Clarkson Lumber Company

2011Ocean Carriers Project EvaluationNatalya Kashirina

Executive SummaryMaking necessary changes to companys policies will produce a positive outcome in the acceptance of the proposed lease. Income tax is the most important factor in this case. United States 35% tax rate will not allow for a positive NPV. Therefore, new vessel must be registered in Hong Kong in order to receive tax exemption. Ocean Carriers 15 year policy is not as advantageous as it appears and should be ignored. Furthermore, the evaluation of the market led us to believe that the proposed contract terms are unfavorable and should be renegotiated. Problem Statement New lease offer would require Ocean Carriers to invest 39 million dollars in the building of a new Capesize vessel. However, under current operations, it is unclear if this new venture would be profitable in the long run. The company has offices in United States and Hong Kong; however, it does not take advantage of tax exemption it is qualified for, and instead incurs an unfavorable 35% income tax rate. In addition, 15-year policy the company follows is undesirable under current conditions and needs to be changed. Analysis Under current policies an investment in a new Capesize vessel will result in an extremely undesirable NPV and become a financial burden to the company. However, making adjustments to some of Ocean Carriers procedures will transform this investment into a highly profitable venture.In 1990 Hong Kong government enacted an independent shipping registry, Merchant Shipping (Registration) Ordinance, which states that ships owned by qualified persons or companies, and registered on the Register established by the Ordinance have to fly the flag of Hong Kong to receive tax exemption on profits. According to the act, qualified persons may include a company incorporated outside of Hong Kong with established place of business in Hong Kong. In addition, Hong Kong has entered into double taxation relief agreements with major trading countries including United States. A critical factor which determines the acceptance of this investment is the income tax rate Since Ocean Carriers has offices in Hong Kong it is eligible for tax exemption. This allows the company to legally earn profits tax-free. With United States 35% income tax rate, the NPV of the new vessel is approximately -6.3 million dollars; implementing zero tax-rate significantly changes this value to a much more desirable outcome of 561k dollars. Registering new vessel in Hong Kong eliminates income tax completely allowing the company to earn greater profits, and making the acceptance of proposed new lease profitable. Ocean Carriers implements a 15-year policy to avoid some of the large survey expenditures required every five years. After 15 years of operation the scrap value of a capesize vessel is insignificant at only 5 million dollars. With 35% income tax rate, NPVs for vessels 15 years in operation and 25 years in operation are both negative; however, the difference in NPV is nearly 1 million dollars, making 25 years in operation a better choice. Therefore, the company should abandon 15-year policy and utilize the ship for its full life of 25 years. Table1 below shows the difference in NPV of a vessel based on its years in operation.

Table 1

Ocean Carriers dry bulk capesize vessels are mainly used to transport iron ore and coal. Dry bulk freight rates are expected to increase due to the strong demand for Capesize vessels and fairly tight availability. Forecasted demand for these vessels is closely correlated with the level of economic growth in the world. Higher level of economic activity and industrial production generally leads to higher demand for industrial raw materials. Global iron ore production and exports are expected to increase in the coming years. Based on this positive view of the dry bulk industry, we have determined that the daily rates offered in the new lease contract are underpriced and should be renegotiated. RecommendationAfter completing the analysis for each scenario, weve come to a conclusion that the proposed new lease offer should be accepted; however, implementation of this decision is contingent on three specific adjustments. First two changes concern the companys policies. It is clear to us that the feasibility of a profitable outcome from this investment depends on the income tax the company is subjected to. New Capesize vessel must be registered in Hong Kong in order to receive tax exemption. Secondly, as seen in Table1, 15 year policy is much less profitable than the vessels full life expectancy of 25 years and should not be applied in this case. In addition, even though these adjustments to companys policies would create a positive return of 2 million dollars, renegotiating the proposed contract terms will produce even higher return of 7 million dollars. Careful evaluation of the market led us to believe that the contract rates are underpriced and should be increased to $22,000 per day with the same escalation rate, and the term of the contract extended to five years.

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