Case Study: Ocean Carriers

Topics: Net present value, Investment, Profit margin Pages: 6 (1553 words) Published: June 28, 2008
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 like Singapore’s. We also assume that the interest rate does not change over the 3 years. Also to simplify the calculations (especially since the case study does not provide us with the information), we assume that payments from the charterer is made annually, at the end of the charter year. Year 1 = $20,000 x 357 = $7,140,000

PV(1)3 = $6,534,111.45
Year 2 = $20,200 x 357 = $7,211,400
PV(2) = $6,407,235.50
Year 3 = $20,400 x 357 = $7,282,800
PV(3) = $6,282,207.25
PV of Contract(2) = $6,534,111.45 + $6,407,235.50 + $6,282,207.25 = $19,223,554.20 Against this gross profit, we have to take away all operating costs for the vessel. The operating costs increase at 1% above inflation, or 4%, each year. While this is highly unlikely in the real world, we would again assume that all operating costs are accrued at the end of the year. Year 1 = $4000 x 365 = $1,460,000

PV(1) = $1,336,106.82
Year 2 = $4,160 x 365 = $1,518,400
PV(2) = $1,349,078.73
Year 3 = $4326.40 x 365 = $1,579,136
PV(3) = $1,362,176.59
PV of Operating Costs = $1,336,106.82 + $1,349,078.73 + $1,362,176.59 = $4,047,362.14 PV of Expected Returns = $19,223,554.20 - $4,047,362.14 = $15,176,192.06 This contract will bring in a net cash inflow of $15,176,192.06 to Ocean Carriers. Value of Cash Injection into the Project

A considerable amount has to be placed in ship construction over the period of 2 years, all of which must be accounted for in the decision to build the ship. The initial cash injection, a deposit to secure the berth, is 10% of the total cost of $39 million, or $3.9 million. A year later, another 10% has to be paid for steelworks to begin. PV(2) = $3,786,407.77

The final payment is 80% of the cost, payable upon delivery of the vessel 2 years later. PV(3) = $29,408,992.36
The total amount to be injected into the building of the vessel would then be: = $3,900,000 + $3,786,407.77 + $29,408,992.36
= $37,095,400.13
Another initial $500,000 in net working capital, presumably to be injected at the...

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, .
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