Mary Linn Evaluating A Proposed Lease of A Ship

Mary Linn Evaluating A Proposed Lease of A Ship

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Mary Linn Evaluating A Proposed Lease of A Ship

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In January 2001, Mary Linn, Vice President of Finance for Ocean Carriers, a shipping company with offices in New York and Hong Kong, was evaluating a proposed lease of a ship for a three-year period, beginning in early 2003. The customer was eager to finalize the contract to meet his own commitments and offered very attractive terms. No ship in Ocean Carrier’s current fleet met the customer’s requirements.

Linn, therefore, had to decide whether Ocean Carriers should immediately commission a new capesize carrier that would be completed two years hence and could be leased to the customer.

Ocean Carriers Inc. owned and operated capesize dry bulk carriers that mainly carried iron ore worldwide. This type of vessel ranged in size from 80,000 deadweight tons to 210,000 deadweight tons of cargo carrying capacity. Capesize carriers were too large to transit the Panama Canal and therefore had to sail around Cape Horn to travel between the Atlantic and Pacific Oceans. In January 2001, there were 553 capesizes in service in the world.

Ocean Carriers’ vessels were mostly chartered on a “time charter” basis for a period such as one year, three years, or five years, although the spot charter market was used on occasion. The company that chartered the ship was called the “charterer.”

The charterer paid Ocean Carriers a daily hire rate for the entire length of the contract, determined what cargo the vessel carried, and controlled where the vessel loaded and unloaded. The company, in turn, supplied a seaworthy vessel that complied with international regulations and manned the vessel with a fully qualified and certified crew.

Ship Operations

Operations also included ensuring adequate supplies and stores were onboard, supplying lubricating oils, scheduling repairs, conducting overall maintenance of the vessel, and placing all insurances for the vessel. 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.

Charterers were not charged a daily rate for the time the vessel spent in maintenance and repair, although operating costs were still incurred. Initially, 8 days a year were scheduled for such work. 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.

The company had a policy of not operating vessels older than 15 years. Every five years, international regulations mandated that a special survey be undertaken to ensure seaworthiness as defined by international regulations. By the fifteenth year, the maintenance required to comply with the special surveys was very costly. Exhibit 1 shows the capital expenditures anticipated in preparation for the special surveys.

These outlays were considered capital expenditures, which would each be depreciated on a straight-line basis over a 5-year period. To avoid the larger expenditures for older ships, the company planned to sell the vessel into the secondhand market, or “scrap” the vessel just before the third special survey. When scrapped, the vessel was demolished and its steel was sold to demolition yards. The company estimated the scrap value to be $5M at the end of the fifteenth year.

Supply of Capesizes

Daily hire rates were determined by supply and demand. 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. When the market demand for shipping capacity was high, owners would keep a vessel in operation as long as possible. Conversely, when market demand was low, scrapping rose.

Supply was also affected by the increases in size and efficiency the newer ships offered. As ships got bigger, faster, and more fuel efficient, fewer ships were needed to carry the same amount of cargo. Moreover, there had been very few scrappings in recent years, and most of the capacity of the worldwide fleet of capesizes was fairly young. Exhibit 2 shows the capesize fleet by age category as of December 2000. Exhibit 3 shows the number of new capesize vessels by expected delivery date.

Exhibit 2 Capesize fleet by age category as of December 2000

Estimates of future orders for vessels were not entirely reliable, especially projections spanning more than two or three years in the future. If sentiment was optimistic on market conditions, more vessels would be added to the order book. If the market outlook was poor, then vessels would be cancelled or converted to other types of vessels.

A capesize took approximately 10 months to build, but contracts were signed to secure a berth place approximately two years before delivery and over one year before steel cutting for the vessel. “Delivery” referred to when the vessel was complete and delivered from the shipyard to the owner.

Market conditions

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.

For example, if a Western European country decided to switch its supply of iron ore from the United States to Australia, the demand for capesizes would increase since the distance between Europe and Australia is greater than the distance between Western Europe and the United States.

Spot charter rates tended to fluctuate more widely than time charter rates, i.e., the highs were higher and the lows were lower in the spot market. Therefore, when the market was high, ship owners sought time charters to lock in the high rates for as long a period as possible while the charterers preferred to trade in the spot market to avoid having to pay high daily rates any longer than necessary.

Because Ocean Carriers’ vessels were relatively new and a bit larger than the industry average, they earned a premium to the market. For example, new ships generally earned a 15% premium in daily hire rates relative to the industry-wide average, while ships over 25 years old typically received a 35% discount from the industry average. Exhibit 4 shows average adjustments to daily hire rates for 3-year time charters based on the age of the ship.

The average prevailing spot market rate at the time was $22,000 per day.1 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 63 new vessels were scheduled for delivery in 2001 and that imports of iron ore and coal would probably remain stagnant over the next two years.

Linn therefore anticipated that spot rates would fall in 2001 and 2002. In 2003, however, Linn was aware that Australian and Indian ore exports would begin, and that these new supplies would significantly increase trading volumes. Demand for capesizes would likely increase with these higher trading volumes, possibly boosting prices. Exhibit 5 provides data on some demand drivers, fleet size, and average daily hire rates over time.

Linn enlisted the services of a shipping-industry consulting firm to help her forecast daily hire rates for a new capesize. Worldwide iron ore vessel shipments and charter rates had been very strongly associated historically. The consulting group felt that this relation would continue to hold in the future, and based its forecast of charter rates off of long-term forecasts for worldwide iron ore vessel shipments. The long-term forecast for worldwide iron ore vessel shipments was for 2% annual growth during 2002 to 2005, and then dropping to 1.5% thereafter. Exhibit 6 shows the forecast of daily hire rates that was prepared for Linn.

Newbuilding

The charterer currently in negotiations with Ocean Carriers for a three-year time charter starting in 2003 had offered a rate of $20,000 per day with an annual escalation of $200 per day. The expected rate of inflation was 3%.

The vessels in Ocean Carriers’ current fleet could not be committed to a time charter beginning in 2003 because the ships were either already leased during that period or were too small to meet the customer’s needs. Moreover, there were no sufficiently large capsizes available in the second-hand market. Ocean Carriers had to decide immediately if it should commission a new 180,000 deadweight ton ship for delivery in early 2003.

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. A new ship would be depreciated on a straight-line basis over 25 years. In addition, Linn expected to make a $500,000 initial investment in net working capital, which she anticipated would grow with inflation.

Linn was also confident that the charterer would honor his proposed contract with Ocean Carriers if the company agreed to the terms. While there is always a risk that the charterer would stop paying before the end of the contract or terminate the contract early, Linn considered that the risk was small. Ocean Carriers had long established relationships with its charterers and only contracted with reputable charterers.

The proposed contract, though, was only for three years, and it was Linn’s responsibility to decide if future market conditions warranted the considerable investment in a new ship.

Ocean Carriers uses a 9% discount rate.

Do you expect daily spot hire rates to increase or decrease next year?

What factors drive average daily hire rates?

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

Should Ms. Linn purchase the $39M capesize? Make two 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.

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

Create and submit an Excel model your team used for FCF and NPV calculations. Grading will be based on a) good organization of spreadsheet layout and b) correct formula for every calculated cell.

Mary Linn Evaluating A Proposed Lease of A Ship

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