Substantive Issue
Ocean Carriers is a shipping company evaluating a proposed lease of a ship for a three-year period to a customer, 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.

Objective of Case Assignment
To provide your team an opportunity to make a capital budgeting decision. That is, to develop an understanding of how discounted cash flow analysis can be used to make investment and corporate policy decisions.

Assignment Questions:

1. Do you expect daily spot hire rates to increase or decrease next year, and why? (This question should also address what factors appear to drive average daily hire rates.)

2. What is the cost of the new ship in present value terms? The company’s cost of capital (i.e., discount rate) is 9%.

3. What are the expected cash flows for each year? (You are expected to setup an Excel spreadsheet to answer this question.)

4. What is the net present value (i.e., net cash flow overall) for the investment in the ship?

5. Should Ms. Linn purchase the $39MM ship?

6. What do you think of the company’s policy of not operating ships over 15 years old?

**Additional Notes to Finance Project**

A. Event Year 0 (on the Excel template) equals the year 2000. This means 2000 is the current year of the case, also stated as period (n) = 0.

B. Based on the above, next year in Question 1 would then be the year 2001.

C. When calculating days in the year, use 365 (i.e., ignore leap years).

D. The initial investment in net working capital of $500,000 (p. 5 of case) occurs at the end of 2002—right before the ship is ready for use at the start of 2003. Net working capital defined: current assets minus current liabilities; the net amount of a company’s liquid...

...“OceanCarriers” case
Assume that OceanCarriers uses a 9% discount rate.
1) Do you expect daily spot hire rates to increase or decrease next year? (5 points)
2) What factors drive daily hire rates? (5 points)
3) How would you characterize the long-term prospects of the capesize dry bulk industry? (10 points)
4) Should Ms Linn purchase the $39M capsize? Make 2 different assumptions. First, assume that OceanCarriers is a US firm subject to 35% taxation. Second, assume that OceanCarriers is located in Hong Kong, where owners of Hong Kong ships are not required to pay any tax on profits made overseas and are also exempted from paying any tax on profit made on cargo uplifted from Hong Kong. (75 points)
5) What do you think of the company’s policy of not operating ships over 15 years old? (5 points)
Solutions:
1) Daily spot hire rates should be determined by supply and demand.
Supply: The number of ships available equaled the number of vessels in service the previous year plus any new ships delivered minus any scrappings and sinkings.
Demand: The demand for dry bulk capesizes was determined by the world economy, especially its basic industries.
As shown in Exhibit 5, since over 85% of the cargo carried by capesizes was iron ore and coal, the amount of iron ore vessel shipments approximately reflects the...

...FIN 555
CASE 1
Q3
Ms.Linn should not purchase the capsize carrier because the NPV is negative.
a. Incremental earning forecast
1. Operating Revenue
From the following Exhibit,
We can see that from year 2003 to year 2007, from year 2008 to year 2012, and from year 2013 to year 2017, 8 days, 12 days and 16days is separately used to repair.
The annual operating revenue = expected daily hire rate * (365- numbers of days for repair)
2. Operating Cost
The annual operating cost = daily operating cost * 365
Because the inflation rate is 3%, daily cost will increase 1% above inflation. So the daily operating cost of year 2013 is $4000. From year 2014, the daily operating cost is 4000*(1.04^n) annually
3. Depreciation Expense
From year 2003 to year 2006, the annual depreciation = book value of new vessel /25 = 39,000,000/25 = 1,560,000
From year 2007 to year 2011, the annual depreciation = new vessel depreciation + survey depreciation = 1,560,000 +300,000/5= 1,620,000
From year 2012 to year 2016, the annual depreciation = new vessel depreciation + survey depreciation = 1,560,000+350,000/5= 1,630,000
In year 2017, the annual depreciation = 1,560,000
4. Unlevered Net Income
Unlevered net income = (operating revenue – operating cost- depreciation)*(1-35%)
b. Free cash flow forecast:
1. NWC:
Net working capital of year 2003 is 500,000, from year 2004 the NWC =500,000*(1.03^t)
At last the increase in NWC...

...OceanCarriers Recommendations and Analysis
We have carefully reviewed and analyzed the proposal for OceanCarriers to lease a ship for a three-year period, beginning in early 2003. Our extensive analysis included considering the cash flows over the lifetime of this investment. We concluded that based on the expected future cash flows of this project the opportunity to take on the contract would not be advantageous forOceanCarriers.
We first considered the future expectations of the spot and daily hire rates. These rates are both driven by the supply and demand of the market. We expect that the spot hire rates will decrease in the next year, and will continue to decline in 2002, with a possible increase in 2003. This decision was based on the fact that there is not going to be an increase in demand for imports of iron ore and coal over the next two years, and there will be an increase of 63 vessels into the market. Additionally, we also anticipate the average daily hire rates will continue to decline until 2003. This forecast was provided by a shipping-industry consulting firm based on future expectations of iron ore shipments and percent of growth. As a result, OceanCarriers’ cash flows over the next 2 years will decline.
Another concerning factor in taking on this contract is the fact that the net present value calculated based a various options continues...

