Ocean Carrier's Financial Management - Case Study Example

PART I: EXECUTIVE SUMMARY The Vice-President of Ocean Carrier for finance is confronting with a huge investment decision that needs to be evaluated immediately in order to meet a customer’s requirements. The customer is willing to charter a ship for a period of three years on attractive terms, but the company does not have any ship available that could meet his needs. Therefore, it will need to purchase a new ship in order to accept the project. As the investment is heavy and the contract is supposed to be for three years, its feasibility needs to be analyzed in the light of expected hire rates that could be generated for the whole life of the ship. The analysis of market conditions leads to the anticipation of a rise in demand for the ships in future. Some significant risk factors are also operative concerning the unexpected changes in market and economic conditions, and most importantly the risk concerning whether or not the customer will honor the contract for the proposed time period. The attractiveness of investment that is needed to purchase the ship and bear the costs is evaluated with the help of Net Present Value (NPV) model based on hire rates expected in future. The analysis of NPV suggests a positive result, which implies that it is feasible for the company to purchase the new ship and accept the customer’s proposal. PART II: DETAILED REPORT Statement Of The Problem Under Consideration The Vice President of Finance for Ocean Carriers has received an attractive proposal from a prospective customer who wants to lease a ship for the period of three years from the company. The customer, his offer and contract terms are all feasible, but the problem is that the company does not have any ship available at that time to meet the customer’s unique needs. Therefore, the company needs to urgently purchase a new ship so as to fulfill the customer’s request on time, or on the contrary reject the customer’s proposal. Situation Analysis The problem underlying the case is not merely concerning the acceptance or rejection of the lease proposal by the customer. As the company cannot meet the customer’s demand simply with any of the available ships, it either needs to purchase a new ship matching the customer’s needs or to reject the proposal altogether. This does not concern the company with a single moment of thought regarding a new investment. The problem basically lies in investigating and analyzing the attractiveness of the customer offer against the investment that the company needs to make in this project. The crux of the issue is whether or not the company should purchase the new ship, which is necessary if Ocean Carrier wants to accept the proposal of this customer; otherwise the company will have to forego the attractive return offered. Secondly, the customer is willing to contract the ship for a period of three years, while the life of the ship would be 25 years. However as per the company’s policy, it utilizes a ship for no more than 15 years of its operations. Therefore, the investment in this new ship exclusively for this customer’s request needs to be analyzed in the perspective if the market environment is feasible for the purchase of new ship and that the ship can be used to generate returns for the company throughout its useful life. Alternative Solutions That Need To Be Examined The alternative solutions that need to be analyzed in the case simply concerns two dimensions: If the customer’s offer is attractive enough for the purchase of new ship and that the investment required to be made in the new project is feasible enough considering the market conditions and demand for the ship, the company can go for the contract and purchase the new ship immediately to provide it to the customer on time. On the contrary, if the analysis reveals that the investment in purchasing new ship is not feasible as against the customer’s proposal, the expected market condition and the future demand patterns, the company should decide not to accept the customer’s request or invest in the project. Decision Criteria The criterion of decision to be taken by the company concerning the customer’s prospective contract rests on the evaluation of feasibility of investment that is supposed to be made by the company in purchasing a new ship that could meet the customer’s demands. Hence, this evaluation of investment attractiveness is the criterion on which the Ocean Carriers will decide whether to purchase a new ship or not. The feasibility of this millions of dollars of investment can be analyzed in the light of this customer’s proposal i.e., hiring rates and terms etc. Also, as a matter of fact, the customer would lease the ship for a period of three years; therefore, an analysis of investment attractiveness has also been done considering the expected market and industry conditions for the whole useful life of the ship. The data for daily hire rates for the whole life of the ship has already been obtained by the company’s Vice-President. This date (see exhibit 1) will be used to calculate and analyze the cash flows and net present value of the investment. The