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(economy shipping abgd p. 1 of 2)

Economy Shipping Company (Abridged)

In the spring of 1995 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 Conway had a useful life
of another 20 years provided that adequate
repairs and maintenance were made. The
book value of the Conway was $39,500,
but the controller believed that if the
company sold the boat in 1995, 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 1993, 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, a crew of 20 operated the
Conway. Annual operating costs for the 20-
person crew are shown in Table A.

TABLE A
Annual Operating Costs for the Conway and Its Crew

Wages $110,200
Vacation and sickness benefits 1,880
Social security payments 2,400
Life insurance 1,800
Commissary supplies 15,420
Repairs and maintenance 24,400
Fuel 34,500
Miscellaneous service and supplies 12,550
Total $203,150

The controller estimated that the cost of
dismantling and scrapping the Conway 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
of $325,000 for a diesel boat. An additional
$75,000 for a basic parts inventory would
be 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.
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(economy shipping abgd p. 2 of 2)
The useful life of a diesel-powered boat
was estimated to be 25 years; at the end of
that time the boat would be scrapped or
completely rehabilitated at a cost
approximately equal to that of a new boat.
The controller did not contemplate the
possibility of 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 consulting 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 and the
inventory of parts, $37,500.

Another factor the controller was
considering at this time was alternative
uses of funds. In the spring of 1995,
Economy had sufficient funds to buy four
diesel-powered boats; however, there were
alternative uses for these funds. The other
projects that 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%.

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 1,680
Life insurance 1,170
Commissary supplies 10,020
Repairs and maintenance
a
21,700
Fuel 28,800
Miscellaneous service and supplies 14,650
Total $156,640

a
Excluding possible major overhaul of diesel engines.


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, assume the following:

The diesel boat, if acquired, would be sold at the end of the twentieth year.
The inventory of parts for the diesel boat can be depreciated for tax purposes over a
25-year period.
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.
The book cost of the Conway, including rehabilitation costs, would be depreciated
over a 20-year period if rehabilitation were chosen.
The $32,500 residual value for the diesel boat in year 20 assumes no overhaul of
the engines in year 20.