Lecture Note 6

Case study“Ocean Carriers”

IntroductionIn January 2001, Mary Linn, Vice President of Finance of Ocean Carriers, a shipping company with offices in New York and Hong Kong, was evaluating a proposed lease of a ship for a three year period, beginning in early 2003. The customer was eager to finalize the contract to meet his own commitments and offered a very attractive terms. Next Page

No ship in Ocean Carrier’s current fleet met the customer’s requirements. Linn, therefore, had to decide whether Ocean Carriers should immediately purchase a new capesize carrier (a large cargo ship) that would be completed two years hence and could be leased to the customers.

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However, the proposed contract with the customer is only for three years. Therefore, after the three years, the ship will have to be leased for other customers.It is Linn’s responsibility to decide if future market conditions warranted a considerable investment in the new ship.The objective of this case study is to estimate the net present value of the investment in the new capesize carrier.

The case presents necessary information for you to compute the net present value of the project.However, before computing the net present value of the project, let us look at the following two items

1. How the Capesize Carriers’ business is conducted.

2. The future prospect of the market.

How the Ocean Carrier’s business is conducted.

A capesize carrier is a large ship too large to go through the Panama Canal, thus has to go through the Cape Horn to travel between the Atlantic and Pacific oceans.Ocean Carriers’ vessels were mostly charted on a “time hire” basis for a period such as one year, three year or five years.However, spot charter market is also available.

How the Ocean Carrier’s business is conducted. (Contd)

The customer of Ocean Carriers who charters a vessel pay a daily hire rate for the entire length of the contract. Thus, the daily hire rate as well as the number of days the ship is chartered determine the revenue from the ship.To examine the viability of the investment, it is important to consider the possible daily hire rate as well as the demand for such vessels.

Future prospect of the market-Supply of the capesize vessels (Co

ntd)Since the daily hire rate is determined by the supply and the demand for such services, we first take a look at the supply of Capesize vessels.Future supply of the capesize vessels is the sum of current vessels, minus the vessels that will be scraped, plus new ships delivered.Exhibit 2 shows the existing capesize carriers in terms of the sum of the loading capacity. (See Exhibit 2 of your case study note)

Future prospect of the market-Supply of the capesize carriers (Co

ntd)There are 2 million tones of capesize with the age over 24 years. We can expect that these old vessels would be soon scrapped, which in turn would reduce the supply of the capesize vessels.However, such old vessels were small portion of the total existing vessels. So we would not expect a large reduction in supply due to the scraping of old vessels.

Future prospect of the market-Supply of the capesize carriers (Co

ntd)-Exhibit 3 shows the current order of new capesize vessels delivered in the coming 4 years.As can be seen, there will be a large supply of new capesize vessels in 2001 2002 and 2003. This will increase the supply of capesize vessel in the near future.

Future prospect of the market-Supply of the capesize carriers (Co

ntd)-In summary,

1. Existing capesize vessels are relatively new, thus we do not expect a large reduction in capesize vessels due to the scraping of old vessel.

2. A large number of new ships will be delivered in the coming 3 years.

3. Thus, we expect a substantial increase in the supply of capesize vessels in the coming 3 years.

Future prospect of the market-Demand for the capesize vessels-Over 85% of the capesize vessels are used for shipping iron ore and coal. Linn took a look at the market for iron ore. She found that Australian production in iron ore will be strong, and that Indian iron ore exports are expected to take off soon.

Future prospect of the market

In summary, the supply of vessel may increase substantially in the coming 3 years, which may decrease the daily hire rate in the short term. However, considering a favorable forecast of Australian and Indian production, we can expect a favorable demand for capesize vessel service in the long run.

Future prospect of the market

Linn used a shipping industry consulting firm to help her forecast daily hire rates for a new capesize.Exhibit 6 shows the estimate of the daily hire rate in the coming 25 years.

Computing the Net Present Value of the investment in new capesize carr

ier.Should Ms Linn purchase the $39 million capesize? The company plans to operate the ship for 25 years. Make the following two alternative assumptions. First, assume that Ocean Carriers is a U.S. firm subject to 35% taxation. Second, assume that Ocean Carriers is located in Hong Kong, where owners of Hong Kong ships are not required to pay any tax on profits made overseas and are also exempted from paying any tax on profit made on cargo uplifted from Hong Kong. The company’s appropriate cost of capital (discount rate is 9%).

Cash flow of investmentFirst, figure out the cash flow of investment.

Exercise:

Collect all the information necessary to compute the cash flow of investment

Cash flow of investment (contd)To compute the cash flow of investment, note the following.

1. The ship would cost $39 million, with 10% of the purchase price payable immediately and 10% due in a year’s time. The balance would be due on delivery. (p5)

2. Linn expect to make a $500,000 initial investment in net working capital, which would grow with inflation. (p5)

3. Expected rate of inflation is 3% (p4)4. A new ship would be depreciated on a straight-line basis

over 25 years. (p5)5. Every five years, international regulations mandated that a

special survey be undertaken to ensure seaworthiness as defined by international regulations. Exhibit 1 shows the estimates of the cost of such survey. The outlays for the survey is considered capital expenditure, which would each be depreciated on a straight line basis over a 5 years. (p2) (Assume that the company does not do survey on 25th year since it will scrap the vessel)

Cash flow of investment (contd)

Exercise

Compute the cash flow of investment for each period.

Operating revenue and Operating cost

Now figure out the operating revenue and operating cost

Exercise:

Collect all the relevant information from the case study

Operating revenue and Operating cost (contd)

To compute the operating revenue and cost, note the following.

1. For a new ship coming on line in early 2003, operating costs were expected to initially average $4000 per day, and to increase annualy at a rate of 1% above the inflation (p1)

2. Charterers are not charged a daily rate for the time the vessel spent in maintenance and repair, although the operating cost is still incurred. Initially, 8 days a year were scheduled for such work, 12 days per year after 5 years, 16 days for ships older than 10 years. (p1)

Operating revenue and Operating cost (contd)

Now, Compute the Operating revenue and Operating cost

TaxFigure out tax payment

Exercise:

Collect all the necessary information necessary to compute tax payment from the case study.

Tax (cotd)To figure out tax payment, notice the following.

1. A new ship would be depreciated on a straight-line basis over 25 years. (p5)

2. Every five years, international regulations mandated that a special survey be undertaken to ensure seaworthiness as defined by international regulations. Exhibit 1 shows the estimates of the cost of such survey. The outlays for the survey is considered capital expenditure, which would each be depreciated on a straight line basis over a 5 years. (p2) (Assume that the company does not do survey on 25th year since it will scrap the vessel)

Tax (cotd)

Exercise

Now figure out the tax payment.

Computing the net present value of the investment in the new capesize carrier

Should Linn invest in the project?