NPV result will go a long way for the company in taking the decision concerning the purchase of new ship (See exhibits 6 and 7). Analysis Of Industry And Market Demand Trend Ocean Carriers belongs to the shipping industry based in the United States. The prosperity of this industry is mainly reliant upon the trading patterns between United States and the customer countries, demand and supply of major products for which the ships are used, economic conditions and also the fluctuations in spot charter rates. The two forces of supply and demand determine the daily hire rates that the shipping companies receive, which of course are subject to variation. The variations in supply and demand forces are precipitated by a number of factors that are operating in an economy. The daily hire rates increase with a rise in demand for ships and vice versa. The rates are also affected by the supply or availability of ships in the market. If following a rise in demand and strong market conditions, the shipping companies are able to increase their supply, this will cause the rates to shift downwards. However, increasing the supply implies increasing the number of ships, which is not always possible in the short-run because of the time required to build or purchase a ship. Also, the supply is affected by the advancement of shipping technology i.e., as more new and fast ships are available in the market, less number of ships need to be supplied. The demand for ships in the market are affected by the trading patterns between United States and other countries, trading of major commodities such as iron ore and coal. The daily hire rates are also determined by the fluctuations in spot charter rates, however the company charters its vessels on a “time-charter basis” that fluctuate less than the spot rates. An analysis of the trade and market pattern reveals that a strong growth is expected in the exports of iron ore and coal that is likely to have a positive impact on the demand for ships and the daily hire rates. However, it is also likely that the number of bigger, better and faster ships might also increase, balancing the impact of the expected rise in demand. Risks Faced The company confronts several risks that come along with this investment in the new ship related to market, industry, and environmental factors. These are assessed and analyzed below: If the company enters into contract with the customer, the risk is there because the ship will have to be purchased before the beginning of year 2003 and delivered to the customer for a period of three years. At that time, Ocean Carriers would have made all the investment in purchasing the ship. In the meantime, if the customer changes his minds and does not honor his contract with the company. Even after the delivery of the ship, there is a risk that the charterer will stop paying half way through the contract period or before the contract terminates. If any such thing happens, the company will have to face severe losses. The risk also lies in market and demand conditions. Even if the customer does honor his contract and completes the agreed 3-year period of time, the market conditions may change. For example any change in the trading patterns of countries as well as political situations going against the shipping industry would lead to losses. Although, the demand and trading patterns for shipping industry seem favorable but any further increase in the number of new and better ships during the span of these years would cause the anticipated earnings to fall down. Evaluation Of Each Alternative Solution Against The Decision Criteria The evaluation of each alternative solution, as mentioned above, is based upon the calculation of net present value, which is one of the best methods to analyze the attractiveness of an investment. The evaluation of the two alternatives is given as: The analysis of the net present value (see exhibit 6 and 7) of the investment reveals that purchasing the new ship and accepting the customer’s offer is a feasible option for the company. Based on the figures of expected daily hire rates (see exhibit 1), the company will not only be profiting from the rates offered by the customer, but also be able to utilize the ship for all its life. The second alternative, which was about the decision to reject the customer’s proposal and not go for a purchase decision is also evaluated in the light of the NPV analysis. As the customer’s proposal is attractive and the net present value of the investment is also positive, this alternative is not attractive as compared to the first one. Selection Of The Best Alternative As Recommended Solution After an in-depth analysis and evaluation in the light of financial models, the best alternative that can be recommended is that it is feasible for Ocean Carriers to purchase the new ship and accept the customer’s proposal. Assumptions made There are two basic assumptions made for the analysis of this case: The tax rate has been assumed to be 10% The discount rate has been assumed to be 15% Statement Of Results- Net Present Value This is an analysis of the results obtained from the calculation of net present value: The result of