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ISLAND FERRY: A CAPITAL BUDGETING CASE STUDY

Terrance Jalbert, University of Hawaii at Hilo


jalbert@hawaii.edu
Steven P. Landry, The Monterey Institute of International Studies
steve.landry@miis.edu
Mercedes Jalbert, Jayco Travel and Tours

This case analyzes the feasibility of starting a large-scale ferry boat system in Hawaii called Island
Ferry. Students are provided detailed information regarding the proposal and are required to analyze
this information to determine if the project should be undertaken. Students are offered the
opportunity to discuss changes to the ferry system that might increase its chance of success. Spirited
discussions among students frequently occur.

CASE DESCRIPTION
The primary subject matter of this case concerns capital budgeting. Secondary issues
examined include cash flow estimation and calculation, decision criteria, and strategic
planning. The case is designed to be taught in 1.5 class hours and is expected to require 4
hours of outside preparation by students.

CASE SYNOPSIS
In this case the JTA&T Company is faced with an investment decision. The decision
is if the firm should invest in an enterprise called Island Ferry. Island Ferry will offer inter-
island ferry-boat service between the Hawaiian Islands. The managerial staff of JTA&T has
collected various financial information regarding the project. The company is now in the
process of analyzing the data to make a final decision to accept or reject the project. The
new Chief Financial Officer, Sharon Coto is assigned the task of analyzing the data.

INTRODUCTION
Today is January 1, 2002. JTA&T company, an Oregon based company, is
considering starting a new division called Island Ferry. The new division is a ferry boat
system that will transport passengers, vehicles and freight between the islands of Hawaii.
Island Ferry will be operated in a manner similar to the Washington State Ferry. The JTA&T
managerial staff have spent the past several months gathering information about the project to
determine its desirability. It has turned the information over to the new Chief Financial
Officer, Sharon Coto to analyze. Sharon is immediately approached by a disgruntled member
of the Board of Directors, Brian Bikus, who makes it clear that he has concerns about the
project.

Brian: You know Sharon, starting a new business in Hawaii is not as easy as the managerial
staff seems to think. Hawaii is known as one of the most difficult states to do
business in.

Sharon: I have also heard stories of difficulty associated with doing business in Hawaii.
However; it is possible that the prospects for this type of business are different now
than previously.

Brian: Different in which way?

Sharon: I understand that inter-island airfares have increased dramatically over the past five
years. These increased fares could allow Island Ferry to offer a very competitively
priced service. So what may not have been profitable previously might now be
profitable.

Brian: Price doesn’t matter. People want fast transportation. They just will not accept the
slower fairy boat service. I overheard the marketing folks discussing the Island Ferry
sales forecasts. They are crazy if they think they will achieve the numbers they were
discussing.

Sharon: Thank you for expressing your concerns to me, I will make sure to take the
possibility of sales forecast errors into account when I complete my analysis.

THE ISLANDS OF HAWAII


The islands of Hawaii consist of a total of 8 islands: Hawaii, Kahoolawe, Kauai,
Lanai, Maui, Molokai, Niihau and Oahu. Kahoolawe is not inhabited due to the presence of
military waste. In addition, Niihau has only 230 inhabitants because of restricted access. The
remaining six developed islands are the hub of economic and cultural activity in the south
pacific. Figure 1 contains a map indicating the relative location of each island. As-the-crow-
flies distances between various locations are presented in Table 1 (Indio.com 2001).

Figure 1: Map of Hawaii

Table 1: Distance Between Islands


Island To Island Miles
Oahu To Kauai 110
Oahu To East Hawaii 208
Oahu To West Hawaii 165
Oahu To Maui 79
Oahu To Lanai 66
Oahu To Molokai 48
Kauai To East Hawaii 317
Maui To East Hawaii 132
Maui To West Hawaii 96
Combined, the islands have a resident population of about 1,200,000 people. In addition,
approximately 6,740,000 tourists visit the islands each year, many of which tour multiple
islands while visiting the state. Additional state statistics are presented in Table 2 (DBEDT,
1999 & 2001).

Table 2: Hawaiian Island Statistics


Visitor Resident
Island Arrivals Population
Oahu 4,560,142 872,478
Maui 2,347,002 105,336
Hawaii 1,307,720 143,135
Lanai 94,657 2,989
Molokai 69,657 6,838
Kauai 1,089,289 56,603
Niihau 0 230
Kahoolawe 0 0

While the majority of tourists arrive by airplane to the island of Oahu, some international and
mainland flights operate from the islands of Maui, Kauai and Hawaii. In addition, about
44,000 visitors arrive by cruise ship each year. Visitors spend an average of 8.9 days visiting
the islands and spend an average of $171.30 per person per day (DBEDT 1999).

