Since ESC was considering other projects with a rate of return of 10%, each of the above options were considered using the same rate of return. The company’s balance sheet suggests that management was very conservative. The debt-to-equity ratio in 1950 was 0.075, indicating that the company could easily borrow at the going rate of 3% without fear of bankruptcy. Moreover, the company had sufficient funds to purchase four new diesel-powered boats. Overall, ECS was in a very strong position to quickly upgrade their fleet and gain any advantage that may come with the new diesel-powered boats.
The influence of the union to change the working hours for the crew members is noteworthy in this analysis. If the union succeeded, the steamboats would not be capable of accommodating the 3-shift requirement and therefore be noncompliant with the new regulation. If the new regulation had fines associated for any vessel not in compliance with the new guidelines, the results for the steamboat scenarios would only get worse. In this case, the diesel-powered boats could accommodate the anticipated ruling and therefore continue to operate without fear of being unlawful.
Another disadvantage against rehabilitating Cynthia was its age. At the time of the decision the steamboat had already been in operation for 23 years. Although, the realizable cost to renovate the steamboat was already known, the intangible aspect of this alternative was the status of the boat once refurbished. It should be noted that with any overhaul, there are still aspects to the boat that will remain “old” and will eventually fail. The maintenance and repairs listed in the case appear to indicate general maintenance and not a catastrophic event as is suggested. The cost of another large repair that is associated with age has not been calculated for but must be understood as a variable to the rehabilitation options.
The tax savings associated with purchasing the new diesel-powered boat is yet another advantage over the steamboat. With a lower operating cost and higher depreciation (see appendix) the purchasing option saves approximately $11,500 less in taxes (option 4 vs. option 1). During the 25-year useful life of the boat, Economy will save $287,500.
The equivalent annual cost (EAC) analysis was used to evaluate each option. The rehabilitation options had a useful life of 20 years, whereas the purchasing options had a useful life of 25 years. The replacement technique would have required a 100-year analysis. Instead, the EAC procedure returns an annualized cost for each project and allows both the rehabilitation options and the purchasing options to be compared without much hassle.
Between the two rehabilitation options, the option of immediately converting to stoker firing resulted in the lowest NPV (-$970, 889 vs. -$988,249). The additional $30K associated with waiting the two years before performing the stoker conversion explains the discrepancy between these two options. The immediate stoker conversion resulted in an equivalent annual cost of $114,040. Compared to the two purchasing options ($110,833, $111,402) the cost of the rehabilitation option was slightly higher.
Although both of the purchasing options were optimal compared to the alternative of rehabilitating Cynthia, the effect that the union’s proposition would have on the shipping industry would obviously increase the cost of doing business. If the controller’s instincts are correct, the NPV calculation for the purchasing option would increase by $4,850 and the EAC would increase by $570. Although these dollars would eat into the profit, the alternative may be far more costly if fines are administered for those vessels not in compliance. While the analysis may suggest that the two main options (overhaul vs. purchase) are close in cost, it is obvious that with all the intangibles associated with this case that the purchase of the new diesel powered boats guarantees a successful future, whereas the steamboat option is dependent on unlikely events.
Economy Shipping Company
7/21/05
