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Nanyang Technological UniversityNanyang Business School

BF322 Advanced Corporate FinanceCase Study Assignment

Ocean Carriers

Prepared forLuo JiangAssociate Professor

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Content Page

List of Illustration iii

Question 1 1Do you expect daily spot hire rates to increase or decrease next year?

Question 2 4What factors drive average daily hire rate?

Question 3 5How would you characterize the long-term prospects of the capesize dry bulk industry?

Question 4 7Should Ms Linn purchase the $39M capesize?

Question 5 10What do you think of the company’s policy of not operating ships over 15 years old?

Appendix A 11

Appendix B 13

Appendix C 17

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List of Illustration

Exhibit 1 - Capesize fleet by age category as of December 20001

Exhibit 2 - Current Order book for Dry bulk capesizes by delivery date2

Exhibit 3 - Daily hire rate adjustment factor for dry bulk capesizes 8based on age of vessel

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Question 1

Do you expect daily spot hire rates to increase or decrease next

year?

Daily spot hire rates are determined by supply and demand of shipping

capacity.

Supply of shipping capacity

The supply of ships next year is the number of vessels in service the

previous year plus any new ships delivered minus any scrapings.

We would expect the older vessels, especially the 2 million deadweight tons

over 24 years old, to be scrapped. However, operating vessels older than 15

years, which coincides with the costly special maintenance surveys, forms

only 23.15% of the entire portfolio. (See Exhibit 1)

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Over 24 Years

20 - 24 Years

15 - 19 Years

10 - 14 Years

5 - 9 Years Under 5 Years

On Order for 2001

0

5

10

15

20

25

30

35

Exhibit 1 Capesize fleet by age category as of December 2000

Most of the capacity of the worldwide fleet of capesizes are fairly young and

scrapings are expected to be minimum.

Although the estimates of future orders for vessels are not entirely reliable,

the degree of deviation of the projected figure for next year is likely to be

small. Therefore, we can assume that there will be an additional 63 dry bulk

capesizes in the market by next year.

2001 2002 2003 2004

Number of vessels 63 33 21 9

Exhibit 2 Current Order book for Dry bulk capesizes by delivery date

23.15%

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Given that newer ships are faster and more efficient, the additional 11

million deadweight tons of shipping capacity as shown in Exhibit 1 are

expected to be more than adequate to cover for the 8 million deadweight

tons of shipping capacity (20 to 24 Years and Over 24 Years) that is highly

likely to be scrapped.

The case study highlights the presence of a secondhand market where

Ocean Carriers are able to dispose of their ships that are nearing 15 years of

service. Therefore, we can safely assume that a large percentage of the 17

million deadweight ton, under the age group of 15 to 19 years, will not be

scraped and will continue to provide supply to the overall market.

Given our analysis, there is a low downside risk to the availability of shipping

capacity supply and our group concludes that the supply of shipping capacity

for next year is more likely to increase.

Demand of shipping capacity

As stated in the case study, Linn anticipated that Indian and Australia iron

ore and coal exports are expected to take off from 2003 onwards and took a

view that the imports of iron ore and coal would remain stagnant over the

next 2 years, i.e. 2001 and 2002.

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Commodities such as iron ore and coal are closely correlated to global

growth as economic expansions require steel for construction and coal for

energy. Given that the world is not experiencing a spurt of growth during

2001 as compared to 2000, we can add further weight to our argument that

the demand of shipping capacity is likely to stagnant.

Since 85% of the cargo carried by capesizes was iron ore and coal, we can

conclude that the demand for shipping capacity would be at a level similar to

2000.

From our above analysis, where supply is likely to increase and demand of

shipping capacity to stagnate, the daily spot hire rates would decrease next

year.

Question 2

What factors drive average daily hire rate?

As discussed in Question 1, average daily hire rates are influenced by market

supply and demand of shipping capacity.

Factors that influence the demand of shipping capacity

Iron ore vessel shipment

Coal vessel shipment

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World Economy

Changes in trade patterns (Europe to USA as compared to Australia to

USA)

Factors that influence the supply of shipping capacity

Fleet size

Efficiency of ships (faster transportation)

Number of scrapped vessels per year

Number of new ships added to the market

Operational cost of the ship will also affect the daily hire rates as it can be

hypothesized that the shipping firm will pass a portion of the increase in cost

to the charterer (client) so as to not wipe out their profit margin. Increases in

fuel prices and overall maintenance cost of the vessel would affect therefore

have a material impact on the daily hire rates.

However, it is to note that a majority of the factors listed above are unknown

and is estimated and therefore, the underlying aspect that affects those

factors is expectation of the market.

Question 3

How would you characterize the long-term prospects of the capesize

dry bulk industry?