TRAVEL BETWEEN THE ISLANDS


Currently, there are three methods available for traveling between the islands. The
primary method of traveling between the islands is by jet airplane. There are many inter-
island flights each day. The two largest inter-island airlines are Hawaiian Airlines and Aloha
Airlines. Most inter-island airplane tickets range in price from $75-$80 per one-way flight.
A second method of traveling between the islands is by cruise ship. Currently, there are
several cruise ships that offer inter-island service, however; they generally involve a trip to a
foreign port. The price of these cruises start at about $500 per person and are generally sold
out well in advance. Finally, some inter-island transportation is competed by ferry service.
Expedition Ferry offers ferry service between the islands of Maui and Lanai. The boat is
relatively small at 40 foot, and can accommodate 36 passengers but no vehicles. This ferry
service charges $25 per person per one-way trip (Expedition Ferry, 2001). Island Marine
Company offers ferry service between the islands of Molokai and Maui. The boat is a 100-
foot vessel that carries 149 passengers, but no vehicles. The charge for the 90-minute trip is
$40 (Island Marine 2001). Pacific Marine and Supply Company also operates a
demonstration ferry around the island of Oahu called the Wiki Wiki Ferry. This ferry service
is being offered to test the feasibility of commuter ferries in Hawaii. The service is passenger
only and is intended to be an alternate means of transportation for workers commuting to
Honolulu (State of Hawaii Department of Transportation 2001). As envisioned, Island Ferry
will offer faster, more frequent, and less expensive service than the current providers.

ISLAND FERRY CLIENTELE


Island Ferry would meet the demands of several different clientele. The first clientele
are those island tourists wishing to visit multiple islands. In order to visit multiple islands,
with few exceptions, the tourists must fly from island to island. Those driving rental cars
must rent a separate car for each island that they visit. Tourists using Island Ferry would be
able to rent a single automobile for the duration of their stay, thereby enjoying the lower
week-long car rental rates. They would simply transport the vehicle on the ferry with them as
they travel between the islands. In addition, tourists would enjoy the boat ride around the
islands as a tourism activity by itself. The ferry ride will provide passengers the opportunity
to view the islands from a different perspective than is available by air. Moreover, they
would have the opportunity to view marine life such as dolphins, sharks, manta rays and
humpback whales that frequent the islands.

The second clientele are local tourists. Currently, in order for local tourists to visit
alternate islands, they must generally fly from island-to-island, and rent a car on the
destination island. A couple planning a three-day get away would spend about $450 on
transportation (4 inter-island airplane tickets at $75 each and three days of car rental at $50
per day). Island Ferry would allow local tourists to travel more economically. The trip
described above could be completed for about $200 using island ferry. As with other tourists,
the ferry is expected to become a tourism activity by itself for local tourists.

The third clientele are inter-island commuters. The unemployment rate in the
Hawaiian Islands varies substantially from island-to-island. Differences in unemployment
rates are in part due to the difficulty of commuting between islands to seek employment.
While there are currently some employment commuters, the price of inter-island air travel
limits this practice to relatively well-paid individuals. The lower price of inter-island travel
available through Island Ferry will permit more individuals to island-commute.

In addition to passengers and cars, Island Ferry will offer freight service. Freight
services are currently provided by airplane as well as by sea. Airplane freight services are
provided in conjunction with passenger service. Freight-carrying sea vessels visit each island
about once per week. Inter-island freight transported by sea are dominated by two
companies, Matson and Young Brothers (U.S. Coast Guard 2001). 4,287,500 tons of freight
are shipped between the islands each year (Wedemeyer 2001). Island Ferry will be able to
offer very competitive freight service. While freight prices will be similar to those charged
by existing seaboard freight service, Island Ferry will have the competitive advantage of
providing daily service.

