ISLAND FERRY: A CAPITAL BUDGETING CASE STUDY

This case analyzes the feasibility of starting a large-scale ferry boat system in Hawaii called Island
Ferry. Students are provided detailed information regarding the proposal and are required to analyze
this information to determine if the project should be undertaken. Students are offered the opportunity
to discuss changes to the ferry system that might increase its chance of success. Spirited discussions
among students frequently occur.

CASE DESCRIPTION

The primary subject matter of this case concerns capital budgeting. Secondary issues
examined include cash flow estimation and calculation, decision criteria, and strategic planning.
The case has a difficulty level of appropriate for senior level. The case is designed to be taught
in 1.5 class hours and is expected to require 4 hours of outside preparation by students.

CASE SYNOPSIS

In this case the JTA&T Company is faced with an investment decision. The decision is if
the firm should invest in an enterprise called Island Ferry. Island Ferry will offer inter-island
ferry-boat service between the Hawaiian Islands. The managerial staff of JTA&T has collected
various financial information regarding the project. The company is now in the process of
analyzing the data to make a final decision to accept or reject the project. The new Chief
Financial Officer, Sharon Coto is assigned the task of analyzing the data.

INTRODUCTION

Today is January 1, 2002. JTA&T company, an Oregon based company, is considering

starting a new division called Island Ferry. The new division is a ferry boat system that will
transport passengers, vehicles and freight between the islands of Hawaii. Island Ferry will be
operated in a manner similar to the Washington State Ferry. The JTA&T managerial staff have
spent the past several months gathering information about the project to determine its
desirability. It has turned the information over to the new Chief Financial Officer, Sharon Coto
to analyze. Sharon is immediately approached by a disgruntled member of the Board of
Directors, Brian Bikus, who makes it clear that he has concerns about the project.

Brian: You know Sharon, starting a new business in Hawaii is not as easy as the managerial
staff seems to think. Hawaii is known as one of the most difficult states to do business in.

Sharon: I have also heard stories of difficulty associated with doing business in Hawaii.
However; it is possible that the prospects for this type of business are different now than
previously.

Brian: Different in which way?

Sharon: I understand that inter-island airfares have increased dramatically over the past five
 years. These increased fares could allow Island Ferry to offer a very competitively priced
service. So what may not have been profitable previously might now be profitable.

Brian: Price doesn’t matter. People want fast transportation. They just will not accept the slower
fairy boat service. I overheard the marketing folks discussing the Island Ferry sales
forecasts. They are crazy if they think they will achieve the numbers they were
discussing.

Sharon: Thank you for expressing your concerns to me, I will make sure to take the possibility of
sales forecast errors into account when I complete my analysis.

THE ISLANDS OF HAWAII

The islands of Hawaii consist of a total of 8 islands: Hawaii, Kahoolawe, Kauai, Lanai,
Maui, Molokai, Niihau and Oahu. Kahoolawe is not inhabited due to the presence of military
waste. In addition, Niihau has only 230 inhabitants because of restricted access. The remaining
six developed islands are the hub of economic and cultural activity in the south pacific. Figure 1
contains a map indicating the relative location of each island. As-the-crow-flies distances
between various locations are presented in Table 1 (Indio.com 2001).

Figure 1: Map of Hawaii

Table 1: Distance Between Islands

Island To Island Miles

Oahu To Kauai 110
Oahu To East Hawaii 208
Oahu To West Hawaii 165
Oahu To Maui 79
Oahu To Lanai 66
Oahu To Molokai 48
Kauai To East Hawaii 317
Maui To East Hawaii 132
Maui To West Hawaii 96

Combined, the islands have a resident population of about 1,200,000 people. In addition,
approximately 6,740,000 tourists visit the islands each year, many of which tour multiple islands
while visiting the state. Additional state statistics are presented in Table 2 (DBEDT, 1999 &
2001).

Table 2: Hawaiian Island Statistics

Visitor Resident
Island Arrivals Population
Oahu 4,560,142 872,478
Maui 2,347,002 105,336
Hawaii 1,307,720 143,135
Lanai 94,657 2,989
Molokai 69,657 6,838
Kauai 1,089,289 56,603
Niihau 0 230
Kahoolawe 0 0

While the majority of tourists arrive by airplane to the island of Oahu, some international and
mainland flights operate from the islands of Maui, Kauai and Hawaii. In addition, about 44,000
visitors arrive by cruise ship each year. Visitors spend an average of 8.9 days visiting the islands
and spend an average of $171.30 per person per day (DBEDT 1999).

