Assignment Task

Finance & Financial Management in Shipping

Assignment 1

Investment Appraisal Decisions In Martine Business

Ocean Navigation Ltd., a global dry-bulk shipping company, is listed and traded on the New York Stock Exchange. The management develops an ambitious Investment Plan and evaluates the company’s fleet expansion. Based on current market prices, the management investigates the acquisition of secondhand bulker vessels, on a ten-year investment horizon. Three alternative vessel options are comparatively estimated and ranked in priority. The forecasted cash flows and relevant input of the three investment projects are summarized in the tables below.

Freight Revenue

Freight Contracts 1 2 3

Contract Duration Year-1 to Year-3 Year-4 to Year-7 Year-8 to Year-10

Sea Route US Gulf to Japan Argentina to East Europe Australia to Far East

Cargo Quantity (grain tonnes) 100,000 120,000 80,000

Freight Rate (USD/per tonne) 50.0 USD 60.0 USD 75.0 USD

Freight Rate Growth (per annum) 2.0% 2.5% 3.0%

The freight revenue analysis is assumed to run the same for all three alternative vessel options under evaluation. The cash flows are assumed to occur at the (respective) year-end., Years out of the 10-year investment horizon that the respective freight contracts are running.

Assume a constant growth (Gordon-type) model.

Capital Expenditure – Operating Expenses – Terminal Value (in mln. USD)

(amounts in mln. USD) BULKER-1 BULKER-2 BULKER-3

Capital Expenditure

Investment Outlay 15.0 12.0 10.0

Additional Technical Investments 18.0 13.5 6.0

Operating Expenses –

Annual Operating Expenses 35% 30% 25%

Voyage Expenses 30% 40% 45%

Maintenance & Repair Expenses 2.0 3.5 3.9

Annual Insurance Expenses 3.0 2.5 1.0

Cargo Handling Expenses 1.5 1.8 2.2

Financial Expenses 4.3 5.5 6.0

Vessel Terminal Value

Resale Vessel Terminal Value 5.5 4.0 3.0

These three investment options are going to be financed by bank lending (70%), and equity funding (30%). The respective cost funding factors are summarized below.

Financing Assumptions

BULKER-1 BULKER-2 BULKER-3

Capital Structure Mix

Bank Loan 70% 70% 70%

Equity Funds 30% 30% 30%

Funding Terms

Risk-Free Rate 3.0% 3.0% 3.0%

Bank Loan Rate 6.0% 6.0% 6.0%

Market Risk Premium 7.0% 7.0% 7.0%

β-Coefficient 1.5 1.5

1.5

Ocean Navigation has issued 5 mln. common shares outstanding, trading at an average stock market share price of USD 10.

Questions

(1) Determine each investment project’s Net Present Value (NPV) and Profitability Index (PI) and evaluate and rank the three alternative projects. Discuss and explain the attractiveness of these investment options for implementation, based on: a) Net Present Value (NPV) b) Profitability Index (PI).

(2) Which investment option may offer a more attractive payback period, assuming the company sets a target capital recovery time-horizon at five years? Explain your results based on Payback Period (PBP) and Discounted Payback Period (DPBP) approaches.

(3) On the basis of your analysis above, make a suitable recommendation for the Ocean Navigation’s top management explaining the rationale behind it.

(4) Based on the potential choice in (3), assess the potential shift in the company’s market value and calculate the new company market value, after the final investment decision.

(5) Based on ‘sensitivity analysis’, indicate NPV shifts to different values in three critical inputs employed earlier in the NPV approach, i.e., a) annual freight rate growth; b) bank loan rates; c) market risk premium. Provide an interpretation of your results and comment on how valuable you think this analysis may be in taking a decision on the investment. Apart from the sensitivity analysis, use ‘probabilistic scenario analysis’, to assess your capital budgeting results, and discuss the relevant findings

ASSIGNMENT 2

DIVIDEND POLICY AND REINVESTMENTS – CORPORATE VALUATION MODELS

EXERCISE 1: DIVIDEND POLICY AND REINVESTMENTS

Waves Maritime S.A., an international containership company, expects to have earnings per share of USD 6 in the coming year. Rather than reinvest these earnings and grow, the firm plans to pay out all its earnings as a dividend. With these expectations of no growth, Waves Maritime current share price is USD 60.

