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Summary of facts

In January 2001, Mary Linn, vice president of Finance for Ocean Carriers, had to
decide whether to accept an offered leasing contract for the duration of three years.
In the event of acceptance of the above-mentioned contract, the profits of the
company would depend on the agreed hire rates, operating costs, ship depreciation
and inflation. After the closure of the contract, further income would be evaluated
based on expected market daily hire rates.
Problem
The duration of the leasing contract is quite short so the company has to analyze
whether the investment as a whole will prove to be profitable even after the closure
of the contract. In order to do so, they will have to take into account the fluctuations
of the daily spot rates in the short and long terms, as well as existing differences in
taxation policies within its offices in Hong Kong and in the United States. Last but
not least, the company has to question the tenability of its 15-year policy.
Analysis
Spot hire rates
Daily spot hire rates are predicted to fall in 2001 and 2002 due to an increase in the
fleet size (63 new vessels are scheduled for delivery) and expected stagnation in
iron ore and coal shipments. Iron ore and coal imports are very important for the
company because they are about 85% of the cargo it carries every year. Therefore,
due to this future stagnation the company will face a weak market position,
resulting in lower daily spot hire rates.
Overall investment
Despite negative market conditions in the upcoming 2 years, long-term prospects
look much more promising. Iron ore vessel shipments are going to increase due to
new players joining the iron ore industry: India and Australia. As a consequence, in
this new global market, daily charter rates and spot daily charter rates will probably
rise producing additional demand for shipments.
Companys 15-year policy
The company used to scrap or sell ships just before their 15th year of navigation to
avoid paying for maintenance expenses related to the 3rd special survey.
According to our calculations presented in the Exhibit 2, scrapping the vessel before
the 15th year is not recommended. Results show that the NPV of a ship after 15
years is higher than the scrap value of 5 million dollars. Thus, we advise the
company to keep the ship longer than 15-year period, since operating the vessel
over a longer period will earn additional profit and the ship can be scrapped some
time later, granting the same million dollars.
However, there are few factors that signal why company might be willing to get rid
of the vessel. Firstly, if the companys priority is to keep a young fleet of cargo
ships, operating ships older than 15 years may not be the optimal choice. In fact,
older ships are riskier and are less efficient.
Secondly, due to low demand for older ships, leasing the same vessel in future
might be an ineffective venture.
Investment decision
We computed two separate calculations for given two assumptions in Exhibit 2.
According to assumption A the company operates in United States, thus has to pay
35% of taxes, whilst according to assumption B, company operates in Hong Kong,
and its exempt of taxes. Our calculations show that NPV in the first scenario is
negative in both 2017 (-6,350,239) and 2027 (- 4,285,462) due to very high taxes,
while in the second scenario the NPV is positive in both 2017 (1,719,018) and 2027
(4,025,600).
Recommendations
In conclusion, keeping in mind what we demonstrated before, the company should
invest in the production of the new vessel only in Hong Kong and should not scrap it
after 15 years, because its NPV will still be positive.