Case Study

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Memorandum

To:CEO, Ocean Carriers

Re: Ocean Carriers Capital Budgeting

Mary Linn, Vice President of Finance, has been approached by a potential customer with a proposed lease of a ship for a three-year period, beginning in early 2003. The terms are very attractive but we currently do not have a ship that meets this customer’s needs. Ms. Linn has asked Group 4 to research three proposed scenarios to determine whether or not commissioning a new capesize carrier for this customer will be in the best interests of the company. The following are our findings and recommendations:

Background
Daily spot hire rates are expected to decrease over the next year because the iron ore shipments are expected to decrease while fleet size is expected to increase. Exhibit 5 shows that, historically, as iron ore vessel shipments increase or decrease, the average spot hire rate follows suit. The factors driving the average daily rates are fleet supply and world demand in basic industries. The supply of ships is equal to the number of vessels in service the previous year, plus new ships delivered, less scrappings and sinkings. Demand is determined by the world economy, specifically the production and demand of industries such as iron ore and coal. Spot hire rates fluctuate more than charter rates so when the market is high, the demand for spot hire rates is higher because the charterers don’t want to lock in long-term charter rates at high prices. Decreasing daily spot hire rates imply that future cash flows will also decrease because a decrease in hire rates implies decreases in net income and net present value.

The cost of a new vessel in present value terms is $33,738,397:

PV(C) = ΣCn/(1+r)n
PV($39M today) = $39M + ($39M/1.09) + ($31.2M/1.19) = $33,738,397 The book value of the ship is the purchase price, which is $39 million.

Option 1: Sell Carrier for Scrap After 15 Years
It is our recommendation that Ocean Carriers does not...
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