Background

Ocean Carriers Inc. is a shipping company specializing in the operation of capsizes bulk dry carriers. In January 2001, Mary Linn, the vice President of Finance for Ocean Carriers was evaluating the purchase of a new capsize carrier for a three years lease proposed by a motivated customer. The leasing contract offers very attractive terms, but no ship in Ocean Carriers current fleet met the customers requirements. In addition, this proposed contract is only for three years. Therefore, after three years, the new capsize carrier will have to be leased to other customers. So considering in the long run, Linn had to decide whether Ocean Carriers should immediately commission a new ship which could be completed in two years. In the same time, she would have to consider if the company should still follow the policy of scrapping a vessel after 15 years, even though such vessel has a product life of 25 years.

Analysis
There are two main factors would affect the daily spot hire rates which are the number of available vessels and imports of iron ore and coal. From the Exhibit 3 of this case, we know that 63 new vessels were scheduled for delivery in 2001. This number decrease to 33 in 2002 and 21 in 2003. So we can infer that the demand of new vessels is saturated temporary. Besides, with Australian production in iron ore expected to be strong and Indian iron ore exports expected to take off in the next few years, we can infer the long-term market demand for capsizes will be optimistic, but the imports of iron ore and coal will remain stagnant over the next two years. So daily spot hire rates are expected to decrease next year. The world economy will determine the demand for dry bulk capsizes, specifically the iron ore and coal markets, since they take up over 85% of the cargo carried by capsizes. The higher the demand for these products, the higher the daily hire rates could be charged. Trade patterns will also affect the demand for capsizes, like the increase of distance between the supplier and demander will rise the demand for capsizes and the daily hire rates as well.

Considering of that Australian and Indian ore exports may begin in 2003, these new supplies will drive a high demand for capsizes. In the view of long-term, globalization boosts the development of economy so that the demand for capsizes will increase. Moreover, the increased demand for size and efficiency of ships present a new requirement for new capsizes. So the long-term prospects of capsize dry bulk industry are potential and promising. The large amount of demand for capsizes will strengthen this industry. From above, we can see that for the development of company and customer need, it is necessary for Ocean Carriers commission a new capsize carrier. But the dilemma for Ms Linn is whether Ocean Carriers should purchase new capsized now or push it back. There are two assumptions. First scenario, assume that Ocean Carriers is a U.S. firm subject to 35% taxation. The net present value will be calculated based on given data including annual operating days, daily operating costs, daily hire rates, inflation rate and discount rate. The new capsize will be depreciated on a straight-line basis over 25 years and out of being chartered 15 years later in 2017. Under this scenario, the NPV is calculated at -$7,811,354.92. See exhibit 1. Second scenario, assume that Ocean Carriers is located in Hong Kong, where owners of Hong Kong ships are not required to pay any tax on profits. Here we use same data but exempted the tax, and NPV is calculated at -$1,252,915.52. See exhibit 2. From those two scenarios, we realized that both NPVs are negative and Linn will definitely make neither investment. Since the new capsizes have 25 year life, what if we extend its service life from 15 years to 25 years. So we use same data. The NPV is -$7,273,79.78 if the firm located in the U.S. while it is $368,557.29 when the firm located in Hong Kong. See exhibit 3 & 4. Clearly, operating the new capsize for 25 years, without tax, makes it a positive investments. So Ocean Carriers should construct a new capsize with on corporate tax and chartering the capsize for its entire 25 year life. If Ocean Carriers chooses to adhere to their policy with a 15 year service life, the result will turn out to be a net loss on the investment.

Recommendation
My recommendation for Ocean Carriers is not to accept this contract with the customer. From the analysis of exhibit 1 & 2, both of the net present values are negative, so this contract will not be in the best interest of the firm. Even extend the chartering life of capsize, the net present value will still be negative if charge tax. Only when exempting tax, it is positive. But since the development of economy and customers needs, it is necessary for Ocean Carriers to commission new capsizes with bigger size and faster speed to develop the firm well. So the firm should consider extending ships chartering life. Under this condition, the firm could purchase a new capsize with a lower price and adjust the contract with an increased expected hire rate for more than 3 years.