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Ocean Carrier Case Study


Stratton Oakmont
Anna Barzanti, Lorenzo Maria Bollani, Marc de Neergaard, Riccardo Arosio

Class 18

EXECUTIVE SUMMARY. January 2001. A shipping company, Ocean Carriers, faces the urgent investment choice of ordering a new cape-size carrier due to a charterer requiring service of such in 2 years time. The lease agreement provides the company with a declared cash flow for 3 years until the expiration, but at that time the company starts facing uncertainties. Forecasting expected cash flows and evaluating corporate policy shows that the only profitable choice is when buying the $39M vessel and operating the business in Hong Kong; moreover, revoking the routine scrapping of the ship after 15 years to operate it for 25 years controversially. SUMMARY OF FACTS. The initial investment will be split up in parts according to an installment plan, citing yearly payments beginning in January 2001 with $3.9M, $3.9M and $31.2 M respectively, totaling a nominal $39M. While in 2007, a 5-year repeating CAPEX will amount to $0.3M and grow to $8.5M in 2022. The initial capital investment will be depreciated over 25 years with an estimated scrapping value of $5M after 15 year. Meanwhile, the repeating CAPEX increases the scope of operation for the vessel with 5 years with each occurrence. An additional investment will made 2001 in net working capital of $500,000, growing with inflation (expected constant at 3% annually). Daily operating expenses starts at $4,000, increasing annually at 100bps above inflation, excluding other costs which is set to $0. The cash flow from trading the vessel for the first 3 years are considered almost credit risk free since they are charted by an established client. In 2007, Ocean Carriers will in the projected scenario assume the price of the volatile spot rate without ability to lock higher charter rates for longer periods, this shall be taken as the pessimistic view. External help used a vital relationship in order to establish expectations about the daily hire rights descending form in 18,714 in 2007 to 13,448 in 2027 and established that newer ships earn a premium price. Lastly, the discount rate, or WACC equals 9% and further data can be found in the exhibits.

STATEMENT OF THE PROBLEM. If management were to meet short-term customer demand by committing into a considerable long-term investment, what internal and external conditions would justify this venture and how would it create additional value for the shareholders if fulfilled. ANALYSIS. The fragmented shipping industry is one of the most essential industries for continuous globalization and growth; industry prospects are surprisingly stable in contrast to the normal logistics businesses that are highly cyclical. Daily hire rates are found by the interaction of the supply and demand of vessels. The supply is influence by market demand for shipping capacity, the efficiency and size of vessels and the rate of scrapping. The demand is influenced by the situation of the world economy, technological changes and trade patterns. There is a strong positive relationship between spot/time charter hire rates and demand for iron ore vessel shipments (exhibition 5). This is due to the fact that rates are set by current market conditions and expectations that also influences investment decisions in new vessels. In 2001 the iron and coal industry faces a stagnant situation with a reduction of shipment of 0.9%, while the supply increases with the introduction of 63 new ships in 2001-2002. By the end of 2000 the major part of the ships available are new (29M of DWT are Under 5 Years of age) suggesting a decrease in the average/times rate and an additional decrease in the spot rates. Moreover, given only few scrappings in recent years and young age of cape-sizes, we can expect that the suppliers to lower their prices and thus also spot rates in the short run, including next year. (exhibition 6) The forecast is highly optimistic about the industrys long-term prospects with continuous growth. Real economic growth will give rise to higher demand for the commodities transported and spot rates will alienate with the ones from 2000. In fact, in 2002 the iron industry will recover, especially because of an increase in the trading volumes, thanks to the growth of the Indian and Australian market, also influenced by the efficiency gains due to gradual technological improvements.

The choice of making 3 installment payments provides the company with a large non-recurring capital outflow in 2 short years that will cause grave liquidity constraints, investing $500,000 in net working capital compensates for this. However, Ocean Carriers should try to increase the payments period in order to be able to keep working capital at higher levels.

Using the data provided, exhibition 15 and 25 shows how the only profitable choice with current expectations are to choose Hong Kong as main office while using the boat for 25 years, making a NPV of $ 1,363,560. All other alternatives create negative NPVs that should not be accepted since it decreases shareholder value. In order for New York to break even in 15 years, the ship has to cost $27,213,696, which is a lot less than demanded. Worth noting is that the IRR is only 3.979% in the profitable option, which is a very low rate of return considering that they could just invest their money elsewhere on the market. Concerning the WACC which equals 9% for Ocean Carriers, it seems that they are either giving out to much dividends, have low growth expectations or because they are funded by mostly debt. Reevaluating the capital structure is strongly recommended since lower costs would decrease the discount rate and increase the NPV. The corporate strategy obviously has to be reevaluated concerning when to decommission the vessel since this makes the project not financially supported. The higher costs of operating an older vessel is obviously lower that the gains of doing so.

RECOMMENDATIONS. There need to be more data to support that the firm is able to lock higher prices which would enable them to receive higher cash flows and with greater certainty. Extending the years of service for the vessels from 15 to at least a span where NPV is positive is crucial for future projects to be even considered. Furthermore, it is necessary to be a reevaluate why the WACC is so high, even in an industry with such a stable growth projects. Stockholders are able to gain more elsewhere and thats a problem for the management of the company. (exhibition 6/other).

Exhibit 15

Exhibit 25