Dhahran Roads A Case Study Analysis

Introduction

The Bahrain based Civil Engineering Company – SADE is recognized as a market leader based on itssense of innovationand tailored-made solutions, which tend to addressthe specific demands from the industrial firms. The company undertakes a number of operations which include construction of the technical platforms and building, footbridges and car parks, creation of unloading areas and delivery, dismantling of the facilities as well as the road works, such as:gutters, pits and pavements.

Additionally, the company chose expertise and enthusiasm as the watchwords, which continue to represent what the company is and what sets it apart from itsmarket competitors. The combination of the renowned expertise as well as the positive spirit, led the company towards its success path. Furthermore, SADE, with its proven successful track record and extensive experience, could provide anumber of services, including: underground works, rehabilitation, patrimonial management, specialty sectors, digging and earthworks, nuclear, water metering and smart networks.

Decision problem

SADE has been chosen as the prime contractor for the reconstruction of road project in the Saudi Arabia. On the basis of the cost estimates; the project tends to provide 15 percent return on cost, which is significantly lower as compared to the required 18 percent. On account of the specific timings of the payment and the substantial advance payment; the project’s internal rate of return is 40 percent. The financial manager at SADE – Hassan Malik is concerned about the acceptance and rejection of the project, on the basis of the estimation of cost and returns that the project is expected to yield in the near future.

Decision Alternatives & Evaluation

Decision Alternatives

Accept the project

The financial manager at SEDA is presented with the option of accepting the project of constructing and upgrading of the highway network, which tends to link the several terminals of the Dhahran airport and also connects the entire complex with the city.

Reject the project

On the basis of the quantitativeanalysis,including the net present value,internal rate of return and payback period; the financial manager at SADE has the option of rejecting the project if the project does not seem viable and lucrative.

Evaluation

Quantitative analysis

Return on investment analysis

As per the information provided in the case; the cost of the investment is SR 146 million whereas the gain from investment is estimated to be SR 168 million, hence representing 15.07 percent Return On Investment. It is pertinent to note that the return on investment is the popular metric to be used for making the investment oriented decisions,because it represents the rate of return that could be expected from the investment proposal. The measurement of the return on investment is of high importance when making comparison between different investment opportunities. However, in the case;the financial manager is presented with only one project thatis solely based on the return on investment, so the project must be rejected due to the fact that the return on investment is lower than the discount rate or hurdle rate.

In addition to this, the return on investment does not take into considerationthe time value of money concept and the cost of capital, and it alsodoes not represent the inflow and outflow of money, which could mislead the project. The project seems to be viable and feasible and it also tends to contribute in  the improvement of the company’s reputation and image  in the market. It would also help the company in maintaining steady cash flows of the new project in times of the economic downturn, due to which the decision should be solely based on the return on investment. More metrics should be used such as internal rate of return (IRR) and net present value (NPV) with core consideration over decidingwhether the projectis worthy of accepting or not.(ZAMFIR, 2016).

WACC

Using the information provided in the case; the company has contemplated to borrow the amount of loan to help finance the project. The borrowed amount is SR4 million, carrying 12 percent annual interest,which would be repaid at the end of the year 1997. The cumulative debt level is calculated by deducting the principle repayment from the borrowed amount. The unlevered equity cost is calculated by assuming 12% risk free rate of return, 8 percent of the market risk premium and 0.75 unlevered beta. The weighted average cost of capital is calculated to be 18% and the net present value calculated is amounted SR7.17 million, using 18% cost of capital, and the internal rate of return is calculated to be 41 percent.

Flow to equity approach

The flow to equity approach is used to calculate the project’s net present value and its internal rate of return. The cash flow to equity is calculated by adding operating profits and borrowed amount, and deducting the interest payment and principle repayment. The present value of the future cash flows to equity has amounted SR6.47 in beginning of 1993, SR16.85 in the end of 1993, SR17.46 in 1994, SR14.84 in 1995, SR11.2 in 1996 and SR3.56 in 1997. Using the flow to equity approach; the net present value of the project remains same as SR7.17 million and the internal rate of return is 56 percent………………………………

 

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