 928,941 1,134,665 Deficit (1,140,868) (17,300,384) 76,777,849 58,953,396 $ 134,546,930 $ 66,161,151 On behalf of the Board: Darren M. Pylot Director Tony Chan Director The accompanying notes are an integral part of these interim consolidated financial statements.
INTERIM CONSOLIDATED STATEMENTS OF OPERATIONS AND DEFICIT Three Months Ended Three Months Ended 2006 Nine Months Ended Nine Months Ended 2006 Revenue Copper $ 11,375,852 $ - $ 28,199,642 $ - Zinc 2,660,641-6,168,901 - Lead 695,323-1,895,678 - Silver 1,963,270-5,954,594-16,695,086-42,218,815 - Cost of sales (4,711,415) - (11,234,057) - Treatment and transportation (2,709,120) - (7,194,325) - Royalty (385,126) - (913,209) - Depletion (1,135,116) - (2,578,442) - Operating profit 7,754,309-20,298,782 - General and administration expenses Amortization and accretion 216,577 19,007 704,316 45,065 Foreign exchange loss 1,550,721 289,605 1,551,909 156,255 Interest expense 43,853-150,973 - Investor relations 40,683 46,182 168,111 144,814 Management fees 100,000 67,500 195,000 157,500 Office and administration 456,726 53,052 992,467 297,776 Professional fees 196,922 23,796 734,756 154,388 Stock-based compensation (Note 11) 72,555 169,534 290,181 335,555 Travel and accommodation 75,989 102,376 255,999 183,210 Wages 538,597 132,820 866,600 309,637 (3,292,623) (903,872) (5,910,312) (1,784,200) Other items Interest income 414,520 109,894 840,935 167,205 Recovery of variable interest entity 1,056,467-1,056,467 - Write-off of mineral properties (124,173) - (124,173) - Loss on sale of property, plant and equipment - - (2,183) - 1,346,814 109,894 1,771,046 167,205 Earnings (loss) for the period $ 5,808,500 $ (793,978) $ 16,159,516 $ (1,616,995) Earnings (loss) per share Earnings (loss) per common share - basic $ 0.07 $ (0.01) $ 0.20 $ (0.03) Earnings (loss) per common share - diluted $ 0.07 $ (0.01) $ 0.19 $ (0.03) Weighted average number of common shares o/s Basic 81,785,062 69,101,624 81,176,462 55,711,887 Diluted 84,479,722 69,101,624 83,065,449 55,711,887 Deficit, beginning of period (6,949,368) (14,905,774) (17,300,384) (14,082,757) Earnings (loss) for the period 5,808,500 (793,978) 16,159,516 (1,616,995) Deficit, end of period $ (1,140,868) $ (15,699,752) $ (1,140,868) $ (15,699,752) The accompanying notes are an integral part of these interim consolidated financial statements.