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Historically, shipping industries is a high risk business as the construction of

a ship is a large and expensive item which requires high capital outlay. In a

world where the trade volume is highly volatile, the timing of ordering

construction of new ships and scrapping old ones is extremely important.

If ships are built but trade does not grow, the expensive ships sit idle, using

up valuable resources. If ships are not built and trade grows, the daily hire

rates would be extremely high as there will be a shortage of shipping

capacity.

In the long-term prospect of the capsize dry bulk industry, with the start of

Australian and Indian ore exports in 2003 onwards, the trading volume is

likely to increase. This opinion is further backed by the forecast generated by

Linn where her analyst expects the growth in iron ore shipment to grow at a

rate of 2.0% starting from 2003 for a period of 4 years. Subsequently, the

iron ore shipment will continue to grow at a fixed rate of 1.5%.

Therefore, the long term prospects of the industry appear to be good with an

expected increase in trading volume in the near future.

However, Ocean Carrier is not expected to make a high volume of profits in

the long term as from Exhibit 2, we can see that there are 63 new vessels in

2001 and 33 new vessels in 2002 to be added into the market to boost

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shipping capacity. Therefore, even though the demand for shipping capacity

may increase significantly with the opening of new export market in Australia

and Indian, the supply of shipping capacity are also expected to increase,

which may put a downward pressure on the daily hire rates.

In addition, it takes an approximately 2 years for the construction of a new

ship, therefore, at the most optimal situation, Ocean Carrier or any other

shipping companies that are well positioned to ride on the new Australia and

Indian markets, are expected to make above average profits for a period of

2-3 years before competitors increased their shipping capacity to undercut

the prices for hire rates.

Finally, the long-term prospect of the shipping industry is largely dependent

on the growth of the global economy. As seen in Appendix A, which provides

a forecast of the seaborne iron ore trade to Europe and Asia from 1998 to

2006, the outlook for the long term prospect of the shipping industry appears

to be very strong. Trading volumes are expected to increase due to China

economic expansion. Ocean Carriers, domiciled in both New York and Hong

Kong, are well placed to take advantage of the increase in Chinese import of

iron ore due to their close proximity to China with Hong Kong.

Question 4

Should Ms Linn purchase the $39M capesize?

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Make 2 different assumptions.

First, assume that Ocean Carriers is a U.S. firm subject to 35%

taxation.

Second, assume that Ocean Carriers 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.

Three-year time charter starting in 2003 at a rate of $20,000 per day

with an annual escalation of $200 per day

Expected inflation rate is 3%

Operating cost expected to be $4,000 per day and to increase at a rate

1% above inflation

Maintenance days: Initial 8 days, 12 days after 5 years and 16 days

after 10 years annually

Capital Expenditure in 2007:$300,000 and 2012:$350,000

Estimated scrap value at end of fifteen year is $5,000,000

Daily Hire Rate Adjustment

Over 24 20 to 24 15 to 19 10 to 14 5 to 9 years Under 5

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years years years years years

0.65 0.75 0.8 1 1.05 1.15

Exhibit 3 Daily hire rate adjustment factor for dry bulk capesizes based on age of vessel

Assumption made in Calculation

365-day per year

Ocean Carrier will dispose of the ship at the end of 15th year, without

incurring the cost of the third survey

Due to lack of information on the premium Ocean Carrier charged

above the market due their new and larger fleet, we shall compute the

revenue using the industry average adjustment to daily hire rate

For a detailed calculation of the NPV, please refer to Appendix B.

In summary, in the first case scenario where Ocean Carrier is subjected to

35% corporate tax, the NPV of the project is -$8,762,612.

Under the second case scenario where Ocean Carrier is subjected to no

corporate tax, the NPV of the project is -$1,432,918.

Since the NPV for both projects is negative, Linn should not take up the

project given the assumptions listed above.

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Question 5

What do you think of the company’s policy of not operating ships

over 15 years old?

Building on our model in Question 4, we assumed that the company does not

scrap the ship after 15 years of service and continue to utilize them up till 25

years. See Appendix C for computation.

Under a corporate tax of 35%, the NPV of the project is -$7,269,097.

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Suppose that there is no corporate tax, the NPV of the project is $266,373

As seen from the NPV analysis, if the ships are to continue to operate up till

25 years of service, the NPV result is slightly better as compared to adhering

to the policy of not operating ships over 15 years old.

This shows that Ocean Carriers strategy of having a relatively young fleet of

ships and rotating out older ships to command a higher premium over the

market is not effective as they can further unlock even more value from their

high capital investment assets under the same set of conservative

assumptions.

--- End of Report ---

Appendix A Forecast of International Seaborne Iron Ore Trade

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