THE ISLAND FERRY BUSINESS


In order to start Island Ferry, eight terminals will be purchased. One terminal will be
built on each of four of the islands Island Ferry will service and two terminals on each of the
islands of Oahu and Hawaii. Service will not be provided to Niihau or Kahoolawe. The land
for each terminal will cost $10,000,000. The land will be purchased, and paid for the land on
December 31, 2002. Average construction costs of each terminal facility will be
$15,000,000. It will take three years to complete construction of the terminals. One third of
the total construction cost will be paid on each of December 31, 2002, December 31, 2003,
and December 31, 2004. However, depreciation of the construction costs will not be started
until the day Island Ferry opens for business. The terminal construction costs will be
depreciated using twenty-year straight-line depreciation to a salvage value of $5,000,000 per
terminal. In addition, a freight warehouse will be constructed at each terminal. On average,
each freight warehouse will cost $10,500,000. Two years after construction of the terminals
begins, construction of the freight warehouses will begin. One-half of the freight warehouse
construction costs will be paid on December 31, 2004 and ½ of the freight warehouse
construction costs on December 31, 2005. The freight warehouses will be depreciated using
30-year straight-line depreciation to a salvage value of 0. Depreciation will not start on the
freight warehouses until January 1, 2006. Of course, the land will not be depreciated.
In addition, Island Ferry will need to purchase the boats. Two different sized boats
will be used. Ten large boats will be purchased at a cost of $150,000,000 each. Ten small
boats will be purchased at a cost of $70,000,000 each. Thus, Island Ferry will purchase a
total of twenty boats. The price of these boats is somewhat higher than prices paid by other
ferry services. The higher price reflects the plan to utilize high-speed, fuel-efficient boats
(FMS Ltd. 2001). Island Ferry will take delivery (and pay for) the boats on December 31,
2004. Island Ferry will depreciate the boats using ten-year straight-line depreciation to a
combined salvage value of $1,000,000,000. Depreciating the boats will not begin until the
day Island Ferry starts offering service. It is also necessary to purchase freight handling
equipment. This equipment will cost $4,500,000 for each terminal for a total of $36,000,000.
Island Ferry will take delivery (and pay for) the warehouse equipment on December 31,
2004. The freight handling equipment will be depreciated using 7-year straight-line
depreciation to a combined salvage value of $15,000,000. Island Ferry will begin
depreciating the warehouse equipment the day it begins offering freight service, January 1,
2006. Island Ferry will also need to invest $10,000,000 in working capital into the company
on December 31, 2003.

A group of anonymous men, eager for JTA&T to open the business, as it will create
many jobs and will increase tourism to the state, and increase sales at their respective
businesses. As such, they have agreed to give Island Ferry an incentive to open the business.
The incentive is a cash payment of $10,000,000 at the end of each of Island Ferry’s first five
years of operation (not including the construction time). In addition, the state has negotiated
a tax deal for Island Ferry so that Island Ferry is exempt from all federal, state, and general
excise taxes for the construction (startup) period and the first five years of operation. After
that, Island Ferry’s combined federal and state income tax rate will be 38 percent. In
addition, Island Ferry will have to pay a general excise tax of four percent of sales after the
exemption expires.

Island Ferry will begin providing passenger service on January 1, 2005. The boats
will operate 365 days per year. At any given time, 24 hours per day, seven of the small boats
and seven of the large boats will be operating. The remaining boats will be shut down for
repairs and maintenance. The large boats have a capacity of 200 cars, 1500 passengers and
500,000 pounds of freight. In addition, the large boats will have thirty sleeping/meeting
rooms each. The small boats have a capacity of 100 cars, 750 passengers and 200,000
pounds of freight. The small boats will not be equipped with sleeping/meeting rooms. Each
boat will be equipped with airplane-style seating. The car storage area of each ship can be
utilized for additional freight when demand dictates. The boats will have a cruising speed of
40 knots (about 46 miles per hour). The boats will average 55 percent full of both
automobiles and people on each trip in the first year of operation. Usage statistics for the
other years of operation are presented in Table 3.

Table 3: Passenger and Automobile Usage Data


Year Percent Full
2005 55
2006 56
2007 57
2008 58
2009 59
2010 60
2011 61
In addition, on average, 20 sleeping rooms will be rented on each trip. Each operating boat
will average 4 one-way trips per day. The average charge for inter-island transportation is
$50 per vehicle (one-way) and $25 per person (one way). Sleeping rooms rent for an
additional $50 per one-way trip. Travel agents will make one-half of the passenger, vehicle
and sleeping/meeting room arrangements. Island Ferry will pay the travel agents a 3 percent
commission on the sales they arrange. Island Ferry will sell food on the boats. Average food
sales on the ferry are expected to be $4 per passenger on each one-way trip. Island Ferry will
also sell food at the terminals. Average food sales at each terminal are expected to be $2,000
per day. The prices charged for the food, the transportation and the rooms will be increased
by 5 percent per year.

Island Ferry will begin offering freight service on January 1, 2006. The average
freight charge will be $0.02 per pound of freight transported in the first year of freight
operations. The freight charge will be increased by 2 percent in each subsequent year. Sixty-
five percent of the base freight capacity (not including the extra capacity that can be obtained
by utilizing the car storage areas of the boats for freight) will be utilized in the first year that
Island Ferry offers the freight service. A full listing of the freight capacity usage is presented
in Table 4. Income from all sources will be received in cash at the end of each respective
year.

