Finance--Ocean Carriers Inc

Introduction

Ocean Carriers Inc. is a shipping company specializing in the operation of capsizes bulk dry carriers. In January 2001, the vice president of finance for Ocean Carriers was evaluating a contract proposal. In the proposed contract, Ocean Carriers would lease one ship to a client for a three year time frame. The customer would begin utilizing the ship in 2003. In 2001, Ocean Carriers did not have a ship that would meet the needs of this customer, and thus was considering purchasing a new capsize carrier to be leased to the customer. The vice president of finance for Ocean Carriers was also interested in looking at the corporate policy of scrapping a vessel after 15 years, even though such vessels have a product life of 25 years.

Analysis

In considering whether Ocean Carriers should purchase the new capsize carrier for the potential customer, we completed a net present value analysis of the ship. We utilized the given expected daily hire rate to calculate the revenue that could be expected over the lifetime of this vessel. We chose to use the expected daily hire rate because it most accurately represented Ocean CarrierÐ'ÐŽÐ'¦s future cash flows: the contract terms in years 1-3 once the vessel is complete, and then expected rates in years 4-25. We came to the annual daily hire revenue using the annual operating days over the life of the new vessel. The daily operating cost for the vessel was provided for year 2 at $4,000. For years 3-26, we increased the operating costs at 1% over the inflation rate of 3%, which we assumed would remain constant for the life of the vessel. Appendix A shows operating costs are incurred 365 days per year, leading to annual operating costs of $1,460,000 in year 2, and $1,518,400 in year 3. Survey costs were calculated using Ocean CarriersÐ'ÐŽÐ'¦ data, and we continued the practice of not incurring the cost of surveys the year prior to the boat being scrapped. Thus, no survey preparation costs were incurred in year 25. The costs were depreciated using straight-line depreciation over the life of the survey, 5 years. Depreciation of the vessel was also calculated using straight-line depreciation over 25 years. Appendix A shows an annual vessel depreciation expense of $1,560,000 beginning in year 2. We calculated taxes at the given tax rate of 35% and assumed the tax rate would not change over the life of the project. As required by the vessel manufacturer, our analysis includes a down payment of $3,900,000 in years 0 and 1; followed by the remaining cost 80% of the cost when Ocean CarriersÐ'ÐŽÐ'¦ takes possession in year 2. Since we donÐ'ÐŽÐ'¦t believe the vessel will have a salvage value, we did not include a possible sale in year 26 at the end of the vessels life with Ocean Carriers. Appendix A shows our analysis included the change in net working capital. We assumed the initial outlay of networking capital would take place in year 1, just prior to taking possession of the ship. All net working capital will be liquidated in year 26, as explained in the case guidelines. Free cash flows were calculated and using a recommended discount rate of 9%, we found the net present value of the ship to be -$4,644,969.

In considering Ocean CarriersÐ'ÐŽÐ'¦ policy of scrapping ships at year 15, we completed an additional net present value calculation. We recognized that calculating the value of the same proposed contract over a 15 year life, we could do a simple comparison which could be used as a guideline for all ships in the Ocean CarriersÐ'ÐŽÐ'¦ fleet. We held all assumptions in the value of the 25 year vessel to be true with the value of the 15 year vessel. In calculating the project value over a 15 year life, we utilized the same values for annual revenue and annual operating costs over years 2-16. Only two survey preparation costs were incurred, and these were depreciated over a 5-year straight-line depreciation. We depreciated the vessel over a 25 years using straight-line depreciated. Although Ocean CarriersÐ'ÐŽÐ'¦ intends to only use the vessel for 15 years, the ship does have a working life of 25 years. Appendix B shows taxes were calculated using the provided corporate tax rate of 35%. The same payment schedule was used in purchasing the vessel; however Ocean CarriersÐ'ÐŽÐ'¦ expects to earn $5,000,000 from selling the ship in year 16. Ocean CarriersÐ'ÐŽÐ'¦ will incur a tax expense of $1,750,000 on the revenue from selling the vessel. The initial net working capital expense was assumed to be in year 1, just prior to taking possession of the vessel. All net working capital was liquidated in year 16. We calculated the free cash flows over the 16 year time-frame and the resulting net present value. According to our analysis, the net