MS&E 352
Decision Analysis II
January 15th, 2015
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Case Study #1 S.S. Kuniang
Due Thursday, January 29th, 2015
Part I The Decision Situation
On April 9, 1981 the S.S. Kuniang ran aground off of the Florida coast during unseasonably severe
weather conditions. Ed Brown, Chairman and CEO of the New England Electric System (NEES),
received a call from Captain McIver, the head of his shipping subsidiary. McIver suggested that they
turn this unfortunate accident to their advantage.
The British owners of the Kuniang intended to declare the vessel a total loss, so that NEES might
get the opportunity to acquire the ship, repair it, and then use it to haul coal.
The management of NEES had been wrestling for some time with how to transport coal to their
generating plants. NEES had recently arranged to have General Dynamics construct and operate a
self-unloading ship with a capacity of 36,250 tons, a vessel universally referred to as the GD-I.
New England Electric System
NEES was a public utility holding company which owned four electric operating subsidiaries:
Massachusetts Electric Company serving 750,000 customers in Massachusetts, Narragansett Electric
Company serving 265,000 customers in Rhode Island, Granite State Electric Company serving
25,000 customers in New Hampshire, and New England Power Company (the generating
subsidiary). In addition, NEES owned a service subsidiary, New England Power Service Company, a
fuel exploration company, New England Energy Incorporated, and a shipping subsidiary, New
England Shipping.
As an aftermath of the energy price shocks of the early 1970's, NEES' long range plan incorporated
the goals of reducing dependence on foreign oil and diversifying the fuel mix for the system's
generating plants. NEES sought to achieve an energy mix of 39% coal, 25% nuclear, 18% domestic
oil, 10% imported oil, and 8% hydro, wind power, and other alternatives. This plan would call for the
conversion of more than half of the utility's oil-fired capacity to coal. After full conversion, NEES
plants would require 3.125 million tons of coal each year: 2.7 million tons at Brayton Point,
Massachusetts, 0.3 million tons at Salem Harbor, Massachusetts, and 0.125 million tons at the
Providence, Rhode Island generating plants.
An important part of NEES long range plan was the annual transportation of 3.125 million tons of
coal. To this end, NEES established a shipping subsidiary under the direction of Captain McIver, an
experienced commercial shipper.
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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TRANSPORTATION
Existing Arrangements
The GD-I was being built by General Dynamics Ship Building division, in Quincy, Massachusetts.
The vessel, the first coal-fired transport ship to be ordered in 25 years, would carry 2.25 million tons
of coal per year from Virginia to Brayton Point, Massachusetts. Delivery of the vessel was set for
April 1, 1983.
Current requirements for coal transportation were being met by a charter with Universal American
Barge Company (UABC). The UABC charter was split into two phases determined by the date that
the GD-I became available. Once the GD-I began operation, the UABC charter could be terminated
or could carry the remaining tonnage not carried by GD-I. NEES must use one of the options listed
below (null, GD-II, or Kuniang) to ship the remaining 875,000 tons of coal each year. NEES will use
a 25-year time-horizon from the time of delivery of the GD-II to make this decision.
Options Under Consideration
The following options had been singled out by NEES for active consideration:
1) Null Option: Continue to charter ships with UABC (or on the open market) for all coal not
carried by the GD-I.
2) GD-II: Order a second ship from General Dynamics. Under the terms of the shipbuilding
contract, General Dynamics was obligated to offer a series production right to build a second ship.
This new ship would be available January 1, 1984. After accounting for inflation, the cost would be
essentially the same as the sister ship ($70 MM) and would have the same freight capacity (36,250
tons of coal).
This provided NEES with more capacity than needed, but there was a virtually guaranteed demand
for the excess. One potential customer was the U.S. government, for grain transportation. This
business was derived from Public Law 480 by which American grain was donated to third world
countries. NEES was confident that there would be enough demand from this source to ensure that
any additional capacity would be kept occupied.
The GD-II (like the GD-I) has a 25-year lifetime.
3) S.S. Kuniang: Bid for the S.S. Kuniang. In addition to the cost of the bid, NEES, if it won the
bidding, would have to pay for repairs to the Kuniang to make it seaworthy once more. These were
estimated to cost $15 million. The Kuniang has a 15-year lifetime. After this time, NEES could
resume shipping coal via UABC.
