Mini Case 1 Capital Budgeting at Rio Inc

Mini Case #1 Capital Budgeting at Rio Negro, Inc.

Prepared by Group 9:

Feb 3, 2019

I. Introduction

The primary shipping vessel of Rio Negro, Inc. (RNI), Maracas, needs repairs. RNI, a shipping company, is considering two options for overhauling the Maracas, and a third option for replacing Maracas with a new vessel. The repairs associated with overhauling the Maracas would reduce fuel, labor, and maintenance costs. In addition to lower operating expenses, a new vessel would carry a larger load increasing revenue. RNI is considering three options, a basic overhaul of the Maracas, a more robust overhaul of the Maracas including replacing the engine and control systems, or purchasing a replacement vessel. RNI should analyze the present value of the three options, and because the projects have different expected lives, RNI should use the equivalent annual costs to help compare options and make a final decision.

II. Analysis

Comparing two proposed overhaul options

        Without considering the purchase of a new vessel, there are two proposed options for overhauling the Maracas; a basic overhaul to make the ship seaworthy and a more extensive overhaul that includes a new engine and control system. Exhibit 1 shows the detailed calculations of both options.

The present value of costs of the basic overhaul is about $6.5M. The estimated overhaul costs are $820K, and the expected operating costs of keeping the Maracas running are approximately $1.18M annually (in 2016 dollars).

The present value of costs of option 2, with the engine and control system overhaul is about $6.2M. While the enhanced overhaul costs an additional $600K more than the basic overhaul, however, the improved system is expected to reduce annual operating costs by about $160k per year. In addition to the lower expected costs, RCI could leverage the expanded overhaul as a part of a “Green Initiative” aimed at reducing their environmental footprint. This would increase RNI’s overall brand recognition as well as in its efforts to market to potential clients. If RNI was only considering these two options, RNI should proceed with the expanded overhaul of the Maracas as it will be more cost effective over the life of the Maracas.

Purchasing a new vessel

The present value of option 3, buying and operating the new vessel for 20 years, is a bit above $6.6 million. See exhibit 3 for detailed calculations. The $6.6 M assumes the Maracas can be operated for a year while the new ship is built, then sold for the $100k book value. The new ship is expected to be operated for 20 years and depreciated over 7 years. The new vessel will cost about $850k to operate (in 2016 dollars) and is expected to bring in $175k of additional revenue (in 2018 dollars) relative to either of the Maracas overhaul options. Both the operating costs and incremental revenue are expected to increase with 1.25% inflation. At $6.6 M, option 3 has the largest present value of expected costs, but it’s 20 year lifetime skews the analysis. Similar to option 2, a new ship would also allow RCI to tout the increased focus on reducing environmental impacts as a “green initiative” to improve its overall brand image. One additional benefit to purchasing a new ship is that the improved cabin and more modern ship would help RNI recruit and retain a higher-caliber crew, likely with lower turnover.

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