Executive Summary
This report presents the capital expenditure analysis for Ocean carriers proposed $39 million investment. The analysis indicates that the project has a negative NPV and that the IRR is lower than 9%. This was found for both USA and Hong Kong and for both 25 years life and 15 years life. The company should not invest in the project in both tax jurisdictions the company should also review the tax inversion option regardless of the acceptance of the project. Lastly, the company should review the policy to hold vessels past 15 years for other projects and consider the environment of changing market conditions in the analysis.
Summary of Facts
This reports presents the analysis if Ocean Carriers case study. The case is analyzed in light of two tax jurisdictions. The first is in the United States where the corporate taxes stand at 35%. The second jurisdiction is Hong Kong where the corporate taxes are presumed to be 0%. Ocean Carriers has a policy of not operation ships older than 15 years due to the high cost of operations and maintenance. Ships are therefore scrapped for a terminal value of $5 million.
The rate of inflation used in this case study stands at 3% throughout the life of the project. The company is expected to grow at an annual rate of 2% for the years 2002 to 2004. The growth rate is expected to be at a constant rate of 1.5% thereafter. Variable costs in this case are the daily expenditures which amount to $4,000 per day. These operating costs are expected to increase by a rate of 4% annually which is inflation plus 1% premium. The costs are incurred on a daily basis.
The project should be treated as an independent project. The cost of acquiring ship includes the initial cost of $39 million. 10% of the cost ought to be paid in 2001 and 10% in 2002. The remaining 80% must be paid in 2003. The working capital injection stands at $500,000. Other outflows include the special survey costs applied which are incurred after every five years. The special surveys are cost intensive and consequently, the costs are capitalized over the five years following the survey. The company would only incur these second for 2007 and 2012 periodic surveys as $300,000 and $350,000 for the two years respectively. For all the analysis, the discounting rate used is 9%.
Ocean Carriers is considering investing in a new ship. The reason for investing in the new ship is because a customer has approached the company indicating interest in leasing the new ship. However, the client will only lease the new ship for only 3 years between January 2003 and December 2005. The company is not sure about the economic environment after the first three years and it is not even sure whether it will even be possible to lease the new ship. The company requires to conduct capital expenditure analysis to determine whether or not it should invest in the new ship using IRR and NPV (Burksaitiene 2015).
Analysis and Recommendations
In order to determine whether or not Ocean Carriers should invest in the new ship, we computed the annual cash flows for each of the two regions which are Hong Kong and USA. The cash flows were computed by aggregating the daily spot hires, the daily operating expense, the annual depreciation, and the capitalized annual survey expenditures. The cash flows were then determined using the 0% tax rate for Hong Kong and 35% tax rate for USA. The decision was reached using IRR and NPV (Johnson 2013)
The analysis indicates that the daily spot hires are expected to decrease from $15,344 in 2000 to $14,747 in 2001. The daily spot hires will however rebound in 2002 to a level of $15,072 in 2002. The following table shows the expected daily spot hires for the 25 years which is the life of the project. The daily spot hire rates are presented alongside the expected rates if Ocean Carriers adopts the projects. These rates were used in the computation of the expected revenues.
Factors Driving Average Daily Hire Rates
The average daily spot hires are determined mainly by the forces of demand and supply. He number of capsize ships is rather rigid. This means there are a limited slots every day where customers can ship their cargo. As a result, the daily charges are determined by the demand for the limited number of ships with day of lower demand having lower rates and days of high demand having high demand. Some investors charter the ships to hedge against the likelihood of adverse fluctuations in charges and depending on their need for the services.
Characterization of the long-term prospects of the capsize dry bulk industry
The cap-size dry bulk industry prospects are determined by the global economic environment. The environment is looking up with the expectations of increased production of iron ore in India and in Australia. Consequently, the company should expect that in general the business will improve over the years. Considering that global economic growth is also stable, the company should expect to get more business in the long-term. Nonetheless, company must not use this information solely in making the decision as to whether or not it should invest in the new ship.
Should Ms Linn purchase the $39M capsize?
In both the USA context and the Hong Kong context where the tax rates stand at 35% and 0% respectively, the company should not invest in the new ship. The decision holds for both the 15 years life and 25 years of the new ship. This is because analysis of the company’s expected cash flows indicates that the company will incur losses if it invests in the new project. This is because the analysis resulted in negative NPV and also negative IRR which was lower than the 9% WACC. These findings are as summarized in the table below. Both IRR and the NPV were computed using excel functions.
The following table shows all the items and procedures used in the computation of the IRR and NPV values.
My opinion on the company’s policy of not operating ships over 15 years old
Based on the analysis above, I am of the opinion that the 15 years helps the company in cutting loses including the special survey costs and the losses inherent in the reducing daily hire prices. However, this does not have implication in the case of the proposed investment in the new ship. This is because the company is set to have negative NPV within the period of 15 years in both USA and Hong Kong where the rate of taxation is 0%. As the rule of thumb, the project should be rejected if the IRR is lower than the WACC and if the NPV is negative. The law passes for the situation in this case (Keca, Keca, and Pantic 2012).
Bibliography
Burksaitiene, D., 2015. Measurement of value creation: Economic value added and net present value. Economics and Management, (14), pp.709-714 (http://www.socsc.ktu.lt/index.php/Ekv/article/view/9461)
Johnson, C.H., 2013. Measure Tax Expenditures by Internal Rate of Return. Tax Notes, Special Report, April, 15. (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2253291)
Keca, L., Keca, N. and Pantic, D., 2012. Net present value and internal rate of return as indicators for assessment of cost-efficiency of poplar plantations: a Serbian case study. International Forestry Review, 14(2), pp.145-156. (http://www.bioone.org/doi/abs/10.1505/146554812800923345)