The Kuniang, however, had a potentially significant drawback. Under the Jones Act of 1920, only
American-built, American-owned, and American-operated ships could trade between two U.S. ports
(coastwise trade). But the S.S. Kuniang was not American-built, and NEES would need the ship
primarily for U.S. coastal trade. Nonetheless, there was a possible resolution to this potential
problem. A long overlooked law (U.S. Code Title 46, Section 14, enacted December 23, 1852)
permitted a foreign-built ship to be regarded as American for the purposes of the Jones Act if (i) the
previous owners declared the ship a total loss (which the owners of the Kuniang were going to do)
and (ii) the cost of repairs was at least three times the salvage value of the ship.
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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This latter provision created a dilemma. The U.S. Coast Guard was responsible for determining the
salvage value of the ship. Since there were no rules governing salvage values and few precedents to
guide them, it was not clear if they would base their assessment on the ship's scrap value, or its
auctioned price, or on some other basis. The Coast Guard was not going to rule on this matter until
after the sealed bid auction of the Kuniang. A decision on this question would obviously affect its
value.
Acquiring the Kuniang would present another decision. The Kuniang had no self-unloading
capability. The installation of a self-unloader would greatly reduce the time the Kuniang would need
to unload, and therefore effectively increase the yearly capacity of the ship. It was possible to install a
self-unloading capability into the Kuniang. This could be done at any time for a cost of $6 million,
increasing the total repair cost to $21 million.
WHAT TO DO?
Ed Brown valued Captain McIver's many years of experience in the shipping business and was
encouraged by his enthusiasm for the Kuniang alternative. However, it was not clear what to bid for
the Kuniang, much less whether to bid at all.
Bidding for the S.S. Kuniang
Captain McIver had recommended a bid of $3 million, the value of the Kuniang as scrap. But Ed
Brown was concerned that other companies, including other utilities, might enter the bidding and
raise the price needed to win.
The auction was to be held by first-price, sealed bid. In a sealed-bid auction, bidders write the
amount they are prepared to bid in separate envelopes which are submitted individually, but opened
by the seller at an agreed time. The highest bid is accepted. NEES would not know the identity or
number of bidders until the envelopes were opened.
The viability of the Kuniang would depend on the price for which it could be purchased at the
auction and on the Coast Guard's appraisal of its salvage value for the purposes of the Jones Act.
Brown thought the odds were against the Coast Guard valuing the Kuniang at its scrap value,
estimating this probability at around 30%. Brown also felt that if the Coast Guard did not value the
Kuniang at scrap, they would value it at the winning bid price. This all served to complicate the
question of whether and how much NEES should bid on the Kuniang.
ADDITIONAL ASSUMPTIONS (IF NEEDED)
General
NEES follows the delta property for this range of prospects.
NEES has decided to ship only 2.25 million tons of coal per year using the GD-I.
A converted S.S. Kuniang (with or without unloader) would be ready at the same time a GD-II
would be.
If NEES does not acquire the S.S. Kuniang, it can still purchase the GD-II or hire UABC.
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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If NEES acquires the S.S. Kuniang, it may immediately resell the ship for its scrap value
($3MM).
NEES can (if it desires) increase the repair cost of the Kuniang by, e.g., overpaying its
contractors.
Either the Kuniang or the GD-II may be sold for scrap value ($3MM in nominal dollars) at the
end of their respective useful lifetimes.
Value Model
The 25-years time-horizon starts in 1984, the year the GD-II is delivered.
Any unused capacity can be used to ship grain.
The weighted average cost of capital (WACC) for NEES is 7%.
NEES's revenue is $8 per ton of coal shipped when they charter with UABC.
The UABC charter can be extended from 0 to 25 years at a cost of $7.75 per ton of coal shipped.
After the S.S. Kuniang lifetime has expired, coal will be shipped by UABC.
NEES cannot hire UABC to ship grain. NEES is a publicly owned electric utility, whose
primary business is to provide power to New England. It can only ship grain as a means to fill
excess capacity.
Don't worry about fractional years, or fractional trips. Discount all dollars back to January 1,
1981.
All cash flows occur at the start of the year.
Bidding
No unknown parties will bid on the S.S. Kuniang.
The auction will take place immediately.
The Coast Guard will make its ruling immediately after the auction is held.
The bid and repair costs must be paid immediately after the Coast Guard makes its ruling (if the
auction is won).
