Ocean Carriers

Problem:

In January 2001, Mary Linn, VP of finance for Ocean Carriers, a shipping company with offices in New York and Hong Kong, must evaluate a proposed lease of a ship for a three-year period, beginning in early 2003. No ship in Ocean Carrier's current fleet meets the customer's requirements. Linn has to decide whether it will be profitable for Ocean Carriers to immediately commission a new capsize carrier that will take two years to complete and enter into the proposed lease.

Assumptions:

Operating costs for a new ship are $4,000 per day and will increase annually at a rate of 1% above inflation. Eight days out of each year of the contract will be allotted for repairs and maintenance- these days will not be charged to the customer. The new ship will be depreciated on a straight-line basis over 25 years. The average prevailing daily spot market rate is $22,000 per day. Ocean Carriers uses a 9% discount rate.

Analysis:

When looking at the forecasting done by Linn's analysts and the current expectation of growth in the iron and ore markets, the long-term prospects for the capsize dry bulk industry seem promising. The increased exports of iron and ore will cause the demand for capsizes to increase, and may allow Shipping companies to increase their rates. However, because rates tend to fluctuate greatly and each ship requires a large investment for a long period of time, there is much risk involved in the industry. Therefore, forecasts should not necessarily be considered completely reliable. Over the next year daily hire rates will likely decrease because the iron and ore market is only expected to grow in 2 years time. The decreased demand for new ships will push down prices.

Under the assumption that Ocean Carriers will be subject to a US tax rate of 35%,