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS CASH FLOWS FROM: Three Months Ended Three Months Ended 2006 Nine Months Ended Nine Months Ended 2006 OPERATING ACTIVITIES Earnings (loss) for the period $ 5,808,500 $ (793,978) $ 16,159,516 $ (1,616,995) Items not affecting cash Amortization 216,577 19,007 704,316 45,065 Accrued interest income (47,702) (55,150) (277,086) (38,165) Equipment fee on note receivable 29,055-112,374 - Foreign exchange (106,615) - 60,191 - Depletion 1,135,116-2,578,442 - Share bonuses 389,000-389,000 - Loss on disposition of equipment - - 2,183 - Write-off of mineral properties 124,173-124,173 - Stock-based compensation 72,555 169,534 290,181 335,555 Recovery of variable interest entity (1,056,467) - (1,056,467) - Recognition of deferred revenue (140,805) - (140,805) - Changes in non-cash working capital items (Increase) decrease in accounts receivable (2,717,909) - (5,127,929) 5,000 Increase in taxes receivable (635,845) (309,770) (2,684,175) (1,155,130) (Increase) decrease in prepaids (527,415) 866,961 (650,685) 38,890 Increase (decrease) in accounts payable and accrued liabilities (13,906) (818,522) 1,177,377 (204,296) Decrease in due from related parties - - - 708 Increase in inventory (1,000,635) - (3,846,935) - Increase (decrease) in due to related parties (13,592) - (9,000) (11,208) Cash flows provided by (used in) operating activities 1,514,085 (921,918) 7,804,671 (2,600,576) INVESTING ACTIVITIES Investment in Silverstone Resources Corp. (1,110) (519,919) (1,110) (519,919) Cash assumed by Silverstone Resources Corp. (582,242) - (582,242) - Property, plant and equipment (6,296,359) (490,268) (12,993,898) (1,142,476) Short-term investments - - - (3,000,000) Purchase of marketable securities (304,394) - (304,394) - Mineral Properties 1,029,900 (4,364,132) (170,868) (13,123,033) Cash flows used in investing activities (6,154,205) (5,374,319) (14,052,512) (17,785,428) FINANCING ACTIVITIES Proceeds from issuance of capital stock 180,199 25,736,740 254,949 42,616,981 Capital stock issuance costs - (602,987) 4,024 (602,987) Due from Silverstone Resources Corp. (396,635) - (396,635) - Equipment lease obligations (337,625) - (1,008,829) - Proceeds from sale of silver 22,260,096-22,260,096 - Cash flows provided by financing activities 21,706,035 25,133,753 21,113,605 42,013,994 Change in cash during period 17,065,915 18,837,516 14,865,764 21,627,990 Cash, beginning of period 20,641,443 3,725,844 22,841,594 935,370 Cash, end of period $ 37,707,358 $ 22,563,360 $ 37,707,358 $ 22,563,360 Supplemental disclosure with respect to cash flows (Note 16) The accompanying notes are an integral part of these interim consolidated financial statements.
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION These unaudited interim consolidated financial statements include the accounts of Capstone Mining Corp. and its subsidiaries ( the Company ). All significant intercompany balances and transactions have been eliminated. These unaudited interim consolidated statements have been prepared in accordance with Canadian generally accepted accounting principles. All financial summaries included are presented on a comparative and consistent basis showing the figures for the corresponding period in the preceding year. The preparation of financial data is based on accounting principles and practices consistent with those used in the preparation of annual financial statements. Certain information and footnote disclosure normally included in financial statements prepared in accordance with generally accepted accounting principles has been condensed or omitted. These unaudited interim consolidated statements should be read together with the audited financial statements and the accompanying notes included in the Company's latest annual report. In the opinion of management, its unaudited interim consolidated financial statements contain all adjustments necessary in order to present a fair statement of the results of the interim periods presented. 2. NATURE OF OPERATIONS The Company is engaged in mining and related activities, including exploration, expansion and operating. The Company achieved commercial production at its Cozamin copper-silver-lead-zinc project located in Zacatecas, Mexico on September 1, 2006. 3. SIGNIFICANT ACCOUNTING POLICIES Consolidation of variable interest entity The Company had determined that it had a variable interest in Silverstone Resources Corp. ( Silverstone ) for the year ended August 31, 2006. On April 4, 2007, Silverstone completed a private placement of 22,120,000 units at $1.45 per unit for gross proceeds of $32,074,000. The Company did not purchase any of the units in the private placement. A significant part of the proceeds from the private placement ($22,260,096) were used to purchase the Company s silver production from the Cozamin mine in Mexico. The remaining balance of funds of approximately $9,800,000 will be used to fund the continued operations of Silverstone and in addition, Silverstone will receive revenues from the operations of the Cozamin mine with regards to the silver content in the copper concentrate. Therefore, Silverstone will be able to operate without the financial support of the Company. As at, the Company determined that Silverstone was not a variable interest entity and is not required to be included in the consolidated financial statements of the Company. Marketable securities Investments in publicly traded marketable securities are recorded at the lower of cost or quoted market prices with unrealized losses included in income. The market value is based on the closing price at the end of the period, as reported on recognized securities exchanges. Long-term investments Investments in shares of associated companies over which the Company has significant influence are accounted for by the equity method whereby the investment is initially recorded at cost, adjusted to recognize the Company s share of earnings or loss in the investment and reduced by dividends received. Deferred Revenue The Company has received an upfront payment in relation to the Silverstone agreement (Note 10). Deferred revenue will be recognized as sales on the delivery of silver.
