Ocean Carriers Inc.

A Case Study

By Vaibhav Brajesh

Introduction
Ocean Carriers Inc. owned and operated capesize 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

Cargo Operations

Repairs

Supply of Lubricants

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 with a seaworthy carrier which complied with international norms.

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 didnt 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 the third survey.

SWOT Analysis
Strengths
New and Larger vessels compared to industry So premium is earned compared to market

Weaknesses
Too much dependence on basic industries Not much product differentiation

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

Threats
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
Dont invest in new ship

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

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:
Model NPV at 9 % disc rate IRR

With tax(35%) US based

Without tax HK based

($37,95,134)

7.08%

$84,73,934

12.94%

Option 2 : 25 years life

The DCF analysis of this option gives us the following results:
Model With tax(35%) US based Without tax HK based NPV at 9 % disc rate IRR

($44,94,824) $78,88,144

6.88% 12.44%

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

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 financial burden for Ocean Carriers Inc.

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 dont 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 operate with ships older than 25 years of age as seen from Exhibit 2

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 to opt for a 15 year life of the ship followed by its resale

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. Thus, it is profitable for the company to go for the initial 3 year contract

Our Recommendations
Invest in new ship

OC Inc is HK Based

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

OC Inc is US Based

Dont invest in new ship

THANK YOU