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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Part II Instructions
OVERVIEW
You and your team are members of the Decision Analysis Group at New England Electric System
(NEES). The CEO of NEES, Ed Brown, has asked you to perform a decision analysis on the S.S.
Kuniang and to present your results to him on or about January 28.
The S.S. Kuniang is a British ship that has run aground off the coast of Florida. New England
Electric is considering bidding on the S.S. Kuniang and converting it to a coal transport ship. During
the sealed bid auction you will be competing against four other utilities:
Georgia Generating (GG)
Pennsylvania Power (PP)
Florida Gas and Electric (FG&E)
Louisiana Light (LL)
LOGISTICS
Each group will prepare a PowerPoint presentation and a one-page executive summary of the case.
The PowerPoint presentation should include all relevant elements of the analysis, but should not
exceed 20 slides in length. You should feel free to add written comments to your slides (but you
do not need to), or to add back-up slides beyond the 20-slide limit that will show some details of
your work; however, your grade will be primarily based on the quality of the insights you present in
your main deck of slides.
The case is due at 5:00pm PST on Thursday, January 28. Teams will make their presentation to the
TAs at a time to be announced (most likely on Friday, January 29).
The presentation should not exceed 10 minutes. Please be aware that some penalty will be applied
if the presentation is longer than 10 minutes. After your 10-minute presentation you will have 10
minutes for Q&A session.
You will need to make extensive use of a spreadsheet program (e.g., Excel) for this case study.
DIRECTIONS
This case presents us with a few concepts that have been covered in class lectures this week. You are
to think about this case through the application of a DA cycle. As this is the first case, we have
prepared a few tips for you.
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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1) Goals and Spirit of this Assignment:
In this case and many of the following, try to focus on the insights the case is presenting rather than
on the number crunching. Make sure you help the Decision Makers achieve clarity of action. In
some situations you may need to come up with a strategy for them to follow, this means you need to
specify the action to be taken under each situation. If things are not clear in the case, as they may be
in many real life situations, you may wish to perform sensitivity analysis on certain parameters. In
addition, if you have to, you make reasonable assumptions but state them clearly.
2) The Value Model:
Since every decision situation will require a value node, we have prepared a spreadsheet that will help
you calculate the value model. This will help you determine the value for each alternative. Please read
the section "Valuing Perpetuities and Annuities" in the appendix.
Define the indifferent buying price (IBP) of an alternative as the present equivalent of that
alternative's cash flows, excluding the purchase price of the alternative. In the case of the Kuniang,
the IBP should be calculated before subtracting capital costs and the bid amount.
Please note the data table provided in the appendix.
How to use the Value Model Spreadsheet:
Determine the IBP of the GD-II alternative, the S.S. Kuniang without self-unloader alternative, and
the S.S. Kuniang with self-unloader alternative. Remember that the GD-II and the S.S. Kuniang have
different lifetimes. As a double-check, we calculated the IBP of the Kuniang without unloader to be
$40.7 MM in 1981 dollars. If you make different reasonable assumptions than we did, you may
correctly arrive at a different number. We encourage you to use the Value Model spreadsheet which
we have posted on the class website. We have included some of the numbers so you can check your
work.
3) Deliverables:
Your presentation should bring Ed to clarity of action. At a minimum your presentation should
include the following:
IBP of each shipping alternative
Distributions on competitive bids
Probability NEES will win given their bid
Certain equivalent of your company's decision versus your bid
Optimal bid
Decision tree that clearly displays the best strategy and a decision diagram representing NEES's
decision.
Sensitivity analysis on certain parameters and /or uncertainties.
If needed, value of information on relevant uncertainties.
Note: Do not take Winners Curse into account for this case study
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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PART III APPENDIX
1. VALUING PERPETUITIES AND ANNUITIES
Suppose your friend offers to sell you an asset that will make a one-time payment of x dollars n years
from now. What is your indifferent buying price (IBP) for such an asset? Using the concept of
present equivalent we can determine your IBP. Your IBP is given by:
IBP = x / (1 + r)n
where r is the discount rate.
