Posted: October 26th, 2023

Modelling the Investment Decision in the Dry Bulk Sector: The Choice of a Second Hand Vessel versus a Newly Built Vessel

Modelling the Investment Decision in the Dry Bulk Sector: The Choice of a Second Hand Vessel versus a Newly Built Vessel
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The dry bulk shipping sector is one of the most volatile and cyclical segments of the maritime industry, facing various uncertainties and risks that affect the investment decisions of shipowners and operators. Choosing between a second hand vessel and a newly built vessel is a crucial strategic decision that involves trade-offs between cost, performance, environmental impact, and market conditions. In this paper, we propose a model to assess the investment decision in the dry bulk sector, based