Assignment1_OceanCarriers

Assignment 1 Ocean Carriers

MScEcon 2014 Spring

RC. LI (SID: ********)

I

Should Ms Linn purchase the $39M capsize? Make two different assumptions. First, assume that Ocean Carriers is a U.S. firm subject to a 35% statutory (and effective) marginal tax rate. Second, assume that Ocean Carriers is domiciled in Hong Kong for tax purposes, where ship owners 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, i.e., assume a zero tax rate.

Assumptions:

1 Use constant discount rate of 9%.

2 New ships depreciate on a straight-line basis over 25 years with a salvage value of zero.

3 The market value of the ship in the second-hand market is the same to book value including capital expenditure for maintenance.

4 After the year 2005, the new ship would continue operate at E[Daily Hire Rate] adjusted.

5 Operation cost is initially 4,000 per day, and grows at the rate 4%.

6 Net Working Capital is initially 500,000 and grows with inflation.

7 Scrap value at 2017 is $5M, and adjusted by inflation rate when scrapping in other years.

8 There is no default risk.

9 There is no side effect such as erosion and synergy.

10 When scrapping the ship at special survey year, the firm does not spend money on maintenance. At year 2027 the firm does not sell it in second-hand market and only scrap it.

11 The firm would recover Net Working Capital before selling or scrapping the ship.

12 Calculate one year as 365 days.

1.1 Assume that the firm is a U.S. firm subject to a 35% marginal tax rate and scrap the ship after 15 years’ operation.

The Net Present Value is $-11.59M. So reject the project.

1.2 Assume that the firm is a U.S. firm subject to a 35% marginal tax rate and sell the ship in the second-hand market after 15 years’ operation.

The Net Present Value is $-10M. So reject the project.

1.3 Assume that the firm is domiciled in Hong Kong enjoying a zero tax rate and scrap the ship after 15 years’ operation.

The Net Present Value is $-1.25M. So reject the project.

1.4 Assume that the firm is domiciled in Hong Kong enjoying a zero tax rate and sell the ship in the second-hand market after 15 years’ operation.

The Net Present Value is $1.20M. So accept the project.

Summary: If the firm is domiciled in Hong Kong enjoying a zero tax rate and sell the ship in the second-hand market after 15 years’ operation, Ms Linn should purchase the $39M capesize.

II

What do you think of the company’s policy of not operating ships over 15 years old? Assume that Ocean Carriers can fully utilize any tax benefit it derives from asset sales.

Keep the assumptions in part I.

2.1 Assume that the firm is a U.S. firm subject to a 35% marginal tax rate and scrap the ship after 25 years’ operation.

The Net Present Value is $-11.52M. So reject the project.

2.2 Assume that the firm is domiciled in Hong Kong enjoying a zero tax rate and scrap the ship after 25 years’ operation.

The Net Present Value is $1.03M. But this value is lower than $1.20M of selling after 15 years. So the 15-year policy is better than 25-year policy.

2.3 Real Option Analysis

Now we consider which year is the best to sell the ship given the above assumptions. Suppose the firm could sell the ship in the second-hand market at book value at any year after the charter contract, by the assumptions made in part I, the results are as follows:

This graph shows that as the ship ages, the NPV of selling it after operation is increasing from age 6 on, reach a peak at age 14, and decrease thereafter. This result implies that the firm should sell it at age 14 rather than age 15.

III

Suppose Ocean Carriers pays fixed annual dues of $500,000 to an association of ship owners that provides services to its members such as light houses, lobbying efforts, etc. Should a portion of these dues be included in the NPV calculation for the capesize? If so, what portion seems right?

Answer:

The annual due paid to an association of ship owners is a fixed cost which should be accounted to administrative expense of the firm but not the project. This is irrelevant to the decision so we should not include it in the NPV calculation for the capesize.

IV

Suppose that, two years ago, Ocean Carriers lost a large lawsuit related to a maritime accident where it allegedly caused a competitor’s ship to sustain extensive damage. As a result, Ocean Carriers was fined $10,000,000, which it settled to pay over 10 years. Should the balance of this fine (now standing at $8,000,000) be included in the NPV calculation for the capesize?

Answer:

The balance of this fine is irrelevant to the project so we should not include it in the NPV calculation for the capesize.