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Nanyang Technological University

Nanyang Business School
BF322 Advanced Corporate Finance
Case Study Assignment

Ocean Carriers
Prepared for Luo Jiang Associate Professor

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Content Page
List of Illustration Question 1
Do you expect daily spot hire rates to increase or decrease next year?

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Question 2
What factors drive average daily hire rate?

Question 3
How would you characterize the long-term prospects of the capesize dry bulk industry?

Question 4
Should Ms Linn purchase the $39M capesize?

Question 5
What do you think of the companys policy of not operating ships over 15 years old?

Appendix A Appendix B Appendix C

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List of Illustration
Exhibit 1 - Capesize fleet by age category as of December 2000 Exhibit 2 - Current Order book for Dry bulk capesizes by delivery date Exhibit 3 - Daily hire rate adjustment factor for dry bulk capesizes based on age of vessel

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Question 1
Do you expect daily spot hire rates to increase or decrease next year? Daily spot hire rates are determined by supply and demand of shipping capacity. Supply of shipping capacity The supply of ships next year is the number of vessels in service the previous year plus any new ships delivered minus any scrapings.

We would expect the older vessels, especially the 2 million deadweight tons over 24 years old, to be scrapped. However, operating vessels older than 15 years, which coincides with the costly special maintenance surveys, forms only 23.15% of the entire portfolio. (See Exhibit 1)

35 30 25 20 15 10 5 0 Over 24 Years 20 - 24 Years 15 - 19 Years 10 - 14 Years 5 - 9 Years Under 5 Years On Order for 2001

23.15%

Exhibit 1 Capesize fleet by age category as of December 2000

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Most of the capacity of the worldwide fleet of capesizes are fairly young and scrapings are expected to be minimum.

Although the estimates of future orders for vessels are not entirely reliable, the degree of deviation of the projected figure for next year is likely to be small. Therefore, we can assume that there will be an additional 63 dry bulk capesizes in the market by next year. 2001 Number of vessels 63 2002 33 2003 21 2004 9

Exhibit 2 Current Order book for Dry bulk capesizes by delivery date

Given that newer ships are faster and more efficient, the additional 11 million deadweight tons of shipping capacity as shown in Exhibit 1 are expected to be more than adequate to cover for the 8 million deadweight tons of shipping capacity (20 to 24 Years and Over 24 Years) that is highly likely to be scrapped.

The case study highlights the presence of a secondhand market where Ocean Carriers are able to dispose of their ships that are nearing 15 years of service. Therefore, we can safely assume that a large percentage of the 17 million deadweight ton, under the age group of 15 to 19 years, will not be scraped and will continue to provide supply to the overall market.

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Given our analysis, there is a low downside risk to the availability of shipping capacity supply and our group concludes that the supply of shipping capacity for next year is more likely to increase.

Demand of shipping capacity As stated in the case study, Linn anticipated that Indian and Australia iron ore and coal exports are expected to take off from 2003 onwards and took a view that the imports of iron ore and coal would remain stagnant over the next 2 years, i.e. 2001 and 2002.

Commodities such as iron ore and coal are closely correlated to global growth as economic expansions require steel for construction and coal for energy. Given that the world is not experiencing a spurt of growth during 2001 as compared to 2000, we can add further weight to our argument that the demand of shipping capacity is likely to stagnant.

Since 85% of the cargo carried by capesizes was iron ore and coal, we can conclude that the demand for shipping capacity would be at a level similar to 2000.

From our above analysis, where supply is likely to increase and demand of shipping capacity to stagnate, the daily spot hire rates would decrease next year.

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Question 2
What factors drive average daily hire rate?

As discussed in Question 1, average daily hire rates are influenced by market supply and demand of shipping capacity.

Factors that influence the demand of shipping capacity Iron ore vessel shipment Coal vessel shipment World Economy Changes in trade patterns (Europe to USA as compared to Australia to USA)

Factors that influence the supply of shipping capacity Fleet size Efficiency of ships (faster transportation) Number of scrapped vessels per year Number of new ships added to the market

Operational cost of the ship will also affect the daily hire rates as it can be hypothesized that the shipping firm will pass a portion of the increase in cost to the charterer (client) so as to not wipe out their profit margin. Increases in fuel prices and overall

Page |5 maintenance cost of the vessel would affect therefore have a material impact on the daily hire rates.

However, it is to note that a majority of the factors listed above are unknown and is estimated and therefore, the underlying aspect that affects those factors is expectation of the market.

Question 3
How would you characterize the long-term prospects of the capesize dry bulk industry?

