Case #1 – Ocean Carriers

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Daily spot rates are driven by supply and demand factors, trade patterns, and the age of the vessel. Imports for iron and ore are expected to remain stagnant for 2001 and 2002, until Australian and Indian ore exports begin in 2003. Thus, with a depressed global market for ore and the delivery of additional capesize carriers in 2001, Ocean Carriers will have an oversupply of vessels and daily spot hire rates to decline between 2001 and 2003. Despite the relatively young age of the Ocean Carrier fleet, Linn will not be able to charge a premium on her ships until trade picks up on 2003.

While daily spot hires are less prevalent than annual charters, a lower overall spot rate would have a negative effect on cash flow projections until the demand for iron ore shipments catches up with the size of Ocean Carriers’ capesize carrier fleet. Lower cash flows for the next two years will decrease the overall net present value of the project.

The cost of the new capesize carrier in present value terms is $35,346,134.21 million. The book value in 2003 is $39 million. See equations below.

Nominal interest rate: 9%
Inflation rate: 3%
Real interest » nominal interest rate – inflation rate = 9% - 3% = 6%
Discount rate = 6%

Cost = 39 million with 10% payable immediately (3.9 million) and 10% payable in a year (3.9 million) and the balance (31.2 million) upon delivery

〖PV〗_((cost vessel) )=3.9+3.9/((1+.06))+31.2/〖(1+.06)〗^2 =$35,346,134.21


Book value (2003) = acquisition cost – accumulated depreciations = 39 million

Ms. Linn should not purchase the capesize carrier if Ocean Carriers operates in the US. The NPV of the ship after 25 years is negative, indicating that there’s not enough time for the ship to recoup its value, even with a $5million dollar cash bonus for scrapping it.

If the firm operates elsewhere globally, such as Hong Kong or the Bahamas, then the firm can justify the investment. A globally operating company will not be paying tax on profits made overseas. According to a CNBC article entitled “Flag, crew or cargo? The definition of a US flag ship,” most cargo carriers fly a Flag of Convenience. The flag of convenience allows ships owners to register ships in another country to avoid taxes and regulations surrounding shipping cargo globally. Therefore, shipping from Hong Kong would not be subject to the same taxes and regulations to which US ships are subject. If this were the case, it would change Ms. Linn’s decision from not purchasing the capesize carrier to being able to purchase it.

We use the free cash flow model to make this decision, because it takes into account the incremental effect of a project on Ocean Carrier’s available cash. Ocean Carriers needs to assess how purchasing the new capesize carrier will affect their abilities to make other investments (including this one) and pay their bills and employees. If they sink all of their available cash into this new carrier, they will not have the necessary cash to pay for other expenses. By calculating the free cash flow (shown in the attached Excel spreadsheet), Ocean Carriers can determine whether or not they have enough cash to cover all expenses. Though the carrier will depreciate over time, this depreciation is not an actual cash expense for the firm. We can see this in the response to Question 5 below.

Ms. Linn is also correct in that the ship can be kept beyond its 15-year deadline – the optimal number of years to operate the carrier is the maximum operation time of 25 years. However, this is only feasible if Ocean Carriers is based outside of the US. The NPV for the tax rate of 35% at any point beyond 15 years is negative, while the NPV for a 0% tax rate is positive.

While we do not recommend purchasing the new capesize carrier in the US, if Ms. Linn did make the decision to purchase, she would have to operate the ship for 25 years and salvage for $5 million. In year 25, the cash flow in the US, including the salvage value, is $6.2 million.

Alternatively, Ms. Linn could scrap the carrier at year 16 to recoup some benefit and follow the company’s original guidelines. Please see the attached Excel spreadsheet for details.

Ocean Carriers can sell the ship for $15.6 million in the secondhand market after 15 years. As noted in Line 25 of the attached spreadsheet, the ship’s depreciable value is $34 million. At year 15, the ship has an accumulated depreciation cost of 23.4. Subtract this from the depreciable value, and you will be left with $10.6 million plus the $5 million salvage value.

From a qualitative point of view, when you finance a project from issuing debt, your cash flow will increase or be seen as positive as more money is flowing into the company than flowing out. This ultimately increases the company’s assets. However, your rate of return will decrease over time as you will need to make interest payments on the said debt issued.

The second scenario, issuing debt and cash infusion, is the preferred option. Cash infusion from the owners wouldn’t affect the rate of return, and lessening your debt issued would result in fewer and smaller interest payments. The resulting smaller interest payments would have less of an effect on cash flows.