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Case due: October 8th

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Case Study Questions Capital Budgeting In Practice Ocean Carriers

These questions relate to the Ocean Carriers case in your course packet. You can find the data for this case on the course website in a spreadsheet named: Ocean Carriers Exhibits.xls. - https://docs.google.com/spreadsheets/d/1BWU8U1uMfyJM_YdV62pEHMooNSfZm2lWQd5RCi8ByL 4/edit?usp=sharing

This case provides the opportunity to make a capital budgeting decision by using discounted cash flow analysis to make an investment and corporate policy decision. Ocean Carriers is a shipping company evaluating a proposed lease of a ship for a three-year period beginning in 2003. The proposed leasing contract offers very attractive terms, but no ship in Ocean Carrier’s current fleet meets the customer’s requirements. The firm must decide if future expected cash flows warrant the considerable investment in a new ship.

1. Do you expect daily spot hire rates to increase or decrease next year? Give the reasons for your choice. Which are the factors that drive average daily rates? What does this imply in terms of your cash flow projections? --Looking at 2001 not 2003(Alison)

Over the course of the next year, the Daily Spot hire rates will likely decrease. The reason being that these rates are heavily swayed due to supply and demand rates. They are estimating that the demand will remain stagnant over the next year. Without an increase in demand, there isn’t a need for prices to increase. In 2000, capesize charters saw the highest request for Iron Ore Vessel shipments since 1997. This boosted the average price of a spot rate to $22,575. However, in 2001, it is estimated to have 436 requested iron ore vessel shipments. This is a decrease of 0.9%Which means that the cost of a spot rate charter will decrease as demand has decreased. This means that our cash flow projections would decrease since there would be a high expenditure on the ship for the first three years of production without an income coming in.

The factors that drive average daily rates are:

● Demand

● Supply

● Age of vessel

● Vessel efficiency

● Economic Conditions

● Trade Patterns

63 new vessels expected to e delivered

2. How much is the cost of a new vessel in present value terms? What is the book value of the ship?(Olena)

$39M - 10% today, 10% in a year, 80% due on delivery $500,000 Initial investment

3. Should Ms Linn purchase the capesize carrier? Assume that it is going to be sold for scrap after 15 years. [Hint: Construct the Free Cash Flows of the project!] Explain the reason for constructing the free cash flow rather than some other type of cash flow? Assume that the relevant corporate tax rate is 35%.(Akhil)

NPV using tax amount

Relevant cash flows:

● Depreciation tax shields

● Proceeds from the sale of real assets

● Initial and ongoing capital investments

● Investments in net working capital

● Expected cash flows ●

Ms Linn is considering trying to argue that the firm should operate carriers for more than 15

years before selling them for scrap. What would be the optimal number of years to operate the capesize carrier before scrapping it? Assume that the capesize carrier must be scrapped after 30 years. If the policy is changed should they go ahead and purchase the carrier?

Set NPV to Zero and find the time taken

5. Suppose that Ms Linn is unable to convince the company to change its policy. How much could Ocean Carriers sell the capesize for on the second hand market (as opposed to selling it for scrap) after 15 years?

Future Value Discount at 9%

6. In the quantitative analysis you have done for questions (3.), (4.) and (5.) you used a 9% discount rate. From a qualitative point of view, how is your Free Cash Flows affected if the financing of the project comes from issuing debt in the capital market? If it comes partially from issuing debt and from cash infusion from the owners? Explain clearly and briefly the reason(s) for your answer.

Heavy investment upfront, many years to generate income --

Assumptions on Tax Rates:

For questions (3.), (4.) and (5.) make 2 different assumptions. First, assume that Ocean Carriers is a U.S. established firm subject to 35% corporate taxation rate. Secondly, repeat the same exercise assuming that Ocean Carriers is located in Hong Kong or Bahamas , where owners of Hong Kong or Bahamas ships are not required to pay nay tax on profits made overseas and are also exempted from paying any tax on profit made on cargo uplifted from Hong Kong. How are your results affected? What do you conclude? –You might find it useful to relate this question to movies. What flag do carry vessels have? Why?

