Kellogg Finance Prof Banerjee

Problem Set #2
The purpose of this case is to estimate the relevant financial data necessary to generate cash flow
projections and calculate the Net Present Value (NPV) of an investment opportunity.
This case requires you to value the proposed project, estimating the cash flows, including tax
liabilities. The case materials lay out the information for the cash flow projections, so use the
information in the exhibits provided in the case in addition to the material found below.
Setting: A shipping company is deciding whether to purchase a new cargo ship to lease back to a
customer.
Case questions
1. Estimate the annual cash flows for the full 25 years of operational life for the ship, generated
from purchasing the capesize. Make 2 different assumptions regarding taxes. 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.
2. Should the ship be scrapped for $5 million after 15 years or continue to be operated through the
entire 25 year period? Assume that if the ship is scrapped at year 25, the scrap is still worth $5
million. In either case, assume that the scrap value is anticipated when calculating depreciation.
3. Should Ms. Linn purchase the $39M capesize?
Additional assumptions:
a) Assume Ocean Carriers uses an (after-tax) 9% discount rate for the U.S. and Hong Kong.
b) The initial decision date is January 2001.
c) If purchased, the new ship will deliver in two years. The contract would begin
immediately, so the first operating cash flow would be in 2003. The first investment cash
flow is in 2001.
d) Cash flows and expenses arrive at the end of the year, except for the initial expenditure,
which occurs immediately. Hence, cash-flows occur on Jan 2001, Dec 2001, Dec 2002, and
so on.
Hints and suggestions:
a) To calculate annual revenues from the lease, you need the expected daily hire rate, the
adjustment factor for the hire rate, and the number of operating days per year.
b) Dont forget to include the effects of working capital on your cash flow calculation.
Assume that the first investment in working capital is made in 2002. You can think of this
item as the supplies that will need to be on board the ship before it is put in service at the
beginning of 2003. Recognize that this working capital will be recovered in the final year
of operation for the capesize since in that year, supplies will not be replenished and any
excess supplies will be sold when the ship is decommissioned.
c) Also, include the periodic special survey costs as a capital expenditure, and remember that
they generate depreciation allowances for tax purposes. Each of the survey costs are
depreciated for the five years beginning the year after the survey and ending the year of the
next survey. Similarly, the ship itself generates depreciation allowances, spread over the
entire 25 years of the ships potential life.
d) Assume that Ocean Carriers has sufficiently high taxable income in each year so that any
tax shields can be used immediately.