Lecture Note 6

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Lecture Note 6

• Case study
• Ocean Carriers

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Introduction

• In 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

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• No ship in Ocean Carriers current fleet met the
  customers 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.
• Next Page

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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 Linns 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.

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• 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
• How the Capesize Carriers business is conducted.
• The future prospect of the market.

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How the Ocean Carriers 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.

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How the Ocean Carriers 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.

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Future prospect of the market-Supply of the
capesize vessels (Contd)

• 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)

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Future prospect of the market-Supply of the
capesize carriers (Contd)

• 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.

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Future prospect of the market-Supply of the
capesize carriers (Contd)-

• 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.

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Future prospect of the market-Supply of the
capesize carriers (Contd)-

• In summary,
• Existing capesize vessels are relatively new,
  thus we do not expect a large reduction in
  capesize vessels due to the scraping of old
  vessel.
• A large number of new ships will be delivered in
  the coming 3 years.
• Thus, we expect a substantial increase in the
  supply of capesize vessels in the coming 3 years.

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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.

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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.

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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.

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Computing the Net Present Value of the investment
in new capesize carrier.

• 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
  companys appropriate cost of capital (discount
  rate is 9).

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Cash flow of investment

• First, figure out the cash flow of investment.
• Exercise
• Collect all the information necessary to
  compute the cash flow of investment

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Cash flow of investment (contd)

• To compute the cash flow of investment, note the
  following.
• The ship would cost 39 million, with 10 of the
  purchase price payable immediately and 10 due in
  a years time. The balance would be due on
  delivery. (p5)
• Linn expect to make a 500,000 initial investment
  in net working capital, which would grow with
  inflation. (p5)
• Expected rate of inflation is 3 (p4)
• A new ship would be depreciated on a
  straight-line basis over 25 years. (p5)
• 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)

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Cash flow of investment (contd)

• Exercise
• Compute the cash flow of investment for each
  period.

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Operating revenue and Operating cost

• Now figure out the operating revenue and
  operating cost
• Exercise
• Collect all the relevant information from the
  case study

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Operating revenue and Operating cost (contd)

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

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Operating revenue and Operating cost (contd)

• Now, Compute the Operating revenue and Operating
  cost

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Tax

• Figure out tax payment
• Exercise
• Collect all the necessary information
  necessary to compute tax payment from the case
  study.

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Tax (cotd)

• To figure out tax payment, notice the following.
• A new ship would be depreciated on a
  straight-line basis over 25 years. (p5)
• 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)

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Tax (cotd)

• Exercise
• Now figure out the tax payment.

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

• Should Linn invest in the project?