Economy Shipping Company
In the spring of 1950 the controller of Economy Shipping Company, located near Pittsburgh, was preparing a report for the executive committee regarding the feasibility of repairing one of the company's steam riverboats or of replacing the steamboat with a new diesel-powered boat.
The Economy Shipping Company was engaged mainly in the transportation of coal from the nearby mines to the steel mills, public utilities, and other industries in the Pittsburgh area. Occasionally, the company's several steamboats also carried cargoes to places as far away as New Orleans. The boats owned by Economy Shipping were all steam powered. All were at least 10 years old, and the majority of them were between 15 and 30 years old.
The steamboat the controller was concerned about, the Conway, was 23 years old and required immediate rehabilitation or replacement. It was estimated that the Con-way had a useful life of another 20 years provided that adequate repairs and mainte-nance were made. The book value of the Conway was $39,500, but the controller believed that if the company sold the boat in 1950, it would bring only around $25,000. The immediate rehabilitation costs for the Conway were estimated to be $115,000. The controller estimated that these general rehabilitation expenditures would extend the useful life of the Conway for about 20 years.
New spare parts from another boat, which had been retired in 1948, were available for use in the rehabilitation of the Conway. If these parts were used on the Conway, an estimate of their fair value was $43,500, which was their book value. Use of these parts would, in effect, decrease the immediate rehabilitation costs from $115,000 to $71,500. It was believed that if these parts were sold on the market they would bring only around $30,000. They could not be used on any of the other Economy Shipping steamboats.
Currently, the Conway was operated by a crew of 20. Annual operating costs for the 20-person crew are shown in Table A. Copyright 1973 by the President and Fellows of Harvard College. Harvard Business School case 274-092.
TABLE A
Annual Operating Costs for the Conway and Its Crew
Wages $110,200
Vacation and sickness benefits 1880
Social security payments 2400
Life insurance 1800.
Commissary supplies 15,420
Fuel 34,500
Miscellaneous service and supplies 12,550
Total $203,150
The controller estimated that the cost of dismantling and scrapping the Codwdy 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.
An alternative to rehabilitating the steamboat was the purchase of a diesel powered boat. The Quapelle Company, a local boat manufacturer, quoted the price $325,000 for a diesel boat. An additional $75,000 for a basic parts inventory would necessary to service a diesel boat, and such an inventory would be sufficient to service up to three diesel boats. If four or more diesels were purchased, however, it was estimated that additional spare parts inventory would be necessary.
The useful life of a diesel-powered boat was estimated to be 25 years; at the end that time the boat would be scrapped or completely rehabilitated at a cost app mately equal to that of a new boat. The controller did not contemplate the possibility diesel engine replacement during the 25-year life, because information from Other companies having limited experience with diesel-powered riverboats did not indicate that such costs needed to be anticipated. A general overhaul of the engines, costing $60,000 at current prices, would, however, be expected every 10 years.
After cosulting the Quapelle Company and other companies operating diesel powered boats, the controller estimated that the annual operating costs of such a boat would total $156,640 (See table B).
Although the Economy Shipping controller had not considered the matter, at the end of the twentieth year, the diesel boat would have a realizable value of $32,500 the inventory of parts, $37,500.
Another factor the controller was considering at this time was alternative use of funds. In the spring of 1950, Economy had sufficient funds to buy four diesel-powered boats; however, there were alternative uses for these funds. The other projects that
TABLE B
Annual Operating Costs for a Diesel-Powered Boat
Wages for a 13-person crew $77,300
Vacation and sickness benefits 1,320
Social security payments, 1680
Life insurance 1,170
Commissary supplies 10,020
Repairs and maintenance 21,700
Fuel 28,800
Miscellaneous service and supplies 14,650
Total $156,640
a. Excluding possible major overhaul of diesel engines management was considering at this time had an estimated return of at least 10% after taxes. The income tax rate at the time was $48%.
Questions
What are the relevant cash flows associated with each alternative, and in what years do they occur?
To simplify the calculations, use the straight-line method of depreciation. Also, make the following assumptions:
1. The diesel boat, if acquired, would be sold at the end of the twentieth year.
2. The inventory of parts for the diesel boat can be depreciated for tax purposes over a 25-year period.
3. The hull of the diesel boat ($265,000) would be depreciated over a 25-year period for tax purposes, and the engines over a 10-year period.
4. The book cost of the Conway, including rehabilitation costs, would be depreciated over a 20-year period if rehabilitation were chosen.
5. The $32,500 residual value for the diesel boat in year 20 assumes no overhaul of the engines in year 20.