Case Study: Ocean Carriers
Executive Summary
A decision has to be made on the possible construction of a new ship to meet the demands of a charterer which wants a contract of only 3 years. Based on the calculations of the costs of construction against the value of the contract, it is recommended that Ocean Carriers not go ahead with the construction.
However, if a strategic alliance can be created with another carrier to lease their vessels, Ocean Carriers should accept the contract. If the strategic alliance is mutual, Ocean Carriers should build the vessel to add on to its own fleet.
Key Financial Issues
Mary Linn has to deal with the following key financial issues before making her decision.
1. Assessment of the amount of expected returns over the life of the present contract.
2. Assessment of the value of the cash injection into the project.
Expected Returns
Why do we measure the expected returns over the life of the present contract, instead of over the lifetime of the ship? It is important to take note that the ship was specifically constructed for this contract. Without this contract, the cash could have been used for other opportunities (opportunity cost(1) of the cash) instead. And after this contract, there is no guarantee of new contracts at the same value, so the difference has to be taken as a risk premium(2) for Mary Linn to decide whether it was worth the construction of the vessel.
During the first 3 years, the vessel has to be in the yard for scheduled maintenance and repairs for 8 days a year, during which the charterer does not pay for the charter.
Number of Days Available for Lease Per Year = 357
We calculate below the returns over 3 years from the contract. Note, however, that the contract takes effect 2 years from the present, complicating the PV somewhat.
Since the case study does not provide us with the prevailing market interest rate, we shall assume that it is keeping pace with the inflation rate of 3%, a situation similar to low-inflation economies
A decision has to be made on the possible construction of a new ship to meet the demands of a charterer which wants a contract of only 3 years. Based on the calculations of the costs of construction against the value of the contract, it is recommended that Ocean Carriers not go ahead with the construction.
However, if a strategic alliance can be created with another carrier to lease their vessels, Ocean Carriers should accept the contract. If the strategic alliance is mutual, Ocean Carriers should build the vessel to add on to its own fleet.
Key Financial Issues
Mary Linn has to deal with the following key financial issues before making her decision.
1. Assessment of the amount of expected returns over the life of the present contract.
2. Assessment of the value of the cash injection into the project.
Expected Returns
Why do we measure the expected returns over the life of the present contract, instead of over the lifetime of the ship? It is important to take note that the ship was specifically constructed for this contract. Without this contract, the cash could have been used for other opportunities (opportunity cost(1) of the cash) instead. And after this contract, there is no guarantee of new contracts at the same value, so the difference has to be taken as a risk premium(2) for Mary Linn to decide whether it was worth the construction of the vessel.
During the first 3 years, the vessel has to be in the yard for scheduled maintenance and repairs for 8 days a year, during which the charterer does not pay for the charter.
Number of Days Available for Lease Per Year = 357
We calculate below the returns over 3 years from the contract. Note, however, that the contract takes effect 2 years from the present, complicating the PV somewhat.
Since the case study does not provide us with the prevailing market interest rate, we shall assume that it is keeping pace with the inflation rate of 3%, a situation similar to low-inflation economies
References: 1. Investorwords 1997-2007, ‘Risk Premium’, viewed 18 Aug 07, 2. Ross, Westerfield & Jaffe 2005, ‘Net Present Value and Capital Budgeting’, Corporate Finance. 7th ed. Singapore: McGraw-Hill, p179 3. Ross, Westerfield & Jaffe 2005, ‘Net Present Value’, Corporate Finance. 7th ed. Singapore: McGraw-Hill, p69 4. Traderpedia 2001-2007, ‘Profit/loss ratio’, viewed 18 Aug 07, .