Ocean Carries Financial Management - Case Study Example

OCEAN CARRIERS CASE ANALYSIS (Author’s name) (Institutional Affiliation) Executive summary Ocean Carries vice president, Mary Linn is faced with an investment problem of whether to purchase a new capesize vessel that is required by a charterer over the next three year period. Linn should decide whether it is profitable to purchase the capesize or refuse the terms of the lease. This paper presents the methods that will help Linn make her investment decision on the purchase of a new capesize. These methods are in line with the current trends in capesize dry bulk industry. The projections clearly analyze the current and future market trends based on historical data and current market trends. This study has shown that the purchase of a new capesize would only be profitable if the firm were to purchase a new capesize that would not be sold as scrap but kept till it has no salvage value. Mary Linn should consider the possibility of amending company policy of scraping off capesizes that were older than fifteen years. As shown by the NPV of the vessel, it would be more profitable if the capesize were to be bought and maintained through its twenty five year period. The results of the analysis show that should the company fail to change its policy then, it is more likely that it would be running at losses in the short run which would lead to long term financial problems for the firm. This study shows that the operation base would not matter if the firm were to continue with its current trend of scraping off the ships after fifteen years. Question one: factors driving spot hire rates Spot hire rates are mainly determined by the market demand and supply forces. The demand for capesizes is influenced by production levels, size of capesize, changes in trade patterns and age of the capesize. A change in production levels of goods that required dry bulk capesizes would lead to a shift in capesizes would be needed to transport the products. An increase in production levels would mean that, more capesizes would be hired to cater for the increase. This, in turn, would increase the rates for spot hiring. The size of the ship also determined the demand for the ship. Larger capesizes attract more charterers as their capacity is higher than those of smaller capesizes. A bigger capesize has higher operating expenses, keeping other factors constant. Thus, to cater for this increased operating cost by the owners spot charges rise. The age of the capesizes determined how the capesizes were leased. Newer cape sizes attracted higher spot rates with premiums of up to 15%. On the other hand, older capesizes were leased out at lower spot rates, and at a discount of up to 35%. This difference in the spot rate charges of capesizes is attributed to the fact that newer capesizes are more efficient than older ones in terms of operating expenses, mileage coverage and loading capacity. Trade patterns. A change in movement of the products would highly affect the demand for capesizes. The distance covered by capesizes, significantly influence how the spot rates are determined. Longer distances, generally, call for higher spot rates. The demand for iron ore might not change with the change in trade patterns. However, there will be increased demand for vessels as the charterers would like to use the ships for a longer of time. These charterers would also like to be in possession of the vessels as soon as possible, so as to avoid missing one or to be able to rent a berth place a soon as they can. The number of capesizes greatly influenced the spot charter system. A great number of capesizes meant that the supply would be high, therefore, with a low demand, the owners of the capesizes will be forced to lease out their vessels at lower rates. This is in line with the law of demand and supply. The number of vessels in a given year equals the number of vessels in the previous year less scrapped plus the new fleet. This means that if there are more vessels being ordered with less scrapping then there would an overflow of vessels thus reducing the hire rates to a much lower level. There is an expected delivery of a large fleet of vessels, 63, by Ocean Carriers next year. The iron ore market and production will be stagnant for the next two years. This increase in the size of capesize fleets and stagnation in the iron ore production and market would generally mean that, there will be higher supply of vessels whose demand will be low. This shift according to the laws of demand and supply prompt the spot charges to go down. Question 2: prospects of the capesize industry Most businesses are of the going concern nature. Therefore, market conditions greatly affect the businesses in how they invest or plan their businesses (Groppelli & Nikbakht 2006). According to the consulting firm that ocean carriers hired to look at the prospects of the dry bulk industry, the industry is headed to a good phase.Historically the charter business has been expanding. According to statistics, this industry runs on historical events. Looking at the figures from the company documents it is observable that the average pricing has been on the rise for the past seven years. The average spot prices have increased from an average of $16,851 in 1994 to $22,575 in 2000. The average three year charter rates have been dropping from a high of $18,544 in 1995 to a low of $15,344 in 2000. This drop in average three year charter pricing can be attributed to the fact that most charterers, are not willing to be bound by the contracts of the three year chartering, considering that the forces of demand and supply would affect future industry and thus alter the pricing to a much cheaper affordable rate. The change in trade patterns is expected to, highly; influence the trends of the industry. The collapse of India as the major exporter of iron ore, and the expected increase in the Australian production highly means that the dry bulk capesize business will experience a boom. This is because there will be high production in Australia which is a long way from America. This difference in distance calls for charterers to increase their orders in fleet numbers so as to be able to deliver the required quantity at the right time. This would mean excellent business as most of the vessels are less than “five years old”. These younger vessels are priced at higher rates than the older ones. Therefore, owners will be able to acquire higher profit rates as they will incur less maintenance costs and charge high prices. This income level increase will prompt charter companies to increase their fleet. This has been clearly shown by the long-term forecast of Ocean carriers shipping company, which predicted an annual growth in the industry by 2% for the years 2002 to 2005, and 1.5% hence forth. This 3 year period of 2% growth is the time that charter companies will be building their new capesizes. Question 3: table of analysis The table below shows some of the items necessary