Ocean Carriers Harvard Case Solution & Analysis

OVERVIEW

Ocean Carriers is a shipping company with offices in New York and Hong Kong that operates iron ore capsize carriers with cargo capacities of 80,000 tons to 210,000 tons worldwide. It is in an evaluation process for a lease proposal from a client for which Marry Lin, Vice President needs an analysis of profitability and capital budgeting for the purchase of a new cargo ship to meet the client requirement as none of the existing fleet ships are available or suitable to client specifications.

 

There is a significant capital outlay involved if the proposal is accepted. Although client is reliable and risk of dishonoring the contract is low, contract is only for three years. Industry practice is to lease vessels on a “time charter” basis usually for 1, 3 or 5 year periods. Worldwide fleet is young and Oceans Carriers’ vessels do enjoy a price premium as they are new and bigger. New ships have a 15% premium and older than 25 received 35% discount on daily hire prices.

 

Market outlook is good from 2003 due to increased iron ore shipments which is the primary usage of the vessel under consideration. However for the industry, projections are unreliable for longer time periods. As demand for capsize vessels is closely linked to iron ore production, and rates are also impacted by supply of capsize shipping vessels, there is a risk that Ocean Carriers may end up with one ship too many to cater for the cargo shipment needs. Detailed analysis of the proposal is therefore essential and is as follows.

 

ANALYSIS

We assess the proposed purchase of new vessel under following two scenarios. While most variable are similar for both of these scenarios, there are different tax regimes in US and Hong Kong as Ocean Carriers has offices in both these countries. Customer named Charterer is willing to pay daily hire rate for the entirety of the contract excluding maintenance days. Ocean Carriers would bear operating expenses of the ship. Operating costs are estimated at $4,000 per day and expected to grow at 1% above inflation of 3%. Ship is expected to be in for maintenance for 8 days per year during the first five years of operation and would increase to 12 days after 5 years while taking 16 days per year after 10 years.

 

Company currently operates ships no older than 15 years as special seaworthiness surveys required after 5 years and maintenance is costly after 15 years, therefore ship is to be scrapped before third survey in 2017 for $5 million. Marry Lin need to decide on the purchase now as two years is the order to delivery time for a new ship and that’s the time she has to get the ship for the customer.

 

  1. 1.    Ocean Carriers is a U.S. firm subject to 35% taxation.

Working 2 at excel worksheet layout free cash flows regarding purchase of new vessel and operation for fifteen years as per existing policy of the firm to operate ships for 15 years. Undiscounted net cash flow for the project is $18.4 million which is an impressive 47% (18.4/39). However this technique ignores time value of money. Taking present value of these free cash flows into account, internal rate of return is 5.8% and a positive NPV (@5%) of $1.8 million. Target return for the investment is unknown. Project is acceptable on the basis of IRR and NPV if target return is less than 5.8%. Discounted payback period for the project is 14 to 15 years which seems longer increasing the risk as project returned is earned at the end of the project.

 

  1. 2.     Ocean Carriers is a U.S. firm subject to 35% taxation.

Similarly capital budgeting on Working 1 at excel worksheet provides undiscounted net free cash flows of about $34 million. Discounting these to current value at 10% gives positive NPV of approximately $1.4 million. Internal rate of return of the project also increased significantly to 10.8% however payback time remains higher meaning positive returns are at the end of operation. Impact of no taxation is significant and gives Oceans Carriers the ability to generate better returns on the investment..................

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