New Economy Transport

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The New Economy Transport Company (NETCO) was formed in 1952 to carry cargo and passengers between ports in the Pacific Northwest. By 2002 its fleet had grown to four vessels, one of which was a small dry-cargo vessel, the Vital Spark.

The Vital Spark is badly in need of an overhaul. Peter Handy, the finance director, has just been presented with a proposal, which would require the following expenditures:

Install new engine and associated equipment

$18S,000

Replace radar and other electronic equipment

S0,000

Repairs to hull and superstructure

130,000

Painting and other maintenance

3S,000

$400,000

NETCO's chief engineer, McPhail, estimates the postoverhaul operating costs as follows:17

Fuel

Labor and benefits

Maintenance

Other

$ 4S0,000 480,000 141,000 110,000 $1,181,000

17All estimates of costs and revenues ignore inflation. Mr. Handy's bankers have suggested that inflation will average 3 percent a year.

PART I Value

The Vital Spark is carried on NETCO's books at a net value of only $30,000, but could probably be sold "as is," along with an extensive inventory of spare parts, for $100,000. The book value of the spare parts inventory is $40,000.

The chief engineer has also suggested installation of a more modern navigation and control system, which would cost an extra $200,000.18 This additional equipment would not substantially affect the Vital Spark's performance, but it would result in the following reduced annual fuel, labor, and maintenance costs:

Fuel

Labor and benefits

Maintenance

Other

$420,000 405,000 70,000 90,000 $985,000

There is no question that the Vital Spark needs a new engine and general overhaul soon. However, Mr. Handy feels it unwise to proceed without also considering the purchase of a new boat. Cohn and Doyle, Inc., a Wisconsin shipyard, has approached NETCO with a new design incorporating a Kort nozzle, extensively automated navigation and power control systems, and much more comfortable accommodations for the crew. Estimated annual operating costs of the new boat are

Fuel

$370,000

Labor and benefits

330,000

Maintenance

70,000

Other

74,000

$844,000

The crew would require additional training to handle the new boat's more complex and sophisticated equipment and this would probably require an expenditure of $50,000 to $100,000.

The estimated operating costs for the new boat assume that it would be operated in the same way as the Vital Spark. However, the new boat should be able to handle a larger load on some routes, and this might generate additional revenues, net of additional out-of-pocket costs, of as much as $100,000 per year. Moreover, a new boat would have a useful service life of 20 years or more. The Vital Spark, even if rehabilitated, could not last that long—probably only 15 years. At that point it would be worth only its scrap value of about $40,000.

Cohn and Doyle offered the new boat for a fixed price of $2,000,000, payable half immediately and half on delivery in nine months. Of this amount $600,000 was for the engine and associated equipment and $510,000 was for navigation, control, and other electronic equipment.

NETCO was a private company, soundly financed and consistently profitable. Cash on hand was sufficient to rehabilitate or improve the Vital Spark but not to buy the new boat. However, Mr. Handy was confident that the new boat could be financed with medium-term debt, privately placed with an insurance company. NETCO had borrowed via a private placement once before when it negotiated a fixed rate of 12.5 percent on a seven-year loan. Preliminary discussions with NETCO's bankers led Mr. Handy to believe that the firm could arrange an 8 percent fixed-rate medium-term loan.

NETCO had traditionally estimated its opportunity cost of capital for major business investments by adding a risk premium of 10 percentage points to yields on newly issued

18All investments qualify for the seven-year MACRS class.

Treasury bonds.19 Mr. Handy thought this was a reasonable rule of thumb for the dry-cargo business.

1. Calculate equivalent annual costs of the three alternatives—overhaul, overhaul with improved navigation and control, or a brand-new boat. To do the calculation, you will have to prepare a spreadsheet table showing all costs after taxes over each investment's economic life. Take special care with your assumptions about depreciation tax shields and inflation.

Questions

19In 2002 Treasury bonds were yielding 5 percent.

PART 1

RELATED

WEBSITES

Chapter 1 described the role of the financial manager. More information on careers in finance can be found at:

www.careers-in-finance.com

The following websites, which are concerned largely with personal finance, provide discussions of the time value of money and calculators:

www.bankrate.com

www.financenter.com

www.financialplayerscenter.com

www.invest-faq.com

www.money.cnn.com

www.unb.ca/web/transpo/mynet/ mtw21b.htm (how to use Excel for compound interest calculations)

One of the few sites with material on capital investment decisions is:

www.asbdc.ualr.edu/fod/1518.htm

Chapter 3 explained how bonds are valued. Helpful material and data on bond markets are available on:

www.bondsonline.com (good bond data)

http://bonds.yahoo.com

www.finpipe.com (good explanations of bond markets)

www.fintools.net (contains a bond calculator)

www.ganesha.org (explanation of bond markets and calculator)

www.hsh.com (good bond data)

www.investinginbonds.com (also contains links to related sites)

www.investorguide.com/university.html

(good explanations of bond and equity markets)

http: //money.cnn.com/markets/bondcenter

Chapter 4 was concerned with stock markets and equity valuation. Most major stock exchanges have good websites. See, for example:

www.nyse.com (New York Exchange)

www.nasdaq.com (NASDAQ)

www.londonstockexchange.com (London Exchange)

www.tse.or.jp (Tokyo Exchange)

www.123world.com/stockexchanges (links to exchanges)

www.fibv.com (The World Federation of Exchanges publishes useful comparative statistics)

Data on stock market indexes can be found on:

www.djindexes.com (Dow Jones index)

www.spglobal.com (Standard & Poor's indexes)

www.barra.com (market indices with information on dividend yields, P/Es etc.)

www.wilshire.com

There is a large number of sites with market commentary and data on individual firms and stocks. We find Finance.Yahoo particularly useful.

http://finance.yahoo.com

www.bloomberg.com

http://hoovers.com

www.cbs.marketwatch.com

www.finance.lycos.com

http://money.cnn.com

http://moneycentral.msn.com

http://my.zacks.com (includes earnings forecasts)

The following sites provide useful software and data for calculating company values:

http://financialplayerscenter.com

www.valuepro.net

II. Risk

7. Introduction to Risk, Return, and the Opportunity Cost of Capital

H

un

■■

w

INTRODUCTION TO

RISK, RETURN, AND

THE OPPORTUNITY

COST OF CAPITAL

--1

WE HAVE MANAGED to go through six chapters without directly addressing the problem of risk, but now the jig is up. We can no longer be satisfied with vague statements like "The opportunity cost of capital depends on the risk of the project." We need to know how risk is defined, what the links are between risk and the opportunity cost of capital, and how the financial manager can cope with risk in practical situations.

In this chapter we concentrate on the first of these issues and leave the other two to Chapters 8 and 9. We start by summarizing 75 years of evidence on rates of return in capital markets. Then we take a first look at investment risks and show how they can be reduced by portfolio diversification. We introduce you to beta, the standard risk measure for individual securities.

The themes of this chapter, then, are portfolio risk, security risk, and diversification. For the most part, we take the view of the individual investor. But at the end of the chapter we turn the problem around and ask whether diversification makes sense as a corporate objective.

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  • gundobad
    Which org replace investinginbonds.com?
    7 years ago

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