Ocean Carriers Case

Executive Summary
The Ocean Carriers Inc. was proposed to lease a ship to a customer for 3 years starting in 2003.

Since the company had no ship that met the customers requirements, the finance department was

assigned to evaluate the market conditions in order to estimate whether building a new ship would

be a profitable business decision for the firm. After careful analysis of the market and future cash

flows, the finance department has decided that the investment should be made if the company is

based in Hong Kong.

Summary of facts

It is important to emphasize that in the event of building a new ship, one should consider initial

operating costs, additional maintaining costs, depreciation method used, cost of capital and costs of

conducting special surveys required by international regulations. On the other hand, building a new

ship would provide a premium on the hire rate and ensure the long lasting relationship with a

trustworthy client.

Problem Statement

Since the client is interested in a 3 year contract, Linn has to decide whether the investment is

sustainable on a long term basis. In order to conclude that, she should consider fluctuations in daily

hire rates, market conditions related to supply and demand of iron ore and coal, inflation and

operating/maintaining costs. In addition, she should evaluate the long-term prospects of the industry

and decide if their policy of not operating ships over 15 years is viable.

Analysis

In order to forecast the future changes in the average daily hire rates we have considered the factors

that drive demand and supply. The most important drivers of supply are number of new ships,

number of scrapped ones and technology, whereas demand is influenced by trade volumes and trade
patterns. Additionally, the age of ships is relevant for price determination as newer ships benefit

from a premium on prices and old ones incur a discount. Based on the following factors and our

calculations, we expect the next years* daily spot hire rates to decrease. Linn believes that iron ore

supply is going to remain stagnant in 2001 and 2002. On the other hand, the consulting firm

believes that there will be a 2% growth of daily hire rates. However, the difference in forecasts is

insignificant as the supply of vessels increases by immense 11,39% which we consider enough to

outweigh the possible growth of iron ore supply. On balance, we expect next years spot rates to

decrease. This industry is highly dependent (85%) on the supply of iron ore and coal which tend to

increase with economic growth (infrastructure, construction, energy consumption, etc.) and

technological improvements. Possible changes in infrastructure of water ways such as widening

existing canals or opening new ones, may lead to a sharp decline of the industry due to possible

reclassification of some capsizes as normal ships. As a whole, because of the expected global

positive economic growth we believe that capsize dry bulk industry will continue to expand and

remain profitable in the long run.

Linn has hired a consultancy firm to make forecasts about the future prices in the industry. We

consider the expected daily hire rate given in Exhibit 6 to already take into account the inflation,

and the daily cost in 2003 of $4000, which is growing annually at 4% (1% over expected inflation

of 3%). Moreover we take into consideration the fact that the ships operate less than 365 days in a

year, depending on their age. Using this information we have calculated the EBITDA.

The investment depreciates by 1,560,000 (straight line method for 25 years) and there is additional

maintenance depreciation in years 2007 to 2016 due to the special surveys.

From this point we calculate the EBIT, which is crucial for our analysis in Hong Kong, as there is

no tax and we assume investment is equity financed (no interest), therefore EBIT = Net income. In

the USA instead, we have taxed the EBIT by 35% in order to get the net income (no debt employed

=> no interest assumption holds here as well).

However, our analysis cannot be complete as we have chosen to evaluate our investment using its

NPV and examine future cash flows. The inflows are calculated by adding depreciation to the net

income in each year. In addition, in 2017 we have two more cash inflows - scrap value and NWC.

On the other hand, outflows are: investment, maintenance costs and net working capital investment.

Calculating the net cash flows and discounting with a cost of capital of 9%, we find the NPV of

Linns investment.

After concluding the financial analysis, we obtained a positive NPV of $1,766,636.10 in Hong

Kong, whereas in USA the figure is $(6,208,852.68), highlighting the significant difference

generated by the two business locations.

When carrying out the same analysis under the assumptions that the firm holds onto its ship for 25

years and doesnt sell them for scrap we obtain a NPV of $3,573,907.47 in Hong Kong and

$(4,734,141.92) in the USA, pointing out that the 15-year-usage policy of the firm is

disadvantageous in both cases and should be abolished. We would like to highlight that assuming

the firm will be able to sell the ship for scrap, the investment would be even more profitable.

Recommendation

After careful analysis of both economic and financial nature, we conclude that the company should

definitely not invest if located in the USA and start the project if based in Hong Kong, as it will

prove to be profitable under the forecasted economic conditions. Furthermore, Ocean Carriers

should start operating the capsized ships until the end of their useful life instead of proceeding with

their sale on the 15th year as in this case it will potentially lead to an additional profit of

$1,807,265.37 (102.3%) in Hong Kong and $1,474,710.76 (23.75%) lower loss in USA.