Ocean Carriers

Ocean Carriers Inc.

A Case Study By ab

Introduction • Ocean Carriers Inc. owned and operated cape-size dry bulk carriers worldwide. • Major Cargo type : Iron ore. • Vessel sizes : 80000 DWT to 210000 DWT. • Cape-size carriers travel around Cape Horn rather than the Panama Canal due to size constraints.

Operations Maintenance

Maintaining Supplies And on board Stores

Supply of Lubricants

Cargo Operations

Repairs

Insurance

Business Model • Mostly chartered on “time charter ” basis for one, three , or five year periods. • Occasionally spot charter market was used too. • Charterer paid a daily hire rate for entire duration. • They controlled where the cargo was loaded and unloaded and also determined the cargo. • OC Inc. supplied a qualified crew along

Brief History • In 2003, the average daily operating costs amounted to $ 4000. • This cost increased annually at 1% due to inflation. • Charterers were not charged for days spent in maintenance and repair but operating cost were still incurred.

Maintenance Work Time Details • Initially 8 days a year for repairs and maintenance. • This time increased to 12 days per year for ships operating for more than 5 years. • For ships operating for more than 10 years the repair and maintenance days increased to 16 day per year.

Operating Policies • Ocean Carriers didn’t operate ships which were more than 15 years old. • As per international maritime regulations they underwent special surveys every 5 years for seaworthiness of the carriers. • As per the norms maintenance costs of ships older than 15 years was too high. • To avoid these costs they sold the ships in scrap or second hand market before

SWOT Analysis Strengths

Weaknesses

• New and Larger vessels compared to industry • So premium is earned compared to market

• Too much dependence on basic industries • Not much product differentiation

Opportunities

Threats

• Great demand for iron ore and coal products in a strong economy • Australian production and Indian Exports creating long term demand

• Probability of defaulting of Charterer • Future estimates not entirely reliable

Case Brief • Background: – Mary Linn, VP Finance at OC Inc is evaluating options whether to invest and if yes how to invest in the new ship to be leased in 2003

• Aim: – To evaluate the various options of capital budgeting, leasing, owning and resale of the new project

ANALYSIS

Assumptions • Ocean Carriers is a U.S. firm • Discount rate is taken to be 9% • In case of 15 year life of the ship, the resale value in 2017 is calculated by assuming that the ‘then discount rate’ would be 12% • Corporate tax rate is assumed to be 35% (Source: US Federal Reserve Data Release, 2001)

Assumptions Continued • Ocean Carriers is located in Hong Kong, where owners of Hong Kong ships are not required to pay any tax on profits made overseas and are also exempted from paying any tax on profit made on cargo uplifted from Hong Kong. • Discount rate is 9% • Inflation rate is 0.4% (Source: Central Bank of China data release, 2001)

Options Available Don’t invest in new ship

Build Operate for 15 yrs Sell off or scrap thereafter

What to choose? Build Operate for 15 yrs Sell off or scrap thereafter

Option 1: 15 Years Life • The DCF analysis of this option gives us the following results:

Option 2 : 25 years life • The DCF analysis of this option gives us the following results:

Business Implications of the analysis: Assume the company is based

Recommendations • NPVs of both the options are negative • Also, the IRR of both the options are less than the existing discount rate • As a result, we recommend that Ocean Carriers Inc. should not go for the investment in the ship • The tax rate of 35% is considerably large • The initial $39 million purchase of the new ship is never fully recovered by expected future revenues since NPV is negative in both the cases • Thus, the investment is too much of a

Business Implications of the analysis: Assume the company is based in HK

Recommendations • Considering the zero tax assumption, we can see that the NPV of both the options is positive and that for 15 year life is more than the 25 year life • Thus, assuming the company is based in Hong Kong, the company must go for the 15 year life option owing to the higher NPV

Reasons for selecting the 15 years life option • As stated earlier, the NPV of this option is more than the other • As the ship gets older than 15 years, the hire rate starts decreasing more rapidly as seen from Exhibit 4 • As it can be seen from the following graph, the hire rate reduces more rapidly after 2017

Expected Daily Hire Rate vs Age

Sell of the ship and don’t scrap • As seen in Exhibit 6, the ship has the potential to generate cash flows even after 15 years • The estimated resale value of the ship at the end of 15 years assuming that the life can be extended up to 25 years is $2,41,78,423 • This value is significantly higher than the scrap value of $5,000,000 • Also, the company has a policy of not operating the ships older than 15 years old • But, there exists a potential for selling off the ship since some other companies do

Continued…. • The current inflation was pegged at 0.4%. But, in case in the future years, say 15 years hence, if the inflation rises above 0.4%, then there would be a significant increase in the operating costs and working capital requirements • Thus, the current forecasts for 20 -25 years down the line may not hold good • Thus, even with this case it is better

Ocean Carriers Inc. should accept the 3 year contract • Amount recovered by the initial contract is $17,192,594 • Many a times, new ships may not be leased out immediately after delivery because of low demand • But, in this case, the ship can be immediately leased out: meaning it can generate cash inflows immediately on commission • Also, since the client is in utter need of the ship, he may offer the company a premium of 10-15% which is beneficial for Ocean Carriers Inc.

Our Recommendations Invest in new ship

OC Inc is HK Based

OC Inc is US Based

Operate it for 15 yrs followed by resale Accept the initial 3 yr contract for

Don’t invest in new ship

THANK YOU