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Executive Summary
In order to meet a contract requirement Ocean Carriers must decide whether to purchase or not a 180000-deadweight tons dry bulk carrier for the price of 39 million dollars in order to lease the vessel.
After careful analysis of both, the industry and exogenous factors we conclude that the purchase of the vessel is advisable only if we base the project on Hong Kong’s tax legislation. Furthermore, it is more profitable to operate the vessel for its entire useful life of 25 years (Ignoring company policy) unless it is able to sell the ship at the end of the 15th year on the secondary market for a price that is greater than $12,042,328.
Statement of Problems
Ocean Carriers faces the decision of purchasing or not a new capsize dry bulk in order to lease the vessel throughout its useful life or up to its 15th year of operations as indicated in the company’s policy.
Summary of Facts
The decision to acquire or not to acquire the dry bulk carrier for chartering must be based on a careful analysis of elements that will directly influence the profitability of the project. The profitability of the project will rely heavily on the location of the firm due to tax purposes. Furthermore, the decision to undertake such a project depends on both the short-term and long-term outlook of the bulk carrier industry which will surely influence chartering rates, and finally, our decision depends on the accounting rules and company policies regarding the operation of Ocean Carrier vessels. In case of acquisition, the choice of keeping the vessel in service for 15 or 25 years and how to dispose of it at the end of this period, depending on the net present value (NPV) of the investment and on the assumption of a steady cost of capital equal to 9%. In conclusion, the firm should reject any project with a negative NPV and undertake the project with the highest NPV.
Analysis & Recommendations
To assess the profitability of the project it is necessary to understand what drives the daily hire rates charged to the clients. Daily hire rates are determined by supply and demand. The total supply of capsizes (i.e total number of ships available) is given by the vessels in service plus any new vessel delivered minus any scrapping or sinking. Supply is mainly affected by the technological improvements the nautical industry can incorporate, with newer ships getting bigger and more fuel efficient, fewer vessels were needed to transport the same amount of cargo. The demand for capsizers is mainly affected by the performance of the world economy, especially of the basic industries. Furthermore, demand is also dependent on the trade patterns since the demand for capsizes increases the longer the distance of the trade route. Together with supply and demand, the age of the vessels is also an important determinant of the daily hire rate. As evidenced in Exhibit 4, newer vessels earn a premium with respect to the average market daily hire rate. As the age of the vessels increases, the daily hire rate progressively decreases. We can expect decreasing charter rates in 2001 and 2002 due to stagnant imports of coal and iron ore together with the delivery of 63 new vessels. Starting from 2003, the beginning of Australian and Indian iron ore exports, joined by expected sustained growth in worldwide shipments of iron ore together with a downward trend in the delivery of new capsizes will certainly place upward pressure on the charter rates.
Aware of the industry environment and exogenous determinants, we evaluate the investment opportunity using the NPV method. We assume the possibility of choosing where to base the project, whether in the USA or in Hong Kong, without incurring in particular costs1, and that the internal policy of not operating ships older than 15 years is still valid. The minimum redeemable amount of money at the end of 2017 is given by the scrap value of 5 million dollars. The NPV in New York, using the straight-line depreciation method2 and a 35% corporate tax rate, is $ -6,114,639 (see blue cells in Exhibit A); on the other hand, the NPV basing the project in Hong Kong and so considering a 0% corporate tax is $ 1,284,937 (see 1 These comprehend material costs and any unforeseeable burden due to the surrounding social and political conditions 2 For the sake of simplicity we reported depreciation using the straight-line method, but the result of the analysis is substantially the same also with MACRS method orange cells in Exhibit A). Furthermore, from exhibit E, we can see that the carrier will be profitable for all 15 years of activity. Since the NPV is negative in the USA, we conclude that, if we had to pay taxes in New York, we shouldn’t purchase the carrier at all. Instead, in Hong Kong, the NPV is positive and so the investment is convenient. By referring to Exhibit B, we see that the NPV in the USA is always negative, even figuring a hypothetical sale of the ship at the residual value at the end of the fifteenth year, whereas it is always positive in Hong Kong. This conclusion is based on the assumed opportunity cost of capital of 9%. To analyze the policy of not operating ships over 15 years old, we will only look at cash flows in the case where it operates under the Hong Kong tax system. We assume that Ocean Carriers can operate the ship for 15 years, according to the policy, or for 25 years which is the ship’s useful life without the possibility of disposing of it in between these two dates. Looking at Exhibit C, the NPV of operating the ship for its entire useful life of 25 years would be equal to $2,912,230, while operating the ship for 15 years and then scrapping it for $5M would yield an NPV of $1,284,937. Therefore, Ocean Carriers’ should follow its 15-year policy if and only if it expects to sell the ship in the secondary market for a price that yields an NPV strictly greater than $2,912,230, that is, a price strictly greater than $12,042,328 3. Since Exhibit D delivers a residual value at the end of the 15th year equal to $15,600,000 (highlighted in yellow), we could reasonably assume that $15,600,000 would be a fair selling price for the ship. If Ocean Carriers managed to sell it at a price greater than the residual value, it would record a gain on disposal of assets, while if it could only be able to sell it at a lower price but still greater than $12,042,328, it would record a loss on disposal of assets. We recommend that Ocean Carriers purchases the vessel only if it bases the project under Hong Kong’s tax legislation. After acquisition Ocean Carriers should operate the vessel for its entire useful life of 25 years unless, at the end of the 15th year, it expects to sell the ship in the secondary market at a price strictly greater than $12,042,328. 3 This is the selling price at the end of 2017 that delivers an NPV equal to the one we would have in 2027.
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