Useful Hints:

a. You should assume that operating costs will grow annually at 1% in real terms.

b. If Ocean Carriers purchase the ship then working capital will increase to 500,000 at the end

of 2002. If the ship is sold in the second hand market then from that time onwards the buyer will have the same working capital requirements that Ocean Carriers would have had if the ship had not been sold.

c. Assume that Ocean Carriers has sufficiently high taxable income in each year so that any tax shields can be used immediately. You should also make this assumption for any firm that buys the ship in the second hand market.

d. Ocean Carriers uses a 9% discount rate. We are being very vague on the term “discount rate”. Why? Note we are not calling this discount rate expected return on equity, assets or debt. Why?

e. If the ship is sold in the second hand market before it is 25 years old you should assume that the buyer can depreciate the ship straight-line for the remaining years before it is 25 years old. So for example, if the ship is sold after 18 years then the new owner can depreciate it over 7 years. The new owner will use the second hand sale price as the starting book value of the asset.

Link for reference: https://prezi.com/m/gjthkikc0dkc/ocean-carriers-case-analysis/

Ans:

Over the course of the next year, the Daily Spot hire rates will likely decrease. The

reason being that these rates are heavily swayed due to supply and demand rates. They are estimating that the demand will remain stagnant over the next year, while supply is expected to increase. Without an increase in demand, prices are likely to fall. In 2000, capesize charters saw the highest request for Iron Ore Vessel shipments since 1997. This boosted the average price of a spot rate to $22,575. However, in 2001, it is estimated to have 436 requested iron ore vessel shipments. This is a decrease of 0.9% which means that the price of a spot rate charter will decrease as demand has decreased. This means that our cash flow projections would decrease since there would be a high expenditure on the ship for the first three years of production without an income coming in.

The factors that drive average daily rates are:

● ● ● ● ● ●

Ans:

Demand

Supply

Age of vessel

Vessel efficiency Economic Conditions Trade Patterns

the ship?

How much is the cost of a new vessel in present value terms? What is the book value of

Cost in Present Value discounted at 9%

3,900,000 + 3,900,000/(1+0.09) + 31,200,000/(1+09)2 = $33,738,397.44

Book Value

3,900,000 + 3,900,000 + 31,200,000 = $39,000,000

Ans:

After constructing and analyzing the free cash flow for 15 years, we can conclude that

Ms Linn should not purchase the capsize carrier. This conclusion is derived from the Net Present Value(Discounted at 9%) of the project which was calculated to be -$7,247,379.28. All the calculations can be found in the data sheets we have provided.

In case the ship is being run in Hong Kong with no Income tax, the NPV can be calculated to -$1,119,654.38. Even in the case of no income tax the NPV is negative, if the company plans to only run it for 15 years, Ms Linn should not purchase the carrier.

4. Ms Linn is considering trying to argue that the firm should operate carriers for more than 15 years before selling them for scrap. What would be the optimal number of years to operate the capesize carrier before scrapping it? Assume that the capesize carrier must be scrapped after 30 years. If the policy is changed should they go ahead and purchase the carrier?

Ans: After constructing and analyzing the free cash flow for 25 years, we can conclude that Ms Linn should purchase the capsize carrier. The Net present value(Discounted at 9%) calculated for the 25 year term is $1,468,976.07. This is the case when the firm is operating via Hong Kong without any income tax. Since the NPV is positive, if the policy is changed, then the carrier should be purchased, and be operated for at least 25 years before getting scrapped.

In case the ship is being run in US instead(35% tax), the NPV can be calculated to -$6,908,395.06. Since the NPV is negative it is a much better option to run the business in Hong Kong compared to the US.

Ans:

Since the ship can be operated for another 10 years and be profitable, and still be sold for the same scrap value, the ship must be sold for more that just scrap value at the end of year 15.

Scrap value + (straight line depreciation over next 10 years) = Total selling price 5,000,000 + (1,360,000)*10 = $18,600,600

The ship can be sold after 15 years for $18,600,600.

(5M + total NPV from operations) = $16M

Ans.