Ocean Carriers Summary

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Executive Summary
Ocean Carriers is a shipping company with offices in New York and Hong Kong. The company has dry bulk carriers for iron ore and coal exports. Mary Linn is the Vice President of Finance at Ocean Carriers. In 2000, a customer approached her ready to sign a 3-year lease starting 2003. The current fleet does not match the customer’s requirements so Linn therefore must decide whether Ocean Carriers should commission the new capesize. Linn should not purchase a new ship, despite being a profitable investment yielding $2,264,010.22, because we believe this is an unlikely overestimate. This capital budgeting analysis contains a discussion of the facts and assumptions used to come to this conclusion, followed by a discussion of key variables that contribute to the risk of this decision.
Statement of the Problem
Should Mary Lin approve the purchase of a $39M capesize carrier assuming that the ship can be sold in the secondhand market for $16 million after 15 years?
Method Analysis

Resale and Depreciation

The ship can be sold in the secondhand market for $16M in 15 years. However, Ocean Carriers usually depreciate over 25 years (at $1,560,000.00 per year). If we accepted both practices the depreciation would lead to a tax revenue. Depreciating the value of the carrier after it is sold is counter to accounting practices, thus we have adjusted the analysis to account for the resale by calculating straight-line depreciation as $39M - $16M / 15 Years = $1,533,333.33 per year for 15 years. (see row 9 on Appendix B attached hereto)
Despite discussions around market demand, we believe it is a reasonable assumption that Ocean Carriers will enact their policy of not using ships 15 years old, especially because of the excessive cost of the required surveys. However, it is incredibly risky, and again counter to standard accounting rules, to overestimate the resale value of the ship to be $16M instead of a scrap value of $5M. With this change, the NPV of the project becomes only $285,609.19. Further investigation is needed to compare accelerated (MACRS) or 100% depreciation methods.
Tax Rate

We assume that Ocean Carriers is based in the US and therefore subject to a corporate tax rate of 35%. The risk of this assumption is dependent on the interpretation of “based;” if Ocean Carriers were able to avoid U.S. taxes by incorporating outside of the U.S. (for example Australia or Hong Kong because of the projected demand for iron) they would be able to significantly change the profitability of this investment. However, because of U.S. foreign tax policy we agree that a 35% rate is a reasonable assumption.
Net Working Capital

The Net Working Capital (NWC) from the $500,000 investment is recovered when the vehicle is sold. This is a common assumption in capital budgeting and therefore does not contribute to the risk of the project.
Inflation

We assumed a Cost of Capital (COC) of 9%. However, to account for a 3% inflation rate, when calculating the present value of Free Cash Flows (CFCs) a “real” cost of capital, equal to 6% was used. Although this is a common method to account for inflation, it does assume a constant rate over the 15-year period. Which is convenient.
Financing
Capital budgeting does not consider how the project is financed; it assumes it finances itself i.e. all equity financed. However, with the considerable upfront cost, it is highly unlikely that Ocean Carriers have the cash to invest. Free Cash Flows (FCFs) are adversely affected if financing the project comes from taking out a loan. When capital budgeting, Ocean Carriers needs to decide if this vessel will produce growth in the long-term. If Ocean Carriers were to fund the vessel with its own cash, this will increase the FCFs.
Recommendations
Depending on how risk averse Ocean Carriers are with this project, Ms. Linn should not commission the $39M capesize. This is due to several combining factors. Firstly, the risk in the assumption they can resell for $16M. Secondly, the corporate tax rate of 35%. Thirdly, the variability in the future inflation rate. And finally, the likelihood of a suboptimal financing method and dept.
To manage or assess this risk further we suggest Ocean Carriers:
1. Compare multiple real COC percentages based on the variance of inflation
2. Change their HQ to a lower corporate tax country
3. Compare accelerated and straight-line depreciation to decrease tax spending
4. Confirm a buyer on the second-hand market
5. Based on market conditions consider the ability to charge a hire spot rate
6. Minimize debt by delaying any financing until the second year. 
Appendix A

We have summarized the facts that were detailed in the case and used to reach our recommendation:
• The consulting fees for projected rates is a sunk cost
• Operating costs expected to be $4000 a day and to increase annually at a rate of 1% above inflation
• Ship scheduled for 8 maintenance days per year initially, 12 days per year after 5 years, and 16 days per year after 10 years.
• Survey capital expenditures depreciated on a straight-line basis over a 5-year period.
• Survey capital expenditures in 2007: $300,000 and 2012: $350,000
• Three-year time charter starting in 2003 at a rate of $20,000 per day with an annual escalation of $200 per day.
• The ship would cost $39 million, with 10% of the purchase price payable immediately and 10% due in a years' time. The balance would be due upon delivery.