TRAVEL BETWEEN THE ISLANDS

Currently, there are three methods available for traveling between the islands. The
primary method of traveling between the islands is by jet airplane. There are many inter-island
flights each day. The two largest inter-island airlines are Hawaiian Airlines and Aloha Airlines.
Most inter-island airplane tickets range in price from $75-$80 per one-way flight. A second
method of traveling between the islands is by cruise ship. Currently, there are several cruise
ships that offer inter-island service, however; they generally involve a trip to a foreign port. The
price of these cruises start at about $500 per person and are generally sold out well in advance.
Finally, some inter-island transportation is competed by ferry service. Expedition Ferry offers
ferry service between the islands of Maui and Lanai. The boat is relatively small at 40 foot, and
can accommodate 36 passengers but no vehicles. This ferry service charges $25 per person per
one-way trip (Expedition Ferry, 2001). Island Marine Company offers ferry service between
the islands of Molokai and Maui. The boat is a 100-foot vessel that carries 149 passengers, but
no vehicles. The charge for the 90-minute trip is $40 (Island Marine 2001). Pacific Marine and
Supply Company also operates a demonstration ferry around the island of Oahu called the Wiki
Wiki Ferry. This ferry service is being offered to test the feasibility of commuter ferries in
Hawaii. The service is passenger only and is intended to be an alternate means of transportation
for workers commuting to Honolulu (State of Hawaii Department of Transportation 2001). As
envisioned, Island Ferry will offer faster, more frequent, and less expensive service than the
current providers.

ISLAND FERRY CLIENTELE

Island Ferry would meet the demands of several different clientele. The first clientele are
those island tourists wishing to visit multiple islands. In order to visit multiple islands, with few
exceptions, the tourists must fly from island to island. Those driving rental cars must rent a
separate car for each island that they visit. Tourists using Island Ferry would be able to rent a
single automobile for the duration of their stay, thereby enjoying the lower week-long car rental
rates. They would simply transport the vehicle on the ferry with them as they travel between the
islands. In addition, tourists would enjoy the boat ride around the islands as a tourism activity by
itself. The ferry ride will provide passengers the opportunity to view the islands from a different
perspective than is available by air. Moreover, they would have the opportunity to view marine
life such as dolphins, sharks, manta rays and humpback whales that frequent the islands.
The second clientele are local tourists. Currently, in order for local tourists to visit
alternate islands, they must generally fly from island-to-island, and rent a car on the destination
island. A couple planning a three-day get away would spend about $450 on transportation (4
inter-island airplane tickets at $75 each and three days of car rental at $50 per day). Island Ferry
would allow local tourists to travel more economically. The trip described above could be
completed for about $200 using island ferry. As with other tourists, the ferry is expected to
become a tourism activity by itself for local tourists.
The third clientele are inter-island commuters. The unemployment rate in the Hawaiian
Islands varies substantially from island-to-island. Differences in unemployment rates are in part
due to the difficulty of commuting between islands to seek employment. While there are
currently some employment commuters, the price of inter-island air travel limits this practice to
relatively well-paid individuals. The lower price of inter-island travel available through Island
Ferry will permit more individuals to island-commute.
In addition to passengers and cars, Island Ferry will offer freight service. Freight services
are currently provided by airplane as well as by sea. Airplane freight services are provided in
conjunction with passenger service. Freight-carrying sea vessels visit each island about once per
week. Inter-island freight transported by sea are dominated by two companies, Matson and
Young Brothers (U.S. Coast Guard 2001). 4,287,500 tons of freight are shipped between the
islands each year (Wedemeyer 2001). Island Ferry will be able to offer very competitive freight
service. While freight prices will be similar to those charged by existing seaboard freight
service, Island Ferry will have the competitive advantage of providing daily service.
THE ISLAND FERRY BUSINESS