Historically, shipping industries is a high risk business as the construction of a ship is a large and expensive item which requires high capital outlay. In a world where the trade volume is highly volatile, the timing of ordering construction of new ships and scrapping old ones is extremely important.

If ships are built but trade does not grow, the expensive ships sit idle, using up valuable resources. If ships are not built and trade grows, the daily hire rates would be extremely high as there will be a shortage of shipping capacity.

In the long-term prospect of the capsize dry bulk industry, with the start of Australian and Indian ore exports in 2003 onwards, the trading volume is likely to increase. This

Page |6 opinion is further backed by the forecast generated by Linn where her analyst expects the growth in iron ore shipment to grow at a rate of 2.0% starting from 2003 for a period of 4 years. Subsequently, the iron ore shipment will continue to grow at a fixed rate of 1.5%. Therefore, the long term prospects of the industry appear to be good with an expected increase in trading volume in the near future.

However, Ocean Carrier is not expected to make a high volume of profits in the long term as from Exhibit 2, we can see that there are 63 new vessels in 2001 and 33 new vessels in 2002 to be added into the market to boost shipping capacity. Therefore, even though the demand for shipping capacity may increase significantly with the opening of new export market in Australia and Indian, the supply of shipping capacity are also expected to increase, which may put a downward pressure on the daily hire rates.

In addition, it takes an approximately 2 years for the construction of a new ship, therefore, at the most optimal situation, Ocean Carrier or any other shipping companies that are well positioned to ride on the new Australia and Indian markets, are expected to make above average profits for a period of 2-3 years before competitors increased their shipping capacity to undercut the prices for hire rates.

Finally, the long-term prospect of the shipping industry is largely dependent on the growth of the global economy. As seen in Appendix A, which provides a forecast of the

Page |7 seaborne iron ore trade to Europe and Asia from 1998 to 2006, the outlook for the long term prospect of the shipping industry appears to be very strong. Trading volumes are expected to increase due to China economic expansion. Ocean Carriers, domiciled in both New York and Hong Kong, are well placed to take advantage of the increase in Chinese import of iron ore due to their close proximity to China with Hong Kong.

Question 4
Should Ms Linn purchase the $39M capesize?

Make 2 different assumptions.

First, assume that Ocean Carriers is a U.S. firm subject to 35% taxation.

Second, assume that 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.

Three-year time charter starting in 2003 at a rate of $20,000 per day with an annual escalation of $200 per day

Expected inflation rate is 3%

Page |8 Operating cost expected to be $4,000 per day and to increase at a rate 1% above inflation Maintenance days: Initial 8 days, 12 days after 5 years and 16 days after 10 years annually Capital Expenditure in 2007:$300,000 and 2012:$350,000 Estimated scrap value at end of fifteen year is $5,000,000 Daily Hire Rate Adjustment

Over 24 years 0.65

20 to 24 years 0.75

15 to 19 years 0.8

10 to 14 years 1

5 to 9 years 1.05

Under 5 years 1.15

Exhibit 3 Daily hire rate adjustment factor for dry bulk capesizes based on age of vessel

Assumption made in Calculation

365-day per year Ocean Carrier will dispose of the ship at the end of 15th year, without incurring the cost of the third survey Due to lack of information on the premium Ocean Carrier charged above the market due their new and larger fleet, we shall compute the revenue using the industry average adjustment to daily hire rate

For a detailed calculation of the NPV, please refer to Appendix B.

Page |9 In summary, in the first case scenario where Ocean Carrier is subjected to 35% corporate tax, the NPV of the project is -$8,762,612.

Under the second case scenario where Ocean Carrier is subjected to no corporate tax, the NPV of the project is -$1,432,918.

Since the NPV for both projects is negative, Linn should not take up the project given the assumptions listed above.

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Question 5
What do you think of the companys policy of not operating ships over 15 years old?

Building on our model in Question 4, we assumed that the company does not scrap the ship after 15 years of service and continue to utilize them up till 25 years. See Appendix C for computation.

Under a corporate tax of 35%, the NPV of the project is -$7,269,097. Suppose that there is no corporate tax, the NPV of the project is $266,373

As seen from the NPV analysis, if the ships are to continue to operate up till 25 years of service, the NPV result is slightly better as compared to adhering to the policy of not operating ships over 15 years old.

This shows that Ocean Carriers strategy of having a relatively young fleet of ships and rotating out older ships to command a higher premium over the market is not effective as they can further unlock even more value from their high capital investment assets under the same set of conservative assumptions.

--- End of Report ---

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Appendix A

Forecast of International Seaborne Iron Ore Trade

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