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 4. MARKETABLE SECURITIES 2007 August 31, 2006 350,000 (2006 - Nil) common shares of Nord Resources Corp. Market value $ 304,394 $ - of $261,660 (2006 - $Nil) $ 304,394 $ - 5. INVENTORY 2007 August 31, 2006 Concentrate inventory $ 4,195,545 $ 1,198,374 Supplies inventory 941,583 204,018 Ore stock piles 661,737 - $ 5,798,865 $ 1,402,392 6. INVESTMENT IN SILVERSTONE RESOURCES CORP. 2007 August 31, 2006 Investment in common shares Shares Amount Amount Conversion of note receivable plus accrued interest 4,056,171 $ 4,867,405 $ - Exercise of share purchase warrants 617 1,110 - Conversion of special warrants 8,407,882 12,191,429 - Total investment in common shares 12,464,670 17,059,944 - Special warrants Issued from Silverstone 19,155,310 27,775,200 - Converted to common shares (8,407,882) (12,191,429) - Total investment in special warrants 10,747,428 15,583,771 - Total investment $ 32,643,715 $ -
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 6. INVESTMENT IN SILVERSTONE (cont d ) Silverstone issued three convertible demand promissory notes totaling in principal $4,610,810. The convertible demand promissory notes bear interest at 6.25% per annum and were due on written demand by the Company at any time on or before July 2, 2007. On or before the demand date the Company had the option to convert some or all of the debt owed to it into common shares of Silverstone at a rate of one common share for each $1.20 of debt owed to the Company. In April 2007, the Company exercised its option and converted the principal amount of $4,610,810 plus accrued interest of $256,595 into 4,056,171 common shares of Silverstone. During the interim period, the Company exercised 617 share purchase warrants of Silverstone (that were acquired in the open market at no additional cost) and purchased 617 common shares at $1.80 per share. As outline in note 10, the Company received 19,155,310 special warrants of Silverstone with a value of $27,775,200 (approximately US$24,000,000) as part of the up front payment for the sale of its silver production. These special warrants are convertible into common shares of Silverstone at no additional cost. In April 2007, the Company converted 8,407,882 special warrants with a value of $12,191,429 in exchange for 8,407,882 common shares of Silverstone. As at, the Company held approximately 19.9% of the issued and outstanding common shares of Silverstone. 7. PROPERTY, PLANT AND EQUIPMENT 2007 August 31, 2006 Cost Accumulated Amortization & Depletion Net Book Value Cost Accumulated Amortization & Depletion Net Book Value Cozamin, Mexico property $ 42,364,995 $ 3,442,144 $38,922,851 $ 29,474,670 $ 250,973 $ 29,223,697 Mine equipment 1,412,247 92,984 1,319,263 742,710 33,843 708,867 Mine equipment under lease 3,642,628 403,286 3,239,342 3,686,725 124,088 3,562,637 Vehicles 528,730 92,374 436,356 220,410 56,910 163,500 Office and equipment 556,147 222,676 333,471 509,718 165,335 344,383 Leasehold improvements 156,138 30,676 125,462 28,157 22,230 5,927 Asset retirement obligation 1,673,554 139,463 1,534,091 1,673,554 13,946 1,659,608 8. NOTE RECEIVABLE $ 50,334,439 $ 4,423,603 $ 45,910,836 $ 36,335,944 $ 667,325 $ 35,668,619 The Company entered into an agreement with a contractor, whereby the contractor agreed to purchase mining equipment under lease. The purchase price including IVA tax totals US$555,450. The lease term is for a period of three years and bears interest at 8% per annum. The lease is repayable at US$15,134 per month, which includes interest. 2007 August 31, 2006 Total note receivable (including taxes) $ 427,595 $ - Current portion due within one year 168,024 - Net long term portion $ 259,571 $ -
