Ocean Carriers - Titanic

Case study: Ocean Carriers Inc.

Members

Gianmarco de Simone - 1706100

Nicola Di Palma - 1715085

Nicolò Dubini - 1747609

Maria Vittoria Moschini - 1713189

Quentin Thibault - 1710607

Class 21

Professor: Elizabeth Talboy

Team: TITANIC


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EXECUTIVE SUMMARY

Ocean Carriers Inc. is a shipping company, owning and operating dry bulk carriers mainly for iron

ore and coal exports, headquartered in both New York and Hong Kong.

In early 2001, the company received a leasing offer from a new potential charterer, for a 3 year period,

starting in 2003. The current fleet does not meet the customer’s needs; therefore, the commission of

a new capesize is being evaluated. Given that the contract will last only for 3 years, Ocean Carriers

has to consider the potential market risk from 2003 onwards.

Historically, the company’s strategy has been not to operate ships older than 15 years, in order to

avoid a third survey, scrapping the vessels or selling them in the second-hand market. According to

our analysis, this policy would lead to a negative NPV.

In conformity with our estimations, the scenario, in which the fiscal base is settled in Hong Kong and

the capesizes are operative for their entire useful life (25 years), causes the considered investment to

be worthy.

SUMMARY OF FACTS

The ship would cost $39 million: $3.9 million (10%) are payable immediately, $3.9 million in 2002

and the balance of $31.2 million on delivery. The vessel will be depreciated using the straight line

method with a residual value of $5M after 15 years or $0 after 25 years.

The potential charterer offers a rate of $20,000 per day with an annual escalation of $200 (three-year

contract starting in 2003). New ships are subject to a premium price which will decrease and

eventually turn into a discount as the ship ages (Exhibit 4).

Furthermore the company’s outflows are due to:

Expected operating costs - $4,000 per day initially, then they are expected to increase annually

at a rate of 1% above inflation. They will still incur when the vessel is under maintenance and/or

repair (8 days a year for the first 5 years, then 12, finally 16 for ships older than 10 years), during

which the charterer would not be charged.


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Survey costs - Exhibit 1; in fact, the company policy of not operating ships older than 15 years

is in order to avoid the third special survey.

Taxes - U.S firms are subject to 35% taxation, while Hong Kong ships are not required to pay

any tax on profits made overseas.

Finally, the risk of the customer’s insolvency is thought to be negligible.

STATEMENT OF PROBLEM

As Ocean Carrier’s current fleet does not meet the potential new charterer’s requirements, the

company has to determine if the commission of a new capesize is a worthy long-term investment or

if it is better to refuse the lease proposal. In case the investment is undertaken, the management

should decide whether to register the ship in New York or in Hong Kong and to invest for 15 years

or extend the project to 25 years.

ANALYSIS

The forces of supply and demand of shipping capacity are the main determinants for the fluctuations

of the daily spot hire rates. There are two relevant factors that affect supply of shipping capacity:

Size and efficiency - The ongoing development of these two features will lead to the production

of bigger, faster and more fuel efficient ships. Hence, fewer vessels will be needed since the

shipping capacity will be higher.

The effective number of operative capesizes - Scrapping has been fairly uncommon in the recent

years due to the youth of the worldwide fleet of capesizes (refer to Exhibit 2). According to the

forecasts (Exhibit 3), 63 and 33 new vessels are expected to be delivered in 2001 and 2002

respectively. Overall, we can conclude that the considered supply driver is going to increase.

On the other hand, the demand of shipping capacity is influenced by two factors:


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World trade and exports - It is important to highlight the crucial role of iron ore and coal, that

represents 85% of the total cargo. Consequently, the demand for capesizes is highly correlated

to the one for iron ore and coal.

Changes in trade patterns and routes - They must be taken into account in order to determine

the demand for capesizes.

In conclusion, data suggest that the supply of shipping capacity is going to increase next year. On the

other hand, the demand of capesizes is likely to remain stable. Indeed, according to forecasts, the

Indian and Australian iron ore and coal exports are expected to remain stagnant over the next 2 years.

Therefore, due to this incompatibility, the daily high spot rate will probably decrease next year.