for the detmination of the cash flows that would eventually lead to decision making by the company manager Item method Revenues Daily hire rates Operating expenses (opex) Initial operating expenses*365*(1+interest rate)t Depreciation (initial cost – salvage value)/ years Tax Tax rate is zero Capital expenditure(capex) Anticipated capital expenditures /depreciation Change in working capital Net working capital - initial working capital After tax profit for sale of equipment Total revenues-depreciation Cash flow revenue – capital expenditure –change in working capital + depreciation Net working capital (NWC) = initial working capital (IWC) * (1.04)t Where t = time period from 2003 The cost of the ship is 39 million which will be paid in instalments of 10% immediately (2001), another 10% the following year (2002) then the rest of the money on delivery. Therefore, the expected pay for the ship on delivery (2003) is; =Initial cost price * (1-downpayment rate) =39000000 * (1-0.2)=31,200000 Depreciation of the vessel is calculated on a straight line basis over the vessels life period. Thus, the expected depreciation values would be, from 2003; Depreciation = (cost price – salvage value)/years Dep = 39000000 – 5000000)/25 = 1,560,000 The operating costs (OC) are calculated at the actual interest rate (inflation rate + 1% increase) per annum. Therefore, the operating costs figures would be calculated as OC = initial OC * days in a year * nominal interest rate OC = 4000*365*(1+.04)t = 1,460,000(1.04)t Where t=future time – 2003. The company is based in Hong Kong where the tax rates are zero rated. This means that the company will save on it tax exemptions. As the company has a policy of disposing off its vessels, which are over fifteen years. This means that this vessel would only be surveyed twice (2007 and 2012) where its survey costs are expected to be $300000 and $350000. These capital expenditures will be depreciated at 5 year periods hence for the first five years the capital expenditure would be; Capital expenditures in 2007 = 300000/5 = 60,000 Capital expenditure in 2012 = 350000/5 = 70,000 The daily charter rates are expected to stagnate between the period of 2001 and 2002. But, they are expected to increase hence forth. Notably the charterers are not charged the daily spot charges for the period the vessel is undergoing maintenance. The charterer is willing to pay a daily spot charge of $ 20,000 which would then escalate by a $200 annually. Therefore, the annual revenues are expected to be; Yearly revenues = spot charges - operating expenses Spot charges(2003) = 20000 * 357 = 7140000 The operating cash flows (OCF) of the business are calculated as follows OCF = 7140000+1560000-60000-500000 = 8140000 Summary of figures From the above presentation the following data can be acquired year item 2001 2002 2003 2007 Operating expenses 0 0 1,460,000 1707993.50 Depreciation 0 0 1560000 1560000 Cumulative depreciation 0 0 1560000 7800000 Net working capital 0 0 500000 579637.04 Change in working capital 0 0 (500000) 16882.63 Capital expenditures 0 0 60000 300000 revenues 0 0 7140000 6170031 Cash flows (39000000) (39000000) 8140000 13653148.37 The figure above is prepared with the following in mind Inflation = 3%; tax rate = 0% Tax rate is zero since the company is based in Hong Kong Estimating the Net Present Value of the Business The NPV is the sum of present values (PVs) of an individual business entity over a given period of time. Using excel it is possible to calculate cash flows. This is possible by knowing the interest rates. Generally to get the NPV the following formula is to be used NPV = initial cost on capital – {operating cash flows/ (1 + discount rate)t } The ratio of operating cash flows over (1 + discount rate) is the present values calculated over a period of time t. calculating the net present value Initial cost of capital = (39000000) Discount rate = 9% Inflation rates = 3% NPV is calculated for the 15 years and a full term of 25 years. Using the values from an excel worksheet then the NPV is ($1,252,915.52) for 2017 and $496,211.75 for 2027. These cash flows are based on the given data and considering that the firm operates in Hong Kong where the tax rate is zero rated. Knowing that the firm operates in Hong Kong and there is no tax rate, the calculation of NPV is based on the given data using a five year straight line depreciation method. The NPV is calculated, considering the vessels salvage value of $5 million, to ($1,252,915.52). This is the case, if the firm decides to scrap the vessel after 15 years. If the firm decides to keep the capesize till it has no salvage value then the NPV changes from a negative to a positive NPV of $496,211.75. This NPV values mean that it would be more profitable for Ocean Carriers to invest on the capesize then keep it for its entire “lifetime”. NPV values generally show the future cash flows discounted to presented values. Therefore, a negative NPV means that the investment would be a loss if it were invested in today. Based on these values the Linn should consider ordering the new 180,000 ton vessel. This should only happen if the company is willing to hold on to capesize till its value is equal to the scrap value of $5 million. Otherwise, the company will run at loss, despite the fact that, it is not being taxed for its activities in Hong Kong. Considering discounted cash flow values I would advise the Linn to invest in the capesize only if it were to keep it for 25 years else she should turn down the proposed lease from the willing charterer. Company policy The company has a policy of disposing of its capesizes once they hit the fifteen year working period. This scrap value of the capesize is valued at $5million.the company also calculates its depreciation in a straight line method meaning that the accumulated depreciation after fifteen years would be $23,400,000. Cumulative depreciation = 1560000*15 = 23400000 This means that if the firm wants to sell its should sell it at 39000000 – 23400000 = 15600000 At the current scrap value, the firm is will run at a loss of $10600000. As the NPV values agree with this by showing that if the the company scraps of this vessel after fifteen years it would run at a loss. The NPV value after twenty five years is $496,211.75. meaning that if the firm were to keep the capesize for the full period then it would bear profits by buying the capesize now. But if it decides to abide by company policy it would run at a loss. The net NPV shows that despite the fact that operation costs and other maintenance costs would go up with the aging of the capsize and its long term effects would be a positive. My advice to Linn is set up new policies concerning the scrapping of vessels. The company should abandon its present policy of scraping off ships after fifteen years and consider maintaining the capesize for a maximum period so as to benefit from its use. Reference GROPPELLI, A. A., & NIKBAKHT, E. (2006). Finance. Hauppauge, N.Y., Barron's. Read More