net present value is positive (see exhibit 7), which reflects that the project is worth investing in and whatever the company would expectedly receive from this investment i.e., from the customer’s proposal and also from the whole life of the ship in future has a positive value today. Hence, the NPV analysis suggests that it would be profitable for the company to invest in the purchase of new ship and accept the proposal. Limitations Of The Analysis The first and foremost limitation of analysis is that it is based upon assumptions and expected values. For instance, the discount rate, which is an important aspect of NPV analysis had to be assumed. The results are likely to vary with a different discount rate The second significant limitation of the above analysis is the lack of any data concerning the alternative investment opportunity for the company so as to evaluate it against this investment project. Exhibit 1 Annual Hiring Rates Based on Expected hire rates per day 2003 2004 2005 2006 2007 2008 $7,300,000 $7,373,000 $7,446,000 $6,830,610 $6,308,295 $6,380,565 2009 2010 2011 2012 2013 2014 $6,453,930 $6,528,390 $6,603,580 $6,361,220 $6,434,220 $6,508,315 2015 2016 2017 $6,583,140 $6,658,695 $5,388,130 Exhibit 2 Annual Operating Costs for 15 Years 4000 per day (4000 x 365) Expected Inflation= 3% 2003 2004 2005 2006 2007 2008 $1,460,000 $1,503,800 $1,548,914 $1,595,381 $1,643,242 $1,692,539 2009 2010 2011 2012 2013 2014 $1,743,315 $1,795,614 $1,849,482 $1,904,966 $1,962,115 $2,020,978 2015 2016 2017 $2,081,607 $2,144,055 $2,208,377 Exhibit 3 Depreciation Cost Of The New Ship = $39,000,000 Useful Life Of The Ship = 15 years (as per company policy) Scrap Value after 15 years = $5,000,000 Depreciation Method = Straight Line (Cost- SV/ life= 39,000,000-5,000,000/15) 2003 2004 2005 2006 2007 2008 $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 2009 2010 2011 2012 2013 2014 $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 2015 2016 2017 $2,266,667 $2,266,667 $2,266,667 Exhibit 4 Change in working capital year-wise Increase in Accounts Payable = $3,900,000 Initial Investment in net working capital = $500,000 Expected Inflation = 3% Change in first year = $500,000-3900000= -3,400,000 15- year Analysis for Changes in Working Capital 2001 2002 2003 2004 2005 2006 -3,400,000 -3,385,000 3,930,000 11,318,000 18,779,000 18,794,000 2007 2008 2009 2010 2011 2012 18809000 18,824,000 18,839,000 18,854,000 18,869,000 18,884,000 2013 2014 2015 18899000 18,914,000 18,929,000 Exhibit 6 Cash Flows *Considering Expected Inflation =3% 2003 2004 2005 2006 2007 Hire Rates* $7,519,000 $7,594,190 $7,669,380 7035528 6497543 Less: Operating Costs $1,460,000 $1,503,800 $1,548,914 $1,595,381 $1,643,242 Less: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 Operating Income BT $3,792,333 $3,823,723 $3,853,799 $3,173,480 $2,587,634 Tax (10% assumed) $379,233 $382,372 $385,379 $317,348 $258,763 Operating Income AT $3,413,099 $3,441,350 $3,468,419 $2,856,132 $2,328,870 Add: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 Cash Flows $5,679,766 $5,708,017 $5,735,086 $5,122,799 $4,595,537 2008 2009 2010 2011 2012 Hire Rates* $6,571,981 $6,647,547 $6,724,241 $6,801,687 $6,552,056 Less: Operating Costs $1,692,539 $1,743,315 $1,795,614 $1,849,482 $1,904,966 Less: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 Operating Income BT $2,612,775 $2,637,565 $2,661,960 $2,685,538 $2,380,423 Tax (10% assumed) $261,277 $263,756 $266,196 $268,553 $238,042 Operating Income AT $2,351,497 $2,373,808 $2,395,764 $2,416,984 $2,142,380 Add: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 Cash Flows $4,618,164 $4,640,475 $4,662,431 $4,683,651 $4,409,047 2013 2014 2015 2016 2017 Hire Rates* $6,627,246 $6,703,564 $6,780,634 $6,858,455 $5,549,773 Less: Operating Costs $1,962,115 $2,020,978 $2,081,607 $2,144,055 $2,208,377 Less: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 Operating Income BT $2,398,464 $2,415,919 $2,432,360 $2,447,733 $1,074,729 Tax (10% assumed) $239,846 $241,591 $243,236 $244,773 $107,472 Operating Income AT $2,158,617 $2,174,327 $2,189,124 $2,202,959 $967,256 Add: Depreciation $2,266,667 $2,266,667 $2,266,667 $2,266,667 $2,266,667 Cash Flows $44,252,84 $4,440,994 4,455,791 $4,469,626 $3,133,923 Exhibit 7 Discount Factor Assumed @ 15% Year Cash Flows Discount Factor (15%) Present Value 1 2003 $5,679,766 0.870 4,941,396 2 2004 $5,708,017 0.757 4,320,968 3 2005 $5,735,086 0.658 3,773,686 4 2006 $5,122,799 0.572 2,930,241 5 2007 $4,595,537 0.497 2,283,981 6 2008 $4,618,164 0.432 1,995,046 7 2009 $4,640,475 0.376 1,744,818 8 2010 $4,662,431 0.327 1,524,614 9 2011 $4,683,651 0.284 1,330,156 10 2012 $4,409,047 0.247 1,089,034 11 2013 $4,425,284 0.215 951,436 12 2014 $4,440,994 0.187 830,465 13 2015 $4,455,791 0.163 726,293 14 2016 $4,469,626 0.142 634,686 15 2017 $3,133,923 0.123 385,472___ Net Present Value: $30,986,916 References Arnold G (1998), “Corporate Financial Management”, First edition (Financial Times Pitman Brealey R.A. and Myers S.C. (2000), “Principles of Corporate Finance”, McGraw-Hill Puxty, A.G. and Dodds, J.C. (1991), “Financial Management, method and meaning”, Chapman and Hall. London Read More