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 9. RELATED PARTY TRANSACTIONS The Company entered into the following transactions with related parties: a) Paid or accrued management fees of $195,000 (2006 - $157,500) to a management company controlled by the president and director of the Company. b) Charged rent of $9,000 (2006 - $15,000) and administrative services of $13,500 (2006 - $7,500) to a public company with a director in common. c) Charged rent of $11,250 (2006 - $Nil) and administrative services of $7,875 (2006 - $Nil) to a public company with directors in common. The transactions with related parties were in the normal course of operations and were measured at the exchange value, which represented the amount of consideration established and agreed to by the parties. The amounts due to related parties are comprised of due to director of $3,352 (August 31, 2006 - $7,752) and directors fees of $Nil (August 31, 2006 - $4,500) which are non-interest bearing, with no fixed terms of repayment. 10. DEFERRED REVENUE The Company sold all of its silver production from the Cozamin mine in Mexico over a 10 year period to Silverstone in consideration for an upfront payment of US$44,000,000 comprised of US$20,000,000 in cash (received) and US$24,000,000 in 19,155,310 special warrants of Silverstone (received) which are convertible into common shares of Silverstone at no additional cost. In addition to the upfront fee Silverstone agreed to pay for each ounce of refined silver from the mine the lesser of US$4.00 per ounce of silver and the prevailing market price per ounce of silver. The Company agreed to deliver a minimum of 10,000,000 ounces of silver to Silverstone over a 10 year period. If at the end of ten years, the Company has not delivered the agreed 10,000,000 ounces of silver, then it has agreed to pay Silverstone US$1.00 per ounce of silver not delivered. 2007 August 31, 2006 Deferred revenue on sale $ 50,035,296 $ - Deferred revenue recognized (140,805) - Deferred revenue, ending balance $ 49,894,491 $ - 11. EQUIPMENT LEASE OBLIGATIONS The Company leased to purchase certain mining equipment for a total purchase price including IVA tax of US$4,172,522 (CDN$4,638,198) of which US$1,168,439 (CDN$1,298,062) was paid as a down payment. The lease terms range for a period of two to three years. One lease bears interest at 6.5% per annum and is repayable at US$95,469 per month, which includes interest. The second lease bears interest at 8% per annum and is repayable for the first quarter at US$45,802 and each quarter thereafter at US$38,889, which also includes interest. The third lease bears interest at 7.83% per annum and is repayable for the first quarter at US$41,619 and each quarter thereafter at US$41,909, which also includes interest.
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 11. EQUIPMENT LEASE OBLIGATIONS (cont d ) 2007 August 31, 2006 Total lease payable (including taxes) $ 2,011,513 $ 2,560,235 Current portion due within one year 1,479,181 1,315,750 Net long term portion $ 532,332 $ 1,244,485 12. ASSET RETIREMENT OBLIGATION 2007 August 31, 2006 Asset retirement obligation beginning balance $ 1,673,554 $ - Liabilities incurred - 1,673,554 Accretion expense 54,334 - Asset retirement obligation ending balance $ 1,727,888 $ 1,673,554 The total undiscounted amount of estimated cash flows required to settle the obligations is $2,453,998, which was adjusted for inflation at the rate of 2.45% and then discounted at 4.2%. Certain minimum amounts of asset retirement obligations will occur each year with the significant amounts to be paid on closure of the mine. 13. CAPITAL STOCK AND CONTRIBUTED SURPLUS Number of Shares Amount Contributed Surplus Authorized Unlimited common shares, without par value Issued Balance, August 31, 2006 80,830,512 $ 75,119,115 $ 679,848 Issued for commercial production obligation 679,080 1,181,600 - Issued for warrants exercised 94,969 125,198 - Financing fees recovered - 4,024 - Agent s options exercised 54,722 65,268 (16,016) Issued for stock options 80,000 105,571 (25,072) Bonus and long term shares 194,500 389,000 - Stock-based compensation - - 290,181 Balance, 81,933,783 $ 76,989,776 $ 928,941