A perpetuity is an asset that pays a fixed sum each year to perpetuity. For example, a bond that pays x
for certain at the beginning of each year forever, starting in year one, is a perpetuity. What is your
IBP for such an asset? We can calculate your IBP by finding the present equivalent of this cash flow
stream. The PE of the cash flow stream is given by the infinite sum:
IBPperpetuity = [x / (1 + r)n]
With a little algebra you can show that the IBP of a perpetuity can be determined more simply by the
following:
IBPperpetuity = x / r
An annuity is an asset that pays a fixed sum each year for a certain number of years. An annuity can
be thought of as the difference of two perpetuities. The first pays x forever beginning at the start of
year 1 and the second pays x forever beginning at the start of the t+1 year. If we want to find your
IBP of such an asset we find your IBP of an asset that pays x forever beginning in year one and
subtract the IBP of an asset that pays x forever beginning in year t+1. This is given by:
IBPannuity
1
x
x
1
x
r r 1 r t
r r 1 r t
This is the IBP if you begin to receive payments one year hence. If you are not going to receive
payments for three years you need to discount the IBP by two years (hint, hint).
When you are dealing with a company the discount rate, r, is usually taken as the weighted average
cost of capital (WACC).
For more information read Section 9 of the Manuscript in Progress by Professor Howard and Chapter 3
of Principles of Corporate Finance by Richard Brealey and Stewart Myers.
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MS&E 352
Decision Analysis II
January 15th, 2015
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2. COMPETITOR BID DISTRIBUTIONS
BID AMOUNT ($MM)
$0.01 $0.26 $0.51 $0.76 $1.01 -
$0.00
$0.25
$0.50
$0.75
$1.00
$1.25
$1.50
$1.75
$2.00
$2.25
$2.50
$2.75
$3.00
$3.25
$3.50
$3.75
$4.00
$4.25
$4.50
$4.75
$5.00
$5.25
$5.50
$5.75
$6.00
$6.25
$6.50
$6.75
$7.00
$7.25
$7.50
$7.75
$8.00
$8.25
$8.50
$8.75
$9.00
$9.25
$9.50
$9.75
$10.00
$10.25
$10.50
$10.75
$11.00
$11.25
$11.50
$11.75
$12.00
$12.25
$12.50
$12.75
$13.00
$13.25
$13.50
$13.75
$14.00
$14.25
$14.50
$14.75
$15.00
COMPETITOR BID DISTRIBUTIONS
LL
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.010
0.034
0.058
0.083
0.107
0.131
0.155
0.131
0.107
0.083
0.058
0.034
0.010
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
PP
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.010
0.015
0.020
0.026
0.031
0.036
0.041
0.046
0.052
0.057
0.062
0.067
0.073
0.067
0.062
0.057
0.052
0.046
0.041
0.036
0.031
0.026
0.020
0.015
0.010
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
FGE
0.300
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.037
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
GG
0.400
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.024
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
0.000
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Case #1: SS Kuniang
MS&E 352
Decision Analysis II
January 15th, 2015
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Note: this information is also available on the web. You should interpret this as follows: There
is a 0.3 probability that FGE will bid $0 MM, a 0 probability that FGE will bid an amount between
$0.76 MM and $1.00 MM, and a 0.037 probability that FGE will bid an amount between $4.76 MM
and $5.00 MM.
3. DATA TABLE
GD-II
Capital Cost
Kuniang
Kuniang
(without unloader) (with unloader)
$70 MM
Bid Price
+ $15 MM
Bid Price
+ $21 MM
Operating Costs
18,670
23,000
24,300
Allocated Fixed Costs
Total Daily Costs
2,400
21,070
2,400
25,400
2,700_________
27,000
Daily Costs ($/Day)
Performance Data
Capacity (tons of Coal)
36,250
Unloading System
Self-Unload
Speed (Knots)
15
Round Trip (BP) (days)1
5.15
Round Trip (Egypt) (days)2
79
45,750
40,000
Dock Crane
Self-Unload
14
14
8.18
5.39
90
84
Revenue Per Trip ($/Trip)
Coal to Brayton Point1
Grain to Egypt2
304,500
2,540,000
329,400*
3,570,000
336,000
2,800,000
NOTE: Although ships operated 24 hours per day, 25 days per year were allocated for dry dock and
other repairs. The daily costs provided above are calculated for the remaining 340 days per year.
Virginia to Brayton Point, MA: A representative coal trip. Includes unloading time. Use this data
for all coal shipments.
2 U.S. East Coast to Alexandria, Egypt: A representative grain trip.
1
* This figure has been reduced to reflect the cost of tying up dock space during unloading.
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