DHAHRAN ROADS (A)
In the middle of 1998, Mr. Malik, the financial manager of SADE, a Bahraini civil engineering company, was reviewing the contract it had just been awarded by the municipality of Dhahran in Saudi Arabia for the construction of a new road network linking the airport complex and the city. The life of the contract would be the remaining 6 months of 1998 and four full years over the period 1999 to 2003. The details of the five year contract awarded to SADE are described in Figure 1. Equipment would need to be purchased more or less immediately but the main costs and revenues would occur in the period 1999 to 2003. Given the initial advance, cash inflows and outflows in 1998 would be timed so that the maximum cash deficit of the contract at any time would be 11m SR. The construction work would continue until the end of 2002. The invoices (or “billings”) shown in Figure 1 could be treated as sales.
First of all, Mr. Malik planned to review his evaluation of the profitability of the contract and tocheck that it yielded more than the 15% return requested by SADE on projects in Saudi Arabia. (15% percent was also equal to the cost of financing for SADE for construction projects in Saudi Arabia).
Mr. Malik recognized that favourable results on a contract such as this depended on everything proceeding smoothly. Unfortunately, it seemed to him that it would be pure luck if the necessary combination of events were all to occur in his favour. Even though it was unpleasant, his thoughts began to turn to those aspects of the project that could go wrong.
He first wondered which of the various assumptions in his contract evaluation were particularly critical. He decided to make changes to one assumption at a time so that he could see which one had the largest impact on the value of the Dhahran Roads contract.
He felt more or less certain that the key factors that could jeopardize profitability would be cost overruns (such as higher equipment costs or increased annual costs), incomplete or delayed payments by the customer, and the resultant effect on the timing of inflows and outflows of cash.
ASSIGNMENT on DHAHRAN (A):
- Assist Mr. Malik in building a spreadsheet model to evaluate the profitability of the Dhahran Roads contract, using the data in Figure 1. Check that the contract yields more than 15%. Calculate the NPV of the contract at the end of December 1998 i.e. do not discount the estimated cashflow for the six months of 1998, but do so for each subsequent year’s cashflow.
- Carry out sensitivity analysis on your model. In particular, what is the effects on NPV of the following changes in assumptions:
a.Equipment costs that are 10% higher than estimated
b.Annual costs that are 10% higher than anticipated
c.Failure to recover the “retentions” payments
d.The customer pays normally for 98,99 but delays all payments, including the retention payment, from 2000 onwards by on year.
Which risks have most impact on profitability? What do these results tell us about the risk of the Dhahran Roads project?
[Hint: Use the scenario manage to model the above four contingencies.]
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Figure 1: Dhahran Roads Contract
- Total project value: 168 million Saudi Rials (SR).
- Advance made by the client: 15% of the total contract value.
- Schedule of costs and invoices (in millions SR):
Costs incurred / Billings
1998 / 7 / 11
1999 / 28 / 43
2000 / 31 / 48
2001 / 25 / 39
2002 / 17 / 27
In addition to these costs, SADE will have to buy equipment costing 38 million SR (to be paid in 1998). The equipment will be depreciated over 4.5 years and SADE does not expect to be able to use it again for other projects. It is also reasonable to assume that SADE will not be able to resell this equipment.
All costs incurred will be paid in the year they occur.
Amounts billed to the customer should be paid in the same year. The customer is expected however to pay only 80% of each invoice. The 20% deduction corresponds to:
The recovery by the customer of its initial advance (of 15%)
A 5% retention of guarantee. Half of this retention is to be reimbursed upon project completion (in 2002) and the remaining half in 2003). The release of the retention funds however is subject to the completed construction being approved by the customer.
- Project organization: The contract is to be executed by a Saudi company created specifically for the purpose. SADE will own 100% of the capital of this company. SADE wishes to invest a minimum and to be able to draw dividends as quickly as possible.
- Risks: During the past several months, the SADE engineering department has inspected the site, confirmed the surveying and reviewed the drawings that have been provided by the municipality of Dhahran. In the opinion of the Head of the Engineering Department, the project presents no unusual problems. It is very similar to several SADE projects in other countries and these have progressed without any serious difficulties.
The project is to be managed by one of SADE’s most experienced project managers, Mr. H. K. Jones. Mr. Jones has just completed a major waterworks project in Africa and is noted for strong engineering skills and tight cost control.
As the Bahraini Dinar is pegged to the Saudi Rial, the risk of currency variations is very small.
- Taxes: there are no corporate taxes in Saudi Arabia (and no taxes will have to be paid in Bahrain on the profits of this contract).
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DHAHRAN ROADS (B)
While Mr. Malik was delighted that the Dhahran Roads contract would generate a substantial value to SADE, he recognized that a favourable result such as this depended on everything proceeding smoothly. As he continued to think about the risk in the project, it seemed that there were two key areas in which former projects had run into trouble.
Delayed Payments by the Client
There had been occasion when SADE had experienced problems in making the contracting payment agency pay in accordance with the agreed billing schedule. Sade was not the only contractor facing these problems. In fact, there had been several informal discussions among contractors in which they had shared their experiences in this area. During these conversations, a pattern of behaviour seemed to emerge. If there were going to be problems in keeping to the billing schedule, the delay seemed to appear in the third year of the longer-term contracts and, recently, one-year postponements of that billing and all subsequent billings had been experienced. It was felt by many of the contractors that the delay occurred at a point in time when the project had gone so far that they could not abandon it, but at a point where delayed payment represented an effective cost reduction to the client. The delays seemed to have occurred recently in about one fourth of the projects and were often justified by the client on the basis of the slightest of deviations from the performance terms of the contract.
Cost Overruns
Even though SADE prided itself on its ability to control costs, it occasionally experienced overruns, sometimes rather substantial ones. After reviewing the details of many completed projects Mr Malik assessed that annual cost could vary between -10% to +20% of the anticipated costs with the most likely outcome being that there is no significant deviation from the estimates.
Equipment Costs
The cost of equipment needed for such projects varies according to global demand and supply. Mr Malik though was confident that it would not be cheaper by more than 5% or more expensive by more than 10% of the estimated cost.
Retention Payments
In many situations the customer would not make the retention payment at the end of the project blaming the contractor about the substandard quality of the work performed or minor breaches of certain terms of the contract. Not much could be done if such eventuality occurred. By studying historic data from completed projects Mr Malik estimated that the probability of failing to recover retention payments was of the order of 20%.
ASSIGNMENT on DHAHRAN (B):
a)Use scenario analysis to derive bounds to the range of possible outcomes regarding the project NPV.
b)Perform sensitivity analysis to analyse the impact of the four uncertainties described above.
[Hint: Use data tables and tornado diagrams]
c)Use Monte Carlo simulation to analyse the risk profile of this project, focusing on the impact of uncertainty on the NPV and the maximum cash deficit.
Suggestion:
-Use the triangular distribution for annual costs and equipment costs
-Use the RiskDiscrete function to model the uncertainties about delayed payment and the recovery of retention payments. (Look it up in the @Risk help file for details)
d)Discuss the results of the above analysis and provide recommendations about whether the project should be taken and about how the above risks could be managed.
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