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 13. CAPITAL STOCK AND CONTRIBUTED SURPLUS (cont d ) The Company issued 679,080 shares to Grupo Minero Bacis, S.A. de C.V. as payment of the commercial production obligation. A total of 94,969 warrants were exercised, 27,040 at $1.25 at 37,027 at $1.30, and 30,902 at $1.40 per warrant and a total of 54,722 agent s options were exercised at $0.90. A total of 80,000 stock options were exercised, 50,000 at $0.95 and 30,000 at $1.10 per option and the Company issued 194,500 shares to its directors, officers and employees as bonus payments for a total value of $389,000. The Company also received a refund of $4,024 for financing fees not incurred. Stock options The Company has an incentive stock option plan in place under which it is authorized to grant options to executive officers and directors, employees and consultants. The Company has implemented a rolling plan, whereby it has reserved 10% of the issued shares for issuance under the plan. Options granted under the plan have a term not to exceed 5 years and are subject to vesting provisions as follows: 25% on date of grant and 25% every 3 months for a period of 9 months. The following stock options were outstanding at : Number of Options Exercise Price Expiry Date Stock-based compensation 25,000 $ 0.45 September 15, 2008 75,000 0.75 March 22, 2009 100,000 0.75 June 11, 2009 120,000 0.95 January 12, 2010 382,500 1.05 March 1, 2010 100,000 0.95 April 20, 2010 95,000 1.10 January 23, 2011 1,077,500 1.57 March 9, 2011 20,000 1.40 June 14, 2011 10,000 1.65 September 8, 2011 560,000 1.88 March 14, 2012 2,565,000 The total stock-based compensation expense recognized during the nine months ended under the fair value method was $292,858 (2006 - $557,095). The Company expensed $290,181 (2006 - $335,555) leaving an unamortized balance of $205,539 (2006 - $382,339). The following weighted average assumptions were used for the Black-Scholes valuation of stock options: 2007 August 31, 2006 Risk-free interest rate 3.92% 3.92% Expected life of options 2 years 2 years Annualized volatility 43.96% 47.74% Dividend rate 0.00% 0.00%
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 13. CAPITAL STOCK AND CONTRIBUTED SURPLUS (cont d ) Warrants At, the following share purchase warrants were outstanding: Number of Shares Exercise Price Expiry Date 243,697 $ 1.25 December 15, 2007 113,825 1.30 December 15, 2007 4,138,248 1.40 December 21, 2008 14. FINANCIAL INSTRUMENTS Cash held in foreign currencies of the US Dollar and Mexican Peso is subject to currency risks. The Company does not believe it is subject to any significant credit risk although cash is held in excess of federally insured limits, with a major Canadian banking institution. Taxes receivable due from the Mexican government are denominated in Mexican Pesos and the note receivable, commercial production obligation and equipment lease obligations are denominated in US Dollars, which are subject to currency risks arising from the fluctuations in the Mexican Peso and the US Dollar. The Company s other financial instruments consist of goods and service tax receivable (which are included in taxes receivable), receivables, due from Silverstone Resources Corp., due to related parties and accounts payable and accrued liabilities. In management s opinion, the Company is not exposed to significant interest, currency or credit risks arising from the financial instruments. The fair value of these financial instruments approximates their carrying values.