...OceanCarriers
Objectives
• Forecast pro-forma cash flows
for a project
• Estimate project values using
Net Present Value (NPV)
• Conduct sensitivity analysis for
the forecast inputs
Setting
• January 2001
• Customer offering attractive
terms on 3-year lease for a
capesize carrier
• Would require purchase of new
carrier since existing fleet does
not fulfill customer needs
• Should it be purchased?
Industry Dynamics
• Revenue Drivers
• Outlook in the:
– Short run
– Next couple of years
– Long run
Project Evaluation
• Net Present Value (NPV)
examines the present value of
the cash flows net of the
present value of the initial
investment
• Value of the investment
• Estimates of the cash flows
Initial Investment
• $39M vessel
• 10% due immediately
• 10% due in one year
• Remaining due at delivery in two
years
$3.9M
$31.2M
PV = $3.9M +
+
= $33.74M
2
(1 + 9%) (1 + 9%)
Project Free Cash Flow
Operating Revenue
- Cost of Goods Sold
Gross Profit
- Depreciation
- Other Expenses
Operating Profit Before Interest and Taxes
- Taxes
Net Operating Profit After Taxes
+ Depreciation
- Capital Expenditures
- Increase in Working Capital
- Increase in Other Assets
Free Cash Flow
Revenue
• Contract Revenues
• Estimated Charter Rates
• Adjustment for Vessel Age
• Expected Daily Rate
• Number of Operating Days
Expenses...

...OceanCarriers
HW#7 PRINCIPLES OF MORDERN FINANCE (FALL 2012)
JINGYE HAN
“OceanCarriers” case
1) Do you expect daily spot hire rates to increase or decrease next year?
I expect daily spot hire rates to decrease next year.
Based on Exhibit 3, order book in 2002 for dry bulk capsizes decreased, indicating a decrease in demand.
Meanwhile, Based on Exhibit 2, the majority of capsize fleets in December 2000 are in the age within 15 years, among them, the largest portion is of those under 5 years. They will work well and become mire mature till 2002, indicating no significantly increase will take place in 2002. In addition, scrappings and sinkings are very few for the recent years, also indicating not much increase in supply.
With demand decrease whereas supply stays moderate, I expect the daily hire rates to decrease next year.
2) What factors drive daily hire rates?
As the daily spot hire rate is determined by supply and demand. All factors affect supply and demand for capsize fleet count.
Factors affecting the supply are the number of ships available, which equals the number of vessels in service the previous year plus any new ships delivered minus any scrappings and sinkings. Components in this equation all matter.
Factors affecting demand can be the frequency of scrapping in recent years, which is determined by average age of current capsize and efficiency of them....

...OceanCarrierCase Study
Summary
In order to accept the recently submitted leasing contract proposal, OceanCarriers would have to purchase a new ship. The purchasing of a new ship is a considerable investment. We have analyzed whether or not OceanCarriers should make this investment using Free Cash Flow and Net Present Value (NPV) analysis. Given the details of the contract, the forecasted daily time charter rates, and the costs data; we have concluded that OceanCarriers should not accept the proposal and purchase a new ship if the company’s plan is to scrap the ship in 15 years. The NPV of this option is negative, roughly -$43,705, which means that OceanCarriers would lose money over the life of this project. However, further analysis has concluded that operating the ship for its entire useful life, 30 years, can produce a positive NPV, roughly $2,107,016. So OceanCarriers’ should consider taking on this proposal only if they can continue operating the ship for 30 years.
*Please see assumptions and capital budget details.
Answers to Case Questions
1) Spot hire rates will likely decrease in the near term, 2001 and 2002. Imports for ore look to be flat and won’t likely increase for the next two years. With 63 new capsizes scheduled for completion in 2001 there...

...the case, technological developments in ship construction play a role in capacity, as newer ships are bigger, faster, and more fuel efficient, increasing the overall shipping capacity of a fleet. Accordingly the long-term decline in daily hire rates makes sense because technology will continue to enable increased capacity, elongate the useful life of each ship, and the enable the relatively young fleet to last longer than ever before.
2. The cost of a new vessel is $37,095,400 (39,000+39,000*1.03+31,200,000*1.03^2); this figure represents taking the cost of the ship and bringing each of the payments into the dollar value at the time of the decision. By discounting the installments, we realize an effective 5% ((37,095,400 – 39,000,000)/ 39,000,000) deduction from the price of the ship if Linn sets aside the present value amount today.
3. Ms. Linn should not make the investment on the ship to secure the lease agreement. The present value of future revenue streams over 15 years total $23,980,255. By netting the present value of the investment, Linn will incur a loss of over $13 million today. The reason is because of the diminishing marginal return over 15 years as result of high ship operations, depreciation and maintenance. In the final year, these expenses make up 80% of her revenue before taxes. Additionally, the $5 million received from scrapping the ship 15 years in the future is only worth $3 million today. Net loss is still about $10 million....

...and Valuation
Case Analysis
OceanCarriers
March 23, 2011
Executive Summary
Industry Overview
Capesize dry bulk carriers provide shipping services worldwide. Due to their size, Capesize carriers must sail around Cape Horn in order to travel between the Atlantic and Pacifica Oceans – the ships are too large to utilize the Panama Canal. In January 2001, there were 553 capesize vessels in service throughout the world.
Demand for dry bulk carriers is determined by the world economy. Over 85% of the capesize vessels are used for shipping iron ore and coal. In a strong economy, production and demand for iron ore and coal increases. In the next few years, Australian production of iron ore is expected to be strong and Indian iron ore exports are expected to grow. These sources of new iron ore supply will increase trading volumes and therefore demand for capesize ships is likely to increase.
There are 63 new vessels that are scheduled for delivery in 2001. Therefore, the supply of capesize vessels will increase substantially which may decrease the daily hire rate in the short term. However, considering a favorable forecast of Australian and Indian production, there is expected to be favorable demand for capesize vessel service in the long run.
Customers for capesize carriers charter the vessels for a specific time period. Customers...