Time and start point
Assume that the current time (year 0) is the end of the year 2000. One year has 365 days.
When the ship is scheduled for maintenance and repairs, hire rates cannot be earned. Therefore, the annual revenue equals the expected daily hire rates (forecasted by the consulting group) multiplied by the number of days operating, which is 365 days less the time allotted to maintenance and repairs in the respective year.
Operating costs will incur no matter whether the ship is operating or under maintenance. Therefore, the operating cost is 365 days multiplied by $4,000 per day for the first year, increasing annually at a rate of 1% yearly above inflation of 3%. Assume cash will inflow at the end of each operating year. So the first inflow of revenue happens at the end of year 2003.
Cost of Ship
The first payment for the purchase of the ship, which amounts to 10% of the total $39 million, is paid immediately at the beginning of year 2001, which is equivalent to the end of year 2000. Therefore, this $3.9million payment will be discounted by the discount factor of 1. The second payment, another 10% of the total, must be paid at the end of year 2001. The rest will be paid at the end of year 2002 (this time point is equivalent to the beginning of 2003) when the ship is delivered.
Assume that the total cost of the ship ($39million) will be depreciated on a straight-line basis over 25 years. Therefore, the annual depreciation is $1,560,000.
Every five years international regulations require a special survey to ensure the seaworthiness of the vessels. As a result, Ocean Carriers faces additional service expenditures. Assume these capital expenditures depreciate on a straight-line basis over a 5-year period. Therefore, the first CapEx of $300,000, which happens at the end of year 2007, will be depreciated from 2007 to 2011. The second CapEx of $350,000 happens at the end of year 2012 and will be depreciated from 2012 to 2016. If ships are operated for 15 years only, there is no need to consider the third CapEx. For ship operating for 25 years, there are two additional CapEx $750,000 and $850,000 to cover the remaining 10 years. At the end of year 25 it is assumed that the ship will be scrapped. Therefore the fifth outlay of $1,250,000 is not considered anymore.
Net Working Capital
Assume that the net working capital (NWC) put in the business will increase yearly by 3% because of inflation and will be recovered at the end of the business. Therefore, for ships operating for 15 years, the NWC will be recovered at the end of year 2017, while for ships operating for 25 years, the NWC will be recovered at the end of 2027.
What do you think of the company’s policy of not operating ships over 15 years old? In year 15 of the ship’s life, is it better to scrap the ship or continue operating it until the ship is 25 years old?
Assume that there is no requirement to pay tax on profit. Assume the scrap value after 15 years is $5,000,000 while there is no scrap value if operating until the ship is 25 years old.
Firstly, the reasonableness of the company’s policy can be analysed by comparing the NPV of 15-year project to the NPV of 25-year project.
Free cash flow is calculated as revenue less operating cost less CapEx less change in NWC. The NPV for the 15-year policy equals to $-1,252,915.52 while the NPV for operating the ships for 25 years equals to $368,557.29 (see Table 2). Therefore, the company’s policy of not operating ships over 15 years is unreasonable, since the project yields a negative NPV for 15 years and a positive NPV for 25 years.
Secondly, if the decision is to be made in year 15 of the ship’s life, we can also discount the cash flows to year 2017 and compare the NPVs of scrapping the ship or operating it for 10 more years (see Table 1).
Assume the current time (year 0) is year