Table 4: Freight Capacity Usage


Year Percent Full
2006 65
2007 66
2008 67
2009 68
2010 69
2011 70

Thirty-two people will be employed at each terminal. They will average earning $35,000 per
year including benefits. In addition, forty people will be assigned to work on each of the
fourteen operating boats. They will average earning $40,000 per year including benefits. In
addition, there will be two maintenance personnel assigned to each terminal. Each
maintenance person will earn $45,000 per year including benefits. Once Island Ferry begins
freight service, it will need 8 additional employees at each freight warehouse. These
employees will earn an average of $45,000 per year including benefits. A three percent
annual salary increase for each employee has been negotiated with the union. Based on
figures reported by the Washington State Ferry System, fuel costs for the operating boats will
are estimated to be $4,000 per day for the large boats and $2,500 per day for the small boats
for each day the boat is in operation (Washington State Department of Transportation 2001b).
Fuel costs are expected to increase by ten percent per year. Island Ferry will enter into a
warranty contract with the boat manufacturer so that it will pay $200,000 per year for each of
the twenty boats in the fleet for repairs and maintenance. The contract is for ten years and the
price will be the same $200,000 per boat for each year of the contract. Utilities at each
terminal will be $240,000 per year starting on the day that the firm begin offering service.
Utilities at the freight warehouse are expected to be an additional $120,000 per year, starting
the day the firm begins offering freight service. Utility prices are expected to increase by ten
percent per year. In addition, after the tax exemption the state has granted Island Ferry
expires five years after you start operating, the firm will have to pay $100,000 in property
taxes on each of the terminal/warehouse facility combinations each year. Food costs are
expected to be 50 percent of the food sales price. Insurance costs will be $8,000,000 per year
covering the boats the passengers, the freight, the employees and the terminals. The
insurance contract calls for Island Ferry to pay the insurance both during the construction
phase and during the operating phase. General administrative expenses will be $300,000 per
year during the construction period and will increase to 500,000 when the firm begins
offering service. General administrative expenses are not expected to change throughout the
first ten years of operation. Marketing Expenses will be $3,000,000 for each year the boats
operate (Island Ferry will not pay marketing expenses during the start-up years). The
insurance and marketing costs will remain constant for ten years. All expenses discussed in
this paragraph, as well as travel agent commissions, are paid in cash at the end of each
respective year.

The Shark Marine Company who recently heard of the venture have agreed to
purchase the entire operation from JTA&T at the end of the seventh year of operation.
JTA&T is not required to sell the operation to them, but have the option to do so if they wish.
The Shark Marine Company has agreed to purchase the operation from JTA&T for
$1,758,500,000. $1,500,000,000 is for the boats, $95,000,000 is for the terminals,
$65,000,000 is for the freight warehouses, $18,500,000 is for the freight handling equipment,
and $80,000,000 is for the land. In addition, JTA&T will be able to withdraw the working
capital from the company immediately prior to the sale. JTA&T has estimated the cost of
capital for this project to be 14.5 percent.

The figures reported here are believed to be reasonably accurate. However, the
primary goal of this paper is as an educational tool. Substantial differences might occur
between what is reported here and what might be expected in any live future implementation
of a ferry boat system.

QUESTIONS
1. Create a cash flow analysis for capital budgeting purposes for this project. Assume
that JTA&T will sell the entire operation to Shark Marine Company at the end of the
seventh year of operations.
2. Use a scientific technique to determine if you should undertake the project.
3. What, if anything, should Sharon do to address Brian’s concerns about an overly
optimistic sales estimate?
4. Discuss modifications to the plans developed here that might improve its chances of
success. It is not necessary to provide a numerical analysis of your recommendations.

REFERENCES
Department of Business, Economic Development and Tourism (DBEDT) [1999], “1999
Annual Visitors Research Report,” www.hawaii.gov/dbedt/

Department of Business Economic Development and Tourism (DBEDT) (2001), “State Fact
Sheet,” www.hawaii.gov/dbedt/.

State of Hawaii Department of Transportation (2001), “Wiki Wiki Ferry,”


www.state.hi.us/dot/publicaffairs/ferry.

Expedition Ferry Corporate Homepage (2001),


www.mauibound.com/lanaitours_expeditions.html
FMS Ltd. (2001), “Shipbuilding-and-repair.com Newbuildings,” www.shipbuilding-and-
repair.com/newbuildings.htm.

Indio.com (2001), “How Far Is It?,” www.indio.com/distance.

Island Marine Corporate Homepage (2001), www.molokaiferry.com/ferry.html.

Wedemeyer, Starr (2001) “Shipping Company Plans for $2.3 Million in Renovations,” West
Hawaii Today, May 14, Local News Section.

United States Coast Guard (1999), Marine Safety Office Honolulu Fact Book, Freight and
Cargo Fact Sheet, Honolulu, Hawaii,
www.uscg.mil/d14/units/msohono/factbook/freightcargo.htm.

Washington State Department of Transportation (2001), “Your Washington State Ferries,”


www.wsdot.wa.gov/ferries/your_wsf.

Washington State Department of Transportation [2001b], “Frequently Asked Questions,”


www.wsdot.wa.gov/ferries/info_desk/index.cfm/fuseaction/faq.