Ocean Carriers

Problem statement

In January 2001, Mary Linn, Vice President of Finance for Ocean Carriers, was evaluating a proposed lease of a ship for 3 years, beginning in 2003. Linn considered if the company should commission a new vessel and then lease it to the customer.

Assumptions

The evaluation of the project is heavily based on the Net Present Value (NPV) method, which will be explained comprehensively in the “Analysis” section. Before quantifying the arguments, we have to make several assumptions regarding:

1. Future economic environment

Yearly inflation rate is anticipated to be constant at 3%. Scrap value of vessel at the end of 15 years will be $5M and is expected to grow with inflation rate thereafter6. Fair resale value of the vessel after 15 years is assumed to be the present value of all cash flows thereafter as if the ship operates up to 25 years. Average daily hire rates are driven by the demand for iron ore shipping and supply of new ships in the industry. Industrial expected spot hire rates are projected to go up as worldwide iron ore vessel shipment is expected to increase in the long run, holding supply of ships constant.2 (There is no proper way to estimate industrial supply of vessels) Hire rates for individual ships are adjusted by adding a premium or subtracting a discount depending on the age of the ship.

2. Future cash flows

Yearly operating cash flow for new ship in 2003 is expected to be 4000 per day, with a projected rate of annual increase of 1% above inflation. Forecasted daily hire rate computed by consulting firm given in Exhibit 6 is assumed to be fairly accurate. Net working capital (NWC) is also expected to grow at inflation rate. Straight-line depreciation method is used to allocate ship costs and special survey costs throughout their economic life. All future cash flows will happen and be stated at year-ends.

3. Discount rate

Cost of capital of 9% is taken as the discount rate for the calculation of NPV....