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
to check 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):
1. 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
years cashflow.
2. Carry out sensitivity analysis on your model. In particular, what is the effects on NPV of
the following changes in assumptions:
a.
b.
c.
d.

Equipment costs that are 10% higher than estimated

Annual costs that are 10% higher than anticipated
Failure to recover the retentions payments
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.]

Figure 1: Dhahran Roads Contract

1. Total project value: 168 million
Saudi Rials (SR).
2. Advance made by the client: 15% of
the total contract value.
3. Schedule of costs and invoices (in
millions SR):
1998
1999
2000
2001
2002

Costs incurred
7
28
31
25
17

Billings
11
43
48
39
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.
4. 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.
5. 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
SADEs 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.
6. 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).

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 longerterm 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.