According to forecasts, from 2003 onwards, the Australian and Indian iron ore exports are expected

to take off. Overall, the long-term prospects are positive, the trading volumes are expected to be

higher and this will probably cause prices to rise. Moreover, the iron ore vessels shipments are

expected to grow at an annual rate of 2% from 2002 to 2005, then decreasing to 1.5%.

In addition, among other factors that have to be taken into account there are:

Competition - It might strengthen in the future because of the flourishing perspectives in the

market.

Oil price - Its fluctuations can considerably affect the operating costs.

The NPV has been the main basis for our calculations and assessment of the investment. Table A

clearly shows that the scenario in which it would be highly profitable to purchase the capesize is the

one where Hong Kong is chosen as headquarter. Indeed, if Ocean Carriers is based in the USA, the

NPV results to be negative (-$3,445,199), due to 35% taxation. On the other hand, considering Hong

Kong as headquarter, the absence of taxes would significantly enhance the NPV to $6,299,116, while

the IRR would be 8.346%. Given that the NPV is positive and the IRR is higher than the real discount

rate (5.825%), we would advise the company to implement the investment.


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It is clear that not operating the capesizes for more than 15 years results in a significant capital loss.

The scrap value is far from the book value of the ship and, moreover, the survey costs do not impair

the profitability of the capesizes. If the capesize was used for its entire useful life, the NPV and the

IRR would increase both in the Hong Kong and New York scenarios (Table B). In fact, in the former,

considering that the ship is used for 25 years, the NPV and IRR would respectively rise to $10,777,931

and 9.375%. Nevertheless, we assumed that the company would sell the ship before the costs of the

fifth survey incur. If this assumption does not hold, the results will be slightly different.

RECOMMENDATIONS

Overall, it is clear that the investment is more convenient if Hong Kong is chosen as headquarter,

provided the absence of taxation and its strategic position. This policy will be wise for the future

operations. The policy of not operating ships for more than 15 years seems to be fairly unreasonable,

because it leads to a significant capital loss (Table A). Hence, we would advise the firm to start

operating ships for their entire useful life (25 years).


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Exhibit 1 Capital Expenditures Anticipated in Preparation for Special Surveys

Exhibit 2 Capesize fleet by age category as of December 2000

Exhibit 3 Current order book for dry bulk capesizes by delivery date

Exhibit 4 Daily Hire Rate Adjustment Factor for Dry Bulk Capesizes based on Age of Vessel


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Table A ( scenario in which the capesize is used for 15 years )


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Table B ( scenario in which the capesize is used for 25 years )


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Notes (all values are in dollars)

ASSUMPTION: we assumed that the 9% discount rate is nominal. So we calculated the real discount rate, given the 3% inflation, as: real discount rate= (1+nominal

rate/1+inflation rate) -1. So: (1.09/1.03) -1 = .05825 = 5.825%

Accumulated depreciation (2) is calculated as the sum of annual depreciation (7)

Year-end book value (3) is calculated as the difference between capital investment (1) (also considering the surveys) and the annual depreciation (7)

The investment in working capital (4) grows at the rate of 3% (inflation rate)

Sales (5) = Operating Days x Expected daily hire rate

Cost of goods sold (6) grows at the rate of 4% (1% + 3% inflation rate)

Depreciation (7) is calculated as: (39,000,000 – scrap value) /25 + cost of surveys / 5. We supposed scrap value = 0 in case the ships are used for 25 years and

scrap value = $5M if they are used for 15 years.

Capital loss (8): Capital Investment (39M) + Cost of the surveys (650,000) – Final Accumulated depreciation (21,05M) – Scrap Value (5M) in the 15 years scenario.

In the 25 years scenario it is 0.

EBIT is calculated as: 5-6-7-8

Profit HK = EBIT (Taxes = 0). Profit NY = EBIT – Taxes

Change in working capital (12) is the difference between investment in working capital in year X and year X-1

Operating Cash Flow (13) is computed as: 5-6-10. In Hong Kong Taxes (10) = 0.

Net Cash Flow (14) is calculated as the algebraic sum of Operating Cash Flow (13), Capital Investment (1) and Change in Working Capital (12)

Present Value (15) = Net Cash Flow/(1.05825)^T. Real Discount Rate: 5.825%. T: number of year

Net Present Value (16) is the algebraic sum of the Present Values (15)

The IRR is computed considering that it is the rate at which DCF = 0.

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Ocean Carriers - Titanic