Ocean Carrier BHS case Study

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Ocean Carrier BHS case Study

© All Rights Reserved

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Applications

Implementing the NPV Rule

Ocean Carriers

Carriers is evaluating the purchase of a

new capesize carrier for a 3-year lease

proposed by a motivated customer.

Ocean Carriers owns and operates

capesize dry bulk carriers that mainly

carry iron ore worldwide.

Ocean Carriers vessels were mainly

chartered on a time charter basis for 1-,

3-, or 5-year periods, however the spot

charter market was occasionally used.

Breakeven analysis.

and projections. What if some of the projections are

off?

Breakeven analysis asks when do we see zero NPV?

by our forecasts of key variables.

variables are related.

In a recession, the selling price and the units sold may both

be lower than expected.

Breakeven Analysis

we hit zero NPV?

In the Ocean Carriers case the discount

rate, growth in shipments, and expected

inflation are the main uncertainties related

to NPV.

6.6%.

For a ship registered in HK it is 9.2758%.

Breakeven inflation rate is 3.49%.

Breakeven growth in shipments is 1.3642%

Sensitivity Analysis

it considers the consequences for NPV for

reasonable changes in the parameters.

A 5% increase in expected inflation decreases NPV

by 30% and a 5% decrease increases NPV by 29%.

deviation change in inflation. This gives a much more

precise look at the uncertainty inherent in the forecast.

by 57%. A 5% decrease, decreases NPV by 56%.

A 5% decrease in the discount rate increases NPV by

171%. A 5% increase decreases NPV by 161%.

Scenario Analysis

and expected inflation are negatively

related. As prices in general go up

there is less demand for iron ore.

when iron ore shipments decrease by

5% relative to the stated expectations

the NPV is decreased by 85%.

think about NPV in terms of the underlying economics.

NPV is the present value of the projects future economic

profits.

invested capital (i.e. the opportunity cost of capital).

In long-run competitive equilibrium all projects and firms earn

zero economic profits.

theoretical long run competitive equilibrium?

If no plausible answers emerge, any positive NPV is likely

to be illusory.

The general formula (complements of Irving

Fisher) is:

(1 + rNom) = (1 + rReal) (1 +rInf)

Rearranging:

Example:

rReal

1 rNom

1

1 rInf

Inflation Rate=6%

expressed in terms of the actual dollars to

be received or paid out. A cash flow is

called real if expressed in terms of a

common dates purchasing power.

The big question: Do we discount real or

nominal cash flows?

The answer: Either, as long as you are

consistent.

Discount nominal cash flows using nominal rates.

cash flows for an investment project.

0

-1000

600

650

inflation is 5%

Using nominal quantities

NPV = -1000 + 600/1.14 + 650/1.142 = 26.47

0

-1000

571.43 =

600/1.05

589.57 =

650/1.052

rreal = 1.14/1.05 - 1 = 0.0857 = 8.57%

NPV = -$1000 + $571.43/1.0857 + $589.57/1.0857 2

= $26.47

Which method should be used?

The easiest one to apply!

Capital Budgeting

widget producing machine with a useful life of five

years. The machine would be depreciated on a

straight-line basis and would have zero salvage.

The machine can produce 10,000 widgets per year.

Currently, widgets have a market price of $15,

while the materials used to make a widget cost $4.

Widget and raw material prices are both expected to

increase with inflation, which is projected to be 4%

per year. Ralph has considers a real discount rate of

5% per year to be appropriate. The tax rate is 34%.

Nominal Cash Flows

Inflation Rate:

Discount Rate

Year

Investment

Widget Price

Revenue

Input Price

Expenses

Depreciation

Taxes

Net Cash Flow

Present Value

NPV

0.04

0.092

0

300000

15.00

15.60

16.22

16.87

17.55

18.25

156000 162240 168730 175479 182498

4.00

4.16

4.33

4.50

4.68

4.87

41600

43264

44995

46794

48666

60000

60000

60000

60000

60000

18496

20052

21670

23353

25103

-300000

95904

98924 102065 105332 108729

-300000

87824

82958

78381

74074

70022

$93,259

Cash Flows

Inflation Rate:

Discount Rate

Year

Investment

Widget Price

Revenue

Input Price

Expenses

Depreciation

Taxes

Net Cash Flow

Present Value

NPV

0.04

0.05

0

300000

15.00

15.00

15.00

15.00

15.00

15.00

150000 150000 150000 150000 150000

4.00

4.00

4.00

4.00

4.00

4.00

40000

40000

40000

40000

40000

57692

55473

53340

51288

49316

17785

18539

19264

19962

20633

-300000

92215

91461

90736

90038

89367

-300000

87824

82958

78381

74074

70022

$93,259

inflation?

Does depreciation depend on inflation? If not then with real

cash flows shouldnt we see this?

Inflation Rate:

Discount Rate

Year

Investment

Widget Price

Revenue

Input Price

Expenses

Depreciation

Taxes

Net Cash Flow

Present Value

NPV

0.04

0.05

0

300000

15.00

15.00

15.00

15.00

15.00

15.00

150000 150000 150000 150000 150000

4.00

4.00

4.00

4.00

4.00

4.00

40000

40000

40000

40000

40000

60000

60000

60000

60000

60000

17000

17000

17000

17000

17000

-300000

93000

93000

93000

93000

93000

-300000

88571

84354

80337

76511

72868

$102,641

Options

making an investment?

Project A will generate risk free cash flows of

$10,000 per year forever. The risk free rate is

10% per year. Project A will take an immediate

investment of $110,000 to launch.

NPV = 10,000/(.10) - 110,000 = 100,000 - 110,000

= -$10,000

project. Do you take it?

Hint: Do gold mines that are not currently

operated have a zero market value?

will be either 8% or 12% with equal probability.

However, the cash flows associated with this project

are not sensitive to interest rates --- they will be as

indicated above. Next year:

NPV=10,000/.08-110,000=125,000-110,000 = $15,000

or

NPV=10,000/.12-110,000=83,333-110,000 = -$26,666

Dont give up the rights to the project yet! You can wait

until next year, and then commence the project if it

proves profitable at the time. There is a 50% chance the

project will be worth $15,000 next year! As a

consequence, ownership of the project has a positive value

today due to the deferral option (option to delay).

immediate investment of $80,000.

If undertaken, the project will either pay

$10,000 per year in perpetuity or $5,000 per

year in perpetuity, with equal probability.

The outcome will be resolved immediately,

but only if the investment is first made.

Well assume that the project has an

appropriate discount rate of 10%.

.5(5,000)/.10]

= -80,000 + [.5(100,000) + .5(50,000)]

= -80,000 + [75,000] = - $5,000

Suppose that the assets purchased to initiate

this project have a liquidation value of

$70,000 (i.e. you can sell them for use

elsewhere after they are purchased). Then,

the payoff to making the 80,000 initial

investment is the maximum of the value

from operating the project or $70,000. So

NPV = -80,000 +

[.5(Max(100,000 or 70,000))

+ .5(Max(50,000 or 70,000))].

= -80,000 + [.5(100,000) + .5(70,000)]

= -80,000 + [85,000] = $5,000

The option to abandon is worth $10,000

($20,000 if exercised, with a .5 probability of

exercise), which swings the NPV from -$5000 to

$5000.

Real options such as the options to defer,

abandon, or expand can make up a considerable

portion of a projects value.

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