In order to start Island Ferry, eight terminals will be purchased. One terminal will be
built on each of four of the islands Island Ferry will service and two terminals on each of the
islands of Oahu and Hawaii. Service will not be provided to Niihau or Kahoolawe. The land for
each terminal will cost $10,000,000. The land will be purchased, and paid for the land on
December 31, 2002. Average construction costs of each terminal facility will be $15,000,000.
It will take three years to complete construction of the terminals. One third of the total
construction cost will be paid on each of December 31, 2002, December 31, 2003, and December
31, 2004. However, depreciation of the construction costs will not be started until the day Island
Ferry opens for business. The terminal construction costs will be depreciated using twenty-year
straight-line depreciation to a salvage value of $5,000,000 per terminal. In addition, a freight
warehouse will be constructed at each terminal. On average, each freight warehouse will cost
$10,500,000. Two years after construction of the terminals begins, construction of the freight
warehouses will begin. One-half of the freight warehouse construction costs will be paid on
December 31, 2004 and ½ of the freight warehouse construction costs on December 31, 2005.
The freight warehouses will be depreciated using 30-year straight-line depreciation to a salvage
value of 0. Depreciation will not start on the freight warehouses until January 1, 2006. Of
course, the land will not be depreciated.
In addition, Island Ferry will need to purchase the boats. Two different sized boats will
be used. Ten large boats will be purchased at a cost of $150,000,000 each. Ten small boats will
be purchased at a cost of $70,000,000 each. Thus, Island Ferry will purchase a total of twenty
boats. The price of these boats is somewhat higher than prices paid by other ferry services. The
higher price reflects the plan to utilize high-speed, fuel-efficient boats (FMS Ltd. 2001). Island
Ferry will take delivery (and pay for) the boats on December 31, 2004. Island Ferry will
depreciate the boats using ten-year straight-line depreciation to a combined salvage value of
$1,000,000,000. Depreciating the boats will not begin until the day Island Ferry starts offering
service. It is also necessary to purchase freight handling equipment. This equipment will cost
$4,500,000 for each terminal for a total of $36,000,000. Island Ferry will take delivery (and pay
for) the warehouse equipment on December 31, 2004. The freight handling equipment will be
depreciated using 7-year straight-line depreciation to a combined salvage value of $15,000,000.
Island Ferry will begin depreciating the warehouse equipment the day it begins offering freight
service, January 1, 2006. Island Ferry will also need to invest $10,000,000 in working capital
into the company on December 31, 2003.
A group of anonymous men, eager for JTA&T to open the business, as it will create
many jobs and will increase tourism to the state, and increase sales at their respective businesses.
As such, they have agreed to give Island Ferry an incentive to open the business. The incentive
is a cash payment of $10,000,000 at the end of each of Island Ferry’s first five years of operation
(not including the construction time). In addition, the state has negotiated a tax deal for Island
Ferry so that Island Ferry is exempt from all federal, state, and general excise taxes for the
construction (startup) period and the first five years of operation. After that, Island Ferry’s
combined federal and state income tax rate will be 38 percent. In addition, Island Ferry will
have to pay a general excise tax of four percent of sales after the exemption expires.
Island Ferry will begin providing passenger service on January 1, 2005. The boats will
operate 365 days per year. At any given time, 24 hours per day, seven of the small boats and
seven of the large boats will be operating. The remaining boats will be shut down for repairs and
maintenance. The large boats have a capacity of 200 cars, 1500 passengers and 500,000 pounds
of freight. In addition, the large boats will have thirty sleeping/meeting rooms each. The small
boats have a capacity of 100 cars, 750 passengers and 200,000 pounds of freight. The small
boats will not be equipped with sleeping/meeting rooms. Each boat will be equipped with
airplane-style seating. The car storage area of each ship can be utilized for additional freight
when demand dictates. The boats will have a cruising speed of 40 knots (about 46 miles per
hour). The boats will average 55 percent full of both automobiles and people on each trip in the
first year of operation. Usage statistics for the other years of operation are presented in Table 3.

