Finance -AW-Q51

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QPM SHIPPING COMPANY
 
In April 2008, the controller of QPM Shipping Company, located near Pittsburgh, has delivered a recommendation to the board regarding the feasibility of repairing one of the company’s diesel riverboats (“Cargo Master”) or replacing the Cargo Master with a new turbo-diesel powered boat. The Cargo Master, a 12-year-old diesel boat now in dry-dock, requires immediate rehabilitation or replacement. Based upon a consulting firm’s analysis the controller has recommended that the Cargo Master be rehabilitated as soon as possible. Your boss, a board member has asked you to prepare to one to three page memo indicating which option is preferable and why with exhibits that he can use at the next board meeting. Your boss has provided you the following background information.
 
QPM Shipping is engaged in the transportation of coal from nearby mines to the steel mills, public utilities, and other industries in the Pittsburgh area. The company’s diesel boats also on occasion carried cargo on long hauls. All the boats owned by QPM Shipping are diesel-powered. All their boats are between 7 and 18 years old. The Cargo Master has been out of operation for about seven months. A consulting firm was engaged to prepare a feasibility study with the purpose of recommending the rehabilitation of the Cargo Master or replace her with a new turbo-diesel. QPM Shipping has been losing business for the past several months, as their current fleet of five operating diesel boats (excluding the Cargo Master in dry-dock) does not have the capacity to meet current and expected cargo demands.
The consultant’s report ended with a financial summary indicating an expected return from both alternatives exceeded the firm’s current average return on equity of 17%. The financial summary indicates that rehabilitating the Cargo Master is the better alternative given its materially higher expected rate of return and its lower cash outlay.
 
Rehabilitation
 
The consulting firm concluded that the Cargo Master would have a useful life of 15 years after rehabilitation. The consulting company estimated the rehabilitation costs for the Cargo Master to be $430,000. Spare parts from a retired boat with a book value of $86,500 are available for use in the rehabilitation of the Cargo Master. Use of these parts would in effect decrease the immediate rehabilitation costs from $430,000 to $343,500. It was believed that if these parts were sold on the market they would bring only around $60,000. They could not be used on any of the other QPM Shipping diesel boats. QPM is not depreciating the Cargo Master as the ship is not currently in use.
The controller estimated that the cost of dismantling and scrapping the Cargo Master at the end of its useful life after the overhaul would be offset by the value of the scrap and used parts taken off the boat.
 
The consulting firm’s report indicates that with the Cargo Master rehabilitated QPM’s operating revenue would increase by about $985,000 per year resulting in gross profits increasing $235,000 given the firm’s mix of fixed and variable costs. General and administrative costs would increase $65,000 with the additional boat. Details of the increase in operating costs are shown on Table A. A major shareholder is planning to lend the company up to $150,000 for the rehabilitation. The loan would have a 7-year duration and have an 8.25% Interest rate. The balance would come from cash reserves and the firm’s credit line. The rehabilitation will take about 6 months.
 
Acquiring A Turbo-Diesel
 
An alternative to rehabilitating the Cargo Master is to purchase a turbo-diesel powered boat with a six month delivery time. The book value of the Cargo Master was $279,000, but the controller believed that if the company sold the boat, it would bring only around $75,000. The Krasner Company, a local boat manufacturer, had introduced the turbo-diesel about two years ago. The cost of the boat was $1,725,000. An additional $125,000 for a basic parts inventory would be necessary to service the boat. The turbo-diesel powered boat would be purchased with seller-financed 15 year 7.50% loan of $900,000 with the balance paid with funds raised by issuing shares to family members at $135 per share. The useful life of a turbo-diesel-powered boat was estimated to be 15 years; at the end of that time the boat would most likely be scrapped. A general overhaul of the engines, costing $120,000 at current prices, would be expected after 10 years of operation.
 

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With the acquisition of a turbo-diesel revenue is expected to grow by $1,175,000 in 2005 due to a larger cargo capacity and the additional speed of the turbo-diesel boat. The consultants concluded that given QPM Shipping’s mix of fixed and variable costs, gross profits of $376,000 would be generated based upon expected operating costs that are shown on Table B. General and administrative costs would be expected to increase by $65,000.

 
TABLE A
 
ANNUAL OPERATING COSTS FOR THE CARGO MASTER AND ITS CREW
 
Wages (crew of 7) $383,000
Benefits 62,000
Commissary supplies 50,000
Repairs and maintenance 75,000
Fuel 150,000
Miscellaneous service and supplies 30,000
Total $750,000

TABLE B
ANNUAL OPERATING COSTS FOR
THE TURBO-DIESEL

Wages (crew of 6) $328,000
Benefits $53,000
Commissary supplies $43,000
Repairs and maintenance 115,000
Fuel 210,000
Miscellaneous service and supplies 50,000
Total $799,000

FINANCIAL SUMMARY
Cargo Master Turbo-Diesel
Additional Revenue $ 985,000 $ 1,175,000
Additional Operating Costs $ 750,000 $ 799,000
Additional General & Administrative Costs $ 65,000 $ 65,000
Additional interest expense $ 7,500 $ 67,500
Estimated increase in Pre-tax Profits $ 162,500 $ 243,500
Estimated taxes @ 30% $ 48,750 $ 73,050
Estimated Increase in After-tax Profits $ 113,750 $ 170,450

Estimated Out of Pocket Cash $ 243,000 $ 550,000

Expected Return on Equity Investment 47% 31%
($119 / $243) ($170.45 / $550)

 

INCOME STATEMENT
2005 2006 2007 2008
Revenue 4,124,000 4,575,160 4,882,549 4,246,828
Operating Expenses 3,139,457 3,504,220 3,739,333 3,247,409
Gross Profit 984,543 1,070,940 1,143,216 999,419
23.9% 23.4% 23.4% 23.5%
General & Administration 520,920 535,753 589,387 603,356
12.63% 11.71% 12.07% 14.21%
Interest Expense 62,159 66,280 71,619 72,852
Earnings Before Taxes 401,465 468,907 482,209 323,210
Taxes 116,425 140,672 147,074 95,994
Earnings After Taxes 285,040 328,235 335,135 227,217
 

QPM SHIPPING
HISTORICAL FINANCIAL STATEMENTS

 

BALANCE SHEET
2005 2006 2007 2008
Cash 100,000 103,090 155,210 158,489
A/R 600,000 629,815 663,425 614,680
Prepaid Assets 250,000 257,025 258,538 267,491
Tot Current Assets 950,000 989,930 1,077,173 1,040,660
Plant Prop. & Equip. 6,110,000 6,617,942 6,865,303 7,010,541
Accum. Depreciation 4,200,000 4,424,831 4,530,645 4,546,570
Net Fixed Assets 1,910,000 2,193,111 2,334,658 2,463,971
Total Assets 2,860,000 3,183,041 3,411,831 3,504,631
 

Accounts Payable 350,000 335,320 416,130 433,372
Other Current Liabilities 200,000 253,416 287,599 250,212
Current Portion LTD 75,000 88,773 141,315 161,870
Income Tax Payable 60,000 65,572 73,480 104,400
Total Current Liabilities 685,000 743,081 918,524 949,854
Long Term Debt 875,000 924,219 953,281 951,563
Common Stock (21,000 Sh. Out) 100,000 100,000 150,000 150,000
Retained Earnings 1,200,000 1,415,741 1,390,026 1,453,214
Total Liabilities & Equity 2,860,000 3,183,041 3,411,831 3,504,631

 

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