Question

a) Suppose Waves Maritime could cut its dividend payout rate to 75% for the foreseeable future and use the retained earnings to acquire new containerships. The return on its investment in vessels is expected to be 12%. Assuming its equity cost of capital is unchanged, what effect would this new policy have on Waves Maritime’s stock price?

b) Suppose Waves Maritime decides to cut its dividend payout rate to 75% to invest in vessel acquisitions as before. But now suppose that the return on these new investments is 8%. Given its expected earnings per share this year of USD 6 and its equity cost of capital of 10%, explain what will happen to Waves’ current share price in this case

EXERCISE 2: CORPORATE VALUATION MODELS

Company Valuation Using Dividend Discount Model

Smart Shipping Inc. has just invented an environmentally friendly technology to boost LNG vessel productivity, supporting vessel emissions’ decarbonization. Given the phenomenal natural gas market response to this innovative technology, Smart Shipping is reinvesting all its earnings to expand its field operations. Earnings were USD 2 per share this past year and are expected to grow at a rate of 20% per year until the end of year 4. At that point, other companies are likely to bring out competing green fuel and vessel technologies. Analysts project that at the end of year 4, Smart Shipping will cut investment and begin paying 60% of its earnings as dividends and its growth will slow to a long-run rate of 4%. The risk-free rate stands at 5%, the average market portfolio return is 7.50% and Smart Shipping βcoefficient is 1.2.

Question

Based on the information input provided, calculate and explain in detail the value of a Smart Shipping share worth today.

Company Valuation Using Free Cash Flow

Seasun Shipping Ltd. (SSS) had freight revenue (sales) of USD 518 mln. in 2005. Suppose you expect its freight revenue to grow at a 9% rate in 2006, but that this growth rate will slow by 1% per year to a long-run growth rate for the shipping industry of 4% by 2011. Based on SSS’s past profitability and investment requirements, you expect EBIT to be 9% of revenue, increases in net working capital requirements to be 10% of any increase in revenue, and net investment (capital expenditures in excess of depreciation) to be 8% of any increase in freight revenue. Assume that SSS has USD 100 mln. in cash, USD 3 mln. in debt, 21 mln. shares outstanding, a tax rate of 37%, and a weighted average cost of capital of 11%.

Question

Explain and discuss the estimate of the value of SSS’s stock in early 2006. Your empirical analysis and discussion should be based on the discounted free cash flow model that determines the total value of the firm to all investors (shareholders and debtholders).

Question 1:

Capital Expenditure Decision and Investment Criteria

The board of directors of Newton plc has to decide whether or not to invest in a manufacturing plant to produce a new product that has been developed on the basis of research undertaken within the company. The development of the product has been expensive and at a cost of £2.00 million has significantly exceeded the initial budget allocation for the product. One member of the board has argued that the company should not proceed with the investment as it is most unlikely that it will be able to recover what has already been spent on the product.

The marketing department has suggested that the product should be sold at £14.00 per unit and it is anticipated that sales in the first year will be about 400,000 units, rising to 600,000 in year two. Sales are expected to remain at this level for the following three years and fall to 300,000 units in year six. It is thought that the product is unlikely to be competitive after six years given the rate of product innovation in the sector, and it will be withdrawn from the market at this stage.

To manufacture the product an investment of £9.00 million will be necessary in new production facilities. This expenditure can be written off for tax purposes using a 25 percent writing-down allowance. The resale value of the equipment has been estimated to be about £2.50 million at the end of the six-year anticipated product life. Use will also be made of some equipment the company already owns. This equipment is now fully depreciated for tax purposes but would be sold today for £1.20 million. If used in the manufacture of the product its value is expected to fall to £0.30 million by the end of year six.

The production facility will be located in one of the company’s factories that is not being fully utilized. The company has no alternative uses available for this space that is currently being rented out to another manufacturer for £80,000 per annum. The product will be charged £40,000 per annum for the space it utilizes through the company’s internal budgetary system. The fixed costs associated with the production are expected to be £250,000 per annum. Each product sold by the company is also allocated by the company’s accountant an overhead charge of 5 percent of the revenues it generates to cover head office expenses. The direct manufacturing costs are expected to be £7.00 per unit.

The company will need to hold stocks of the final product at the start of each year equivalent to 20 percent of the sales expected in the next year and also stocks of materials and components equivalent to 20 percent of the production expected in the next year. The materials and components account for £4.00 per unit out of the £7.00 overall direct cost per unit. The increase in debtors as a result of introducing the product will be offset by the increase in creditors. The company requires a rate of return of 12 percent on investments of this nature, and the tax rate is 25 percent.

