Question
PanPac Shipping is considering replacing an existing ship with a newer and more efficient one for a 5-year contract of affreightment. The existing ship is
PanPac Shipping is considering replacing an existing ship with a newer and more efficient one for a 5-year contract of affreightment. The existing ship is five years old; it cost $32 million and is being depreciated under the prime cost method at a rate of 10%. The existing vessel has a remaining useful life of five years. The new ship costs $45 million to purchase and $5 million to outfit for service. It will be depreciated under the prime cost method at a rate of 10%. The existing ship can currently be sold for $10 million and will not incur any removal or clean-up costs. At the end of five years, the existing ship can be sold for net $1 million before taxes. The new ship can be sold for net $20 million before tax at the end of the five-year period. The company is subject to a 30% tax rate on both ordinary income and capital gains. The projected profits before depreciation and taxes for the new ship and the existing ship are given in the following table.
The required rate of return used for evaluating each option is the companys Weighted Average Cost of Capital (WACC), which can be calculated according to the following information on the companys capital structure.
Additional information:
The ordinary shares are currently traded at $3.00 per share.
The beta coefficient of PanPac Shipping is 1.5.
The risk-free rate (a 10-year government bond) in the market is 3%.
The average historical market return for the past 10 years is 9%.
The debentures are of 10 years to maturity and priced at $76.00.
The current return (i.e., market yield) on the companys debentures is 10%.
The company tax rate is 30%.
The existing capital structure is unlikely to change.
Complete the following tasks:
a) Using a table in Word or an Excel spreadsheet, set up the cash flows for each option, i.e., purchase the new ship and continue using the existing ship.
b) Calculate the Weighted Average Cost of Capital (WACC) of the company.
c) Calculate the Net Present Value (NPV) of each option.
d) Recommend an option to PanPac Shipping with justification.
\begin{tabular}{|c|c|c|} \hline Year & New Ship & Existing ship \\ \hline 1 & $25,000,000 & $15,000,000 \\ \hline 2 & 25,000,000 & 15,000,000 \\ \hline 3 & 25,000,000 & 15,000,000 \\ \hline 4 & 25,000,000 & 15,000,000 \\ \hline 5 & 25,000,000 & 15,000,000 \\ \hline \end{tabular} \begin{tabular}{|l|r|} \hline Capital structure & Book value \\ \hline Debentures ($100par,6% coupon-annual) & $2,000,000 \\ \hline Ordinary shares ( $1par) & $5,000,000 \\ \hline \end{tabular}
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