Table 3: Passenger and Automobile Usage Data

Year Percent Full

2005 55
2006 56
2007 57
2008 58
2009 59
2010 60
2011 61

In addition, on average, 20 sleeping rooms will be rented on each trip. Each operating
boat will average 4 one-way trips per day. The average charge for inter-island transportation is
$50 per vehicle (one-way) and $25 per person (one way). Sleeping rooms rent for an additional
$50 per one-way trip. Travel agents will make one-half of the passenger, vehicle and
sleeping/meeting room arrangements. Island Ferry will pay the travel agents a 3 percent
commission on the sales they arrange. Island Ferry will sell food on the boats. Average food
sales on the ferry are expected to be $4 per passenger on each one-way trip. Island Ferry will
also sell food at the terminals. Average food sales at each terminal are expected to be $2,000 per
day. The prices charged for the food, the transportation and the rooms will be increased by 5
percent per year.
Island Ferry will begin offering freight service on January 1, 2006. The average freight
charge will be $0.02 per pound of freight transported in the first year of freight operations. The
freight charge will be increased by 2 percent in each subsequent year. Sixty-five percent of the
base freight capacity (not including the extra capacity that can be obtained by utilizing the car
storage areas of the boats for freight) will be utilized in the first year that Island Ferry offers the
freight service. A full listing of the freight capacity usage is presented in Table 4. Income from
all sources will be received in cash at the end of each respective year.

Table 4: Freight Capacity Usage

Year Percent Full

2006 65
2007 66
2008 67
2009 68
2010 69
2011 70

Thirty-two people will be employed at each terminal. They will average earning $35,000
per year including benefits. In addition, forty people will be assigned to work on each of the
fourteen operating boats. They will average earning $40,000 per year including benefits. In
addition, there will be two maintenance personnel assigned to each terminal. Each maintenance
person will earn $45,000 per year including benefits. Once Island Ferry begins freight service, it
will need 8 additional employees at each freight warehouse. These employees will earn an
average of $45,000 per year including benefits. A three percent annual salary increase for each
employee has been negotiated with the union. Based on figures reported by the Washington
State Ferry System, fuel costs for the operating boats will are estimated to be $4,000 per day for
the large boats and $2,500 per day for the small boats for each day the boat is in operation
(Washington State Department of Transportation 2001b). Fuel costs are expected to increase by
ten percent per year. Island Ferry will enter into a warranty contract with the boat manufacturer
so that it will pay $200,000 per year for each of the twenty boats in the fleet for repairs and
maintenance. The contract is for ten years and the price will be the same $200,000 per boat for
each year of the contract. Utilities at each terminal will be $240,000 per year starting on the day
that the firm begin offering service. Utilities at the freight warehouse are expected to be an
additional $120,000 per year, starting the day the firm begins offering freight service. Utility
prices are expected to increase by ten percent per year. In addition, after the tax exemption the
state has granted Island Ferry expires five years after you start operating, the firm will have to
pay $100,000 in property taxes on each of the terminal/warehouse facility combinations each
year. Food costs are expected to be 50 percent of the food sales price. Insurance costs will be
$8,000,000 per year covering the boats the passengers, the freight, the employees and the
terminals. The insurance contract calls for Island Ferry to pay the insurance both during the
construction phase and during the operating phase. General administrative expenses will be
$300,000 per year during the construction period and will increase to 500,000 when the firm
begins offering service. General administrative expenses are not expected to change throughout
the first ten years of operation. Marketing Expenses will be $3,000,000 for each year the boats
operate (Island Ferry will not pay marketing expenses during the start-up years). The insurance
and marketing costs will remain constant for ten years. All expenses discussed in this paragraph,
as well as travel agent commissions, are paid in cash at the end of each respective year.
The Shark Marine Company who recently heard of the venture have agreed to purchase
the entire operation from JTA&T at the end of the seventh year of operation. JTA&T is not
required to sell the operation to them, but have the option to do so if they wish. The Shark
Marine Company has agreed to purchase the operation from JTA&T for $1,758,500,000.
$1,500,000,000 is for the boats, $95,000,000 is for the terminals, $65,000,000 is for the freight
warehouses, $18,500,000 is for the freight handling equipment, and $80,000,000 is for the land.
In addition, JTA&T will be able to withdraw the working capital from the company immediately
prior to the sale. JTA&T has estimated the cost of capital for this project to be 14.5 percent.
The figures reported here are believed to be reasonably accurate. However, the primary
goal of this paper is as an educational tool. Substantial differences might occur between what is
reported here and what might be expected in any live future implementation of a ferry boat
system.
QUESTIONS

1. Create a cash flow analysis for capital budgeting purposes for this project. Assume that
JTA&T will sell the entire operation to Shark Marine Company at the end of the seventh
year of operations.
2. Use a scientific technique to determine if you should undertake the project. NPV, PI, IRR