Determine the investment’s net present value, payback period and discounted payback period. All key assumptions should be specified and explained very carefully

Interpret the NPV, discounted payback period, and payback period, using your evaluation of Newton’s proposed investment to illustrate your answer.

Question 2: Valuation of a Company’s Shares

Take the price-earnings ratios for three companies traded on the London Stock Exchange from the data set given in the attached data file. These companies are drawn from the FT 100, the hundred largest companies traded on the exchange, and the P/E ratios specified are for the end of each year from 2009 to 2021.

The data also gives the P/E ratios for the index. Discuss the factors that might explain the differences in the price-earnings ratios of the three companies you have chosen and the changes that have occurred in their price-earnings ratios over this period. (Choose companies with a range of P/E ratios, to give you one with a relatively low value, one with a relatively high value, and another with a middling value.) You should use the insights provided by valuation models on the determinants of the price-earnings ratios in your discussion, but you should also discuss the role of any other factors that might influence the reported values of price-earnings ratios of the companies you have chosen.

Whilst you need to gather some information on the companies you choose it is not anticipated that you undertake an in-depth analysis of the companies. It is acceptable to make use of some possible reasons to account for the differences in the price-earnings ratios as well as employ the information that you gather on the companies

Question 3: Rights Issue

Barclays announced on July 30 2013 that the company would make a rights issue in September of the same year. The rights issue was planned to raise approximately £5.8 billion, with the shareholders being offered one new share at a subscription price of £1.85 for every four shares they were holding. The total number of shares to be issued was 3,216,893,546, equivalent to twenty-five percent of the shares outstanding at the time of the announcement.

The share price immediately prior to the announcement was £3.095 and this fell to £2.93 when the issue was announced, a fall of 5.3 per cent. The announcement of a rights issue did not surprise the market, but the size of the issue was larger than anticipated. The issue was the 4th largest issue ever made by a bank. The issue was designed to help the bank meet a requirement that Barclays increased the ratio of its risk capital to its assets to 3 percent and at the time Barclays had a shortfall of £12.8 billion in its risk capital given the value of its assets. Other measures were also announced at the same time to explain how Barclays intended to cover the deficit. (Google “Barclay’s rights issue 2013” to gain access to the press coverage of the announcement.)

a) Explain and discuss the rationale provided for the rights issue. In answering the question take into account the financial performance and position of Barclays Bank at the time of the issue.

b) Specify the terms of the issue, and the anticipated ex-rights price and calculate the value of a right. Utilise the price just prior to the announcement to undertake your calculations.

c) Demonstrate that an investor will in principle be equally well off from investing in the issue or selling the rights they have been allocated.

d) Identify and comment on the market’s reaction to the announcement of the issue. Can the price pressure hypothesis account for the market’s reaction or does the information hypothesis provide a better basis for interpreting the reaction?

Question 4

The attached data file (Stock returns 2009-21) gives 156 monthly returns for securities drawn from the FT ALL Share Index for the period January 2009 and December 2021.

a) i. The data set provided identifies four equally weighted portfolios of one, five, ten, and fifteen securities. Determine, using the appropriate Excel function (see fx)) the standard deviation and variances of the monthly returns for each of the companies included in the portfolios. (Use the 168 months returns data in the calculations and use the Excel functions identified as Variance. P and Standard Deviation P.) Next, determine the monthly returns on the four portfolios along with the standard deviation of these returns.

The monthly portfolio returns are simply the average of the monthly returns for each security included in the portfolio. Compare the average value of the standard deviations of the returns on the securities included in each portfolio with the standard deviation of the portfolio’s returns. Comment on the difference between the outcomes.

Discuss the consequences of increasing the number of securities in the portfolios. Compare your results to those of the studies of naïve diversification.

ii. Determine the co-variances for each pair of securities in the portfolio of five securities using the relevant Excel function. Using this information, along with the variances for the returns for the securities, calculate the standard deviation of the returns on the portfolio using the portfolio risk equation. Compare your results to those obtained for the portfolio in part i above.

b) Determine the betas for BP and Ferguson by regressing the returns for each of the two companies on the returns for the FT ALL Share Index (the first column in the spreadsheet).

i) Explain what the values of the betas (the slope coefficients in the regression) indicate and discuss the factors that might explain the differences in the values of the betas of the two companies.

ii) Comment on the implications of the estimated value of beta for investors and the cost of capital for the two companies