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 15. SEGMENTED INFORMATION The Company operates in two reportable operating segments, being the operating of the Cozamin mine and the exploration of mineral properties. Mexico Canada Total Revenue $ 42,218,815 $ - $ 42,218,815 Depletion (2,279,273) (299,169) (2,578,442) Amortization (641,423) (62,893) (704,316) Interest expense (150,973) - (150,973) Earnings (loss) for the period 18,346,996 (2,187,480) 16,159,516 Property, plant and equipment 45,646,543 264,293 45,910,836 Mineral properties 80,200-80,200 Segment assets 94,852,687 39,694,243 134,546,930 August 31, 2006 Revenue $ - $ - $ - Depletion - - - Amortization (243,483) (94,245) (337,728) Interest expense - - - Earnings (loss) for the period (332,902) (2,884,725) (3,217,627) Property, plant and equipment 35,529,719 138,900 35,668,619 Segment assets 43,951,314 22,209,837 66,161,151 Mining Operations Exploration & Development Corporate Total Revenue $ 42,218,815 $ - $ - $ 42,218,815 Depletion (2,578,442) - - (2,578,442) Amortization (641,423) - (62,893) (704,316) Interest expense (150,973) - - (150,973) Earnings (loss) for the period 18,346,996 (124,173) (2,063,307) 16,159,516 Property, plant and equipment 45,646,543-264,293 45,910,836 Mineral properties - 80,200-80,200 Segment assets 94,772,487 80,200 39,694,243 134,546,930
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 16. SUPPLEMENTAL DISCLOSURE WITH RESPECT TO CASH FLOWS 2007 2006 Cash paid during the period for income taxes $ - $ - Cash paid during the period for interest $ 166,756 $ 52,847 Significant non-cash transactions during the nine-month period ended were as follows: a) The Company issued 194,500 common shares with a value of $398,000 to its directors, officers and employees. b) The Company issued 679,080 common shares with a value of $1,181,600 pursuant to the Bacis project agreement. c) Included in inventory is $786,912, which relates to depletion. d) The Company recorded the fair value of $290,181 for stock options vested during the period in contributed surplus. In addition the Company recorded $16,016 for agent s options exercised during the period in capital stock and contributed surplus. e) The Company recorded $25,072 for stock options exercised during the period in capital stock and contributed surplus. f) The Company recorded the sale of mining equipment of $584,529 from property, plant and equipment to note receivable. Included in property, plant and equipment is $1,349,060, which relates to accounts payable and accrued liabilities. g) Included in mineral properties is $33,503, which relates to accounts payable and accrued liabilities. h) The Company reclassified taxes receivable of $2,244,471 from current assets to long-term assets. i) Non-cash effects of Silverstone Resources Corp. ceasing to be a variable interest entity are as follows: Accounts receivable $ 8,563 Taxes receivable 306,802 Prepaid expenses 14,736 Property, plant and equipment 128,775 Mineral properties 3,370,651 Accounts payable and accrued liabilities (226,508) Due to Capstone Mining Corp. (3,729,544) Capital stock (900) Contributed surplus (454,817) Cash assumed by Silverstone Resources Corp. $ 582,242
NOTES TO THE INTERIM CONSOLIDATED FINANCIAL STATEMENTS 16. SUPPLEMENTAL DISCLOSURE WITH RESPECT TO CASH FLOWS (cont d ) Significant non-cash transactions during the nine-month period ended 2006 were as follows: a) The Company issued 1,000,000 common shares with a value of $950,000 pursuant to the Basis project agreement. b) The Company issued 198,250 common shares with a value of $188,338 as part of the finance fee for a brokered private placement. c) Included in due from Silverstone Resources Corp. are $2,799,929 of mineral property costs that relate to the spin-out of the Silver exploration properties of the Company and $744,906 due to related parties. d) Included in property, plant and equipment is $1,150,000 which relates to commercial production obligation, $2,314,002 which relates to equipment lease obligation, $3,450,000 which relates to asset retirement obligation and $24,319,881 which relates to a reclassification of mineral properties. e) Included in mineral property costs is $715,739 which relates to accounts payable and accrued liabilities and $58,793 of amortization on mine equipment. f) The Company recorded the fair value of agent s options at an estimated fair value of $260,365 in connection with a brokered private placement financing. This amount is reflected in capital stock and contributed surplus. g) The Company recorded $666,793 for agent s options exercised during the period in capital stock and contributed surplus. h) The Company recorded $637,880 for stock options exercised during the period in capital stock and contributed surplus.