Economy Shipping Company

Economy Shipping Company

        The Economy Shipping Company’s business belongs to the freight industry, mainly transporting coal from mines to several steel mills, public utilities and other industries. Operations are mostly local (around Pittsburgh), but transactions as far as New Orleans were also existing in their portfolio.

        Steam powered boats were used by the company to transport their goods to their customers. All are owned by the Economy Shipping Company and have useful lives of between 15 to 30 years old.

        Conway, one of the oldest steam boats of the company, is nearing the end of its useful life after being used for 23 years. It requires either replacement or rehabilitation – a decision which the executive committee through the analysis of the company’s controller.

        The replacement, a diesel powered engine, has an estimated useful life of 25 years, but will be sold after 20 years if acquired. Additional inventory for parts will be needed and this, along with the hull, shall be depreciated for 25 years for tax purposes. The engine, however, is spread for a ten-year period only. Should the company choose this alternative, they will be able to sell Conway for a market price lower than the current book value.

        On the other hand, there are two options for rehabilitating Conway – with spare parts or without. Any of these options will extend the useful life of Conway for 20 more years. Purchasing spare parts has a lower rehabilitation cost, and these parts can be sold at the end of the boat’s life.

Statement of the Problem

As the company’s controller, which alternative shall be recommended to the executive committee?

Analysis

        Using the NPV method, a comparison between the cash flows among the three alternatives was presented. The period of analysis was cut off to 20 years, given the assumptions that the new machine will be sold at the end of 20 years.

(Cash Flows for Buying the Diesel-powered Boat) The cash flows considered in buying the diesel-powered riverboat include the following:

• Inflows:

• Cash receipt from selling Conway
• Cash receipt from selling the spare parts from another boat
• Tax savings due to the sales of Conway and spare parts, and the depreciation of the new boat
• Salvage value of the diesel boat in year 20
• Sale on diesel parts inventory in year 20

• Outflows:

• Investment in diesel-powered boat
• Investment in parts inventory (adequate for 3 diesel boats)
• Overhaul of diesel engines in year 10
• Operating costs
• Tax on gain from sale of diesel parts in year 20

(Cash Flows for Repairing Conway with Spare Parts) The cash flows considered in repairing Conway with the spare parts from the other boat are the following.

• Inflows:

• Tax savings due to depreciation

• Outflows:

• Rehabilitation costs
• Operating costs

(Cash Flows for Repairing Conway without Spare Parts) The cash flows considered in repairing Conway without the spare parts from the other boat are the following. The only difference from the previous item is that the cash receipt from the sale of the spare parts from the other boat.