CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 1

The Warwick MBA

Assignment Cover Sheet Submitted by: 1167183 Date Sent: February 20, 2012 Module Title: Corporate Finance Module Code: IB9380 Date/Year of Module: 2012 Submission Deadline: February 20, 2012 Word Count: 780 words Number of Pages: 9 pages (including appendices) Question: Ocean Carriers: Capital Budgeting “This is to certify that the work I am submitting is my own. All external references and sources are clearly acknowledged and identified within the contents. I am aware of the University of Warwick regulation concerning plagiarism and collusion. No substantial part(s) of the work submitted here has also been submitted by me in other assessments for accredited courses of study, and I acknowledge that if this has been done an appropriate reduction in the mark I might otherwise have received will be made.”

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 2

OCEAN CARRIERS: CAPITAL BUDGETING

Should Ms Linn purchase the $39 million capsize?

Methodology:

The Net Present Value (NPV) has been calculated for the investment in the ship over a useful life of 25 years

with cost of capital of 9% for two scenarios, namely,

The company is subject to a corporate tax of 35% in US.

The company is located in Hong Kong and is exempt from paying tax on profit.

Recommendations are made on the basis of whether the NPV is positive or negative.

Assumptions:

The following assumptions have been made to calculate NPV:

Payment 10% of the purchase price of the ship is made in January 2001 and the subsequent payment

are made in January 2002 and 2003 respectively.

The initial working capital of $500,000 is invested at the beginning of 2003 when the lease for the

ship starts.

The special survey is conducted every five years with the first one undertaken in 2008.

The forecasted expected daily hire rates are accurate in the long term.

Number of days in a years are 365 without considering leap year for simplification.

The capsize is sold in scrap at the end of 25 years in 2027 just before the fifth special survey.

If the ship is bought, the entire project will be financed by equity.

Rate of inflation is constant at 3% throughout the operational period.

Calculations:

The detailed spreadsheets of the NPV calculations are enclosed in Appendices A and B. The calculations have

been carried out as follows:

Net revenue = Annual Operating cost – Annual Sales Revenue

Operating profits = Net revenue – Depreciation of capsize – Depreciation of survey cost.

The survey costs are depreciated with straight line method over a period of 5 years. The scrap value

increasing at the rate of inflation is added to the profits of 2027, when the ship is sold.

Profit after tax = Operating profits – Corporate Tax

Net Cash Flow = Profit after tax + Depreciation of capsize + Depreciation of survey cost –

Survey cost – Change in working capital – Initial investment

The working capital accumulated over the period of 25 years is added in the net cash flow in 2027.

Discounted Cash flow = Net Cash Flow * Discount factor @ 9%

Outcomes:

The NPV in case of the company operating in USA is negative with a value of - $4,333,019.42. However, in

Hong Kong the NPV for the same period of 25 years is positive equal to $4,261,248.86. The difference is

primarily due to the tax exemption in Hong Kong.

The present value of purchasing the capsize at $39 million is $33,738,397.44, considering the cost of

capital i.e.9%. The risk free of 6 % is not used since it is assumed that the project is financed by equity.

Therefore, if Ocean Carriers does not buy the ship, the shareholders will want to invest the capital in a project

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 3

that gives them returns equivalent to the cost of capital. Hence, the capital will not be invested in a risk free

asset. The detailed calculation of the present value of buying the ship is enclosed in Appendix C.

Recommendation:

As observed from the outcome of the NPV calculation Ms. Linn should not commission the carrier under

present circumstances as the NPV is negative. Therefore, it is not a good investment. However, if the

company is based out of Hong Kong or if the company is subject to tax exemption the investment should be

made since it promises handsome returns. At the same time, further due diligence would be required to

analyse factors affecting demand, since estimates spanning over three years are not reliable.

Commenting on the company policy not operating vessels older than 15 years, it can be concluded that such

action is not advisable as it deteriorates the NPV both in USA and Hong Kong. In case of Hong Kong, the

NPV is positive even at 15 years, but it is less than the NPV for 25 years, so the investment is not utilized to

the optimum level. To support this argument, NPV for the capsize is calculated for 15 years operations in US

as well as Hong Kong. The vessel is depreciated on straight basis for the period of 15 years taking into

consideration the scrap value of $5 million. The detailed calculations for NPV with 15 years operating period

are enclosed in Appendices D and E.

It can be concluded that Ocean Carrier should commission the project if the company is based out of Hong

Kong. The vessel should be operated for the period of 25 years to maximize the investment.

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 4

APPENDICES

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 5

APPENDIX A

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 6

APPENDIX B

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 7

APPENDIX C

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 8

APPENDIX D

CORPORATE FINANCE INDIVIDUAL ASSIGNMENT

Student id: 1167183 Page 9

APPENDIX E