The main task of the assignment is preparing cash flow projection in Excel spreadsheets (use the template fm-data-worksheet available in the course shell).

For other tasks, prepare your responses in a Word document (no handwriting).

Upload both Excel spreadsheet and Word document to the corresponding submission point.

2 Project information

Savannah Merchant Marine Co. (henceforth SMM or the firm/company) is a cargo shipping company based in Savannah, Georgia, that operates freight vessels in various sizes. In December 2050, the firm is reviewing the proposal for a new dry bulk carrier in an attempt to capture a potential increase in the global demand for freight shipping. The CFO has asked you to estimate cash flows expected from the new ship over its asset life. To aid the analysis, the CFO and the SMM Finance team have collected data from various sources, as summarized below.

a) Discount rate, inflation, tax, and other information CFO has made the following baseline assumptions:

The discount rate is assumed to be 12%, p.a. (per annum)

For simplicity, the CFO has decided to use an expected inflation rate of 3%, p.a., over the next three decades.

SMM is expected to face a marginal tax rate of 20%.

b) Investments required

The purchase price of the new vessel is $44 million. If ordered before the end of 2050, the ship will be ready by the end of 2052. If SMM decides to purchase the ship, 10% of the price is due at the end of 2050, another 10% is due at the end of 2051, and the balance is payable at the end of 2052 when the ship is delivered. It will then begin operating from the beginning of 2053. The useful life Fin. Mgt. 2 of the ship is 25 years with no salvage value. The project life is assumed to be equal to the ship life. The depreciation is on a straight-line basis.

The CFO also assumes that the firm will liquidate the vessel at the end of its life. Based on your industry survey, the market value of the ship at the end of its life is estimated at $8 million.

c) Additional capital expenditures required

To enhance the performance and the cost efficiency of its vessels, the firm makes additional investments in its fleet on a regular basis, typically every five years. Given the liquidation expected at the end of its 25th year, the new ship will undergo four installments of these capital expenditures, with the first one taking place at the end of its 5th year (i.e., 2057 if the ship is ready by the end of 2052). Factoring in additional costs required for old vessels and the overall inflation, these expenditures are estimated as follows:

$300,000 (1st); $350,000 (2nd); $650,000 (3rd); and $1,200,000 (4th)

The firm is allowed to capitalize these four expenditures, and each will be depreciated over five years on a straight-line basis, with no remaining book value at the end.

d) Working capital requirements

The CFO expects that the operation of the new ship requires an initial working capital investment of $500,000 by the beginning of 2053 (equivalently, the end of 2052). From then on, the working capital balance requirement will grow each year at a rate of inflation (provided in subsection a). The working capital balance will be recovered at the end of the project life.

e) Assumptions for forecasting daily hire rates and revenues

The annual revenues are determined by daily ship hire rates (prices) prevailing in the market and the number of days the ship is expected to be hired in a given year. The market price is the function of the demand for shipments and the supply of shipment capacity. The CFO has obtained from Clarksons the industry experts forecast for these factors on an annual basis, as summarized in the spreadsheet. In addition, the CFO has come up with the following econometric model for forecasting the rates at which the average daily prices will change each year:

= 0.007 + 1.4 1.6

where y = % change in ship hire rate; x1 = % change in demand; x2 = % change in supply, all on an annual basis.

For example, suppose that in 2051, the expected growth in the demand for shipments is 0.0217 and the expected growth in the supply of shipping capacity is 0.0213 (note that these figures are Fin. Mgt. 3 taken from the spreadsheet). Then, based on these forecasts and the CFOs model, the % change in daily ship hire rate is estimated at 0.007 + 1.4(0.0217) 1.6(0.0213) = 0.0032 (0.32%). Given the hire rate $50,000 (given) in 2050, the rate in 2051 is then estimated at $50,000*(1.0032) = $50,160 per day. See the spreadsheet for detailed forecasts for the demand and supply and the % changes in these variables.

The number of days hired is assumed to be equal to 365 days less the number of days required to complete annual mandatory maintenance. The companys assumption is that it takes 14 days to complete the annual maintenance.

f) Assumptions for operating costs

The CFO assumes that the operating costs are incurred throughout the year, including the mandatory maintenance period. The annual operating costs therefore can be calculated as the estimated daily operating costs, multiplied by 365 days. In addition, daily operating costs are assumed to grow at a rate that is slightly higher than the expected inflation. The CFO suggests the following equation:

= 1 (1 + )(1.01),

where subscript t indexes year, and h is the expected inflation rate, provided in subsection a.

For example, given the average daily cost in 2050 estimated at $14,000 (given), the daily cost in 2051 is then estimated at $14,000*(1.03)(1.01) = $14,564 (per day).

#3 [5 points] Analytical reasoning: the assumption concerning the supply of ship capacity.

The premise of the CFOs pricing model is that the market rate for ship hire is in principle the function of the demand for commercial shipments and the supply (shipping capacity). However, although the shipping demand, governed by various economic factors, is likely to evolve smoothly, the supply of shipping capacity may be lumpy due to the time-to-build constraints and irreversibility of capital investment. That is, if companies order new vessels once they observe the increased demand for cargo shipping, the new vessels ordered today will be ready in, say, three years later. Moreover, once new vessels are delivered, they are likely to stay in the market for the next 2030 years, resulting in the problem of irreversible investments (i.e., prohibitively costly to disinvest because of illiquid secondhand markets).

Required: In what way would the described lumpiness in the supply of ship capacity play out in determining the market rates for ship hire? Provide your thoughts and discuss.

*Note that a short news article has been provided, which can help you understand the demandsupply dynamics in the industry and prepare your responses