“Ocean Carriers” Case

Assume that Ocean Carriers uses a 9% discount rate.

1) Do you expect daily spot hire rates to increase or decrease next year? (5 points)

2) What factors drive daily hire rates? (5 points)

3) How would you characterize the long-term prospects of the capesize dry bulk industry? (10 points)

4) Should Ms Linn purchase the $39M capsize? Make 2 different assumptions. First, assume that Ocean Carriers is a US 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.

(75 points)

5) What do you think of the company’s policy of not operating ships over 15 years old? (5 points)

Solutions:
1) Daily spot hire rates should be determined by supply and demand. Supply: The number of ships available equaled the number of vessels in service the previous year plus any new ships delivered minus any scrappings and sinkings.

Demand: The demand for dry bulk capesizes was determined by the world economy, especially its basic industries.

As shown in Exhibit 5, since over 85% of the cargo carried by capesizes was iron ore and coal, the amount of iron ore vessel shipments approximately reflects the demand for dry bulk capesizes. The amount of fleet size reflects the supply of capesizes.

As shown in Exhibit 3, the number of new ships delivered in 2001 is 63. Since there had been very few scrappings in recent years, and most of the capacity of the worldwide fleet of capesizes was fairly young, we can assume that the change of fleet size during 2001 mainly comes from these new ships.

 Similarly, we can expect the fleet size in 2002 will be: 612+(612-552)*(33/63) ≈ 643

From Exhibit 6, according to the forecast of the consulting group, iron ore vessel shipments will be 445 millions of tons in 2002. We can compute the growth rates of supply and demand in 2002.

We can see from the table above that the supply will grow faster than the demand, so I expect daily spot hire rate to decrease next year. This can also be explained according to the Linn’s analysis. With Australian production in iron ore expected to be strong and Indian iron ore exports expected to take off in the next few years, Linn took an optimistic view of the long-term market demand for capesizes. However, she also considered that imports of iron ore and coal would probably remain stagnant over the next two years while supply increases. We can reasonably anticipate that spot rates would fall in 2001 and 2002.

2) As mentioned in 1), daily spot hire rates are determined by supply and demand. Demand: As illustrated in the case, the demand for dry bulk capesizes was determined by the world economy, especially its basic industries. Over 85% of the cargo carried by capesizes was iron ore and coal. Production and demand for these products increased in a strong economy. Changes in trade patterns also affected the demand for capesizes. Supply: The number of ships available equaled the number of vessels in service the previous year plus any new ships delivered minus any scrappings and sinkings.

Ocean carriers decided to deliver new ships or scrap old ships mainly based on the demand. Supply was also affected by the increases in size and efficiency the newer ships offered. Moreover, ages of ships affected the company’s scrap decisions and older ships receiver lower daily hire rates. In summary, the world economy, changes in trade patterns, the increases in size and efficiency of new ships (technology) and ages of ships drive daily hire rates.

3) As illustrated in the case, with Australian production in iron ore expected to be strong and Indian iron ore exports expected to take off in the next few years, Linn took an optimistic view of the long-term market demand for capesizes. Linn expected that Australian and Indian ore exports would begin in 2003, and that new supplies would significantly increase trading volumes. Demand for capesizes would likely increase with these higher trading volumes, possibly boosting prices.

From the table above, we can find that worldwide iron ore vessel shipments and charter rates had been very strongly associated historically. Iron ore vessel shipments and daily hire rate changed in the same direction. Moreover, 3-yr charter rates changed much more than iron ore vessel shipments, while spot rates tended to fluctuate more widely than 3-yr charter rates. As mentioned above, Australian production in iron ore expected to be strong and Indian iron ore exports expected to take off in the next few years. I expect worldwide iron ore vessel shipments to increase stably in the long run, which would have a positive effect on daily hire rates.

In terms of supply, the number of ships available equaled the number of vessels in service the previous year plus any new ships delivered minus any scrappings and sinkings. As shown in Exhibit 2, most of the capacity of the worldwide fleet of capesizes was fairly young, there would be very few scrappings in next years. As shown in Exhibit 3, numbers of new ships delivered experienced a downward trend, which means the supply would increase more slowly in the long run. As a result, daily hire rates would be expected to rise in the long run. I take an optimistic view of the long-term prospects of the capesize dry bulk industry.

4) According to the information in the case, we can get the following table:

Operating days: Initially, 8 days a year were scheduled for maintenance and repairs. The time allotted to maintenance and repairs increased to 12 days per year after five years of operation, and to 16 days a year for ships older than ten years. Daily operating costs: For a new ship coming on line in early 2003, operating costs were expected to initially average $4,000 per day, and to increase annually at a rate of 1% above inflation. The expected rate of inflation was 3%. Expenditures for special surveys: Capital expenditures anticipated in preparation for the special surveys would each be depreciated on a straight-line basis over a 5-year period. Depreciation: The ship would cost $39 million, and the value would be depreciated on a straight-line basis over 25 years.

Moreover, the ship would cost $39 million, with 10% of the purchase price payable immediately and 10% due in a year’s time. The balance would be due on delivery. In addition, Linn expected to make a $500,000 initial investment in net working capital, which she anticipated would grow with inflation. Capital expenditures for special surveys would occur in 2007 and 2012. The company estimated the scrap value to be $5M at the end of the fifteenth year. We have to consider tax loss when the ship is sold since the ship has a book value of 15,600,000. Tax loss =(15,600,000-5,000,000)*35%=3,710,000. We can calculate total cash flows as follows:

Assume that Ocean Carriers uses a 9% discount rate, NPV is negative. So Ms Linn should not purchase the $39M capsize.

b) Assume Ocean Carriers is located in Hong Kong, we can calculate total cash flows as follows:

Assume that Ocean Carriers uses a 9% discount rate, NPV is positive. So Ms Linn should purchase the $39M capsize.

5) I think it is a good policy to sell the vessel into the secondhand market, or “scrap” the vessel just before the third special survey. By carrying out this policy, the company could avoid heavy capital expenditures of the third, fourth and fifth surveys. At the same time, the company could benefit from the scrap value of $5M. In addition, the company could charge higher daily hire rates because vessels are comparatively younger. So I think the company’s policy of not operating ships over 15 years old is good.