Case Dhahran Roads - Solution

Darden Case -  DHAHRAN ROADS (A)

The following Assignment Questions are intended for guiding your reading, writing and discussion of the case.

What do you recommend regarding the proposed contract for the Dharan Roads project? Be sure that your recommendation acknowledges any key sources of risk in the conduct of the project and any negotiable parameters of the proposed contract.

Use your answers to the questions below to back your analysis and conclusions, but don’t feel limited by them.

1. Malik suggests that the project offers a 15% return. Try and figure out how that figure was calculated. Do you agree with that type of analysis?

ROI = (Gain from Investment - Cost of Investment)/Cost of Investment → 

ROI = (168-146)/146 = 0,15 or 15%

ROI is a very simple and popular metric for making investment decision. It shows the rate of return that can be expected from the investment proposal. This measurement is good when comparing different investment opportunities. However, in this case, there is only one project to consider and based solely on ROI, project should be rejected as 15%<18%(hurdle rate). Moreover, ROI doesn’t take into account time value of money, and doesn’t represent inflows and outflows of the cash flows, doesn’t take into account cost of capital, which can mislead the decision. Project is important to the company’s reputation and may help to maintain a steady flow of new projects during these slow economic times. Even though the ROI demonstrates that rate of return will be lower than the benchmark, project can still bring value to the company. Therefore, more metrics (e.g. NPV, IRR) should be used to decide if project worth taking.

1. Use the provided spreadsheet (Dhahran Roads - CF Analysis Template.xlsx ) to perform a cash flow analysis based on the “base scenario” (i.e., assuming that everything goes “right”).

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1. Apply to such cash flows (CFs) the investment criteria discussed in Chapter 5 of Brealey, Myers and Allen.

Investment criteria: Positive NPV, IRR that makes NPV=0, Payback period, Profitability Index, Book rate of Return. We can apply to the company:

1. Payback period: 4 years. The initial investment of 3,3 million will be covered by the end of 1996, but we don’t have the cut-off date.
2. NPV at 15% discount rate = 8,8 million → positive number, thus project should be accepted.
3. IRR = 41%, much higher than the hurdle rate of 18%
4.  For other investment criteria, there is not sufficient information.

1. Calculate the NPV for the discount rates of 7%, 12% and 18%.

1. How might the stated 18% hurdle rate have been arrived at?

Hurdle rate can be equal to WACC for the company. To derive hurdle rate company first needs to define its cost of equity and cost of capital, as well as capital structure.  Capital asset pricing model (CAPM) can be used to derive cost of equity. In the particular example, there is not enough data to carry out the possible calculations that were done to get the hurdle rate of 18%.

For deriving hurdle rate company should consider all the risk factors. It could be derived based on the company’s previous experience with the same projects or industry benchmark for such projects.

1. Consider the impact of the unfavourable scenarios.

1. The final part of retention repayment due end of 1998 can be eventually not repaid if roads will show some flows.

Impact: There will be no significant impact as NPV will still stay positive, nevertheless it will decline. IRR and total cash inflow will also decline.

1. The situation will be worse (IRR, NPV, Cash inflows) will decline much more if the whole retention repayment will not be repaid.
2. Equipment payment schedule can be changed (e.g. the whole price would have to be paid earlier) or the price for the equipment can increase. Therefore, company will need more cash to cover the costs. The cost of capital will be higher, which will lower the NPV.
3. There is not enough information on how much financial resources company currently has, but in the negative scenario it can happen that 1. Company is not able to get a loan at all 2. The interest payment on a loan will be higher than expected. Because of that company may face a shortage in cash to cover the costs of the project.
4. Delays in payments may cause the company a shortage of cash to cover costs.
5. Some unexpected situation which cannot be influenced by the company can cause delays and increase operation costs.

In all the negative/unexpected scenarios company may receive the lower return than expected. The NPV as well as IRR will decline.  

Recommendations:

Based on the available information and the analysis of the situation (questions1-6), the recommendation is to accept the project as it has positive NPV and IRR much higher than the hurdle rate. However, considering possibilities of negative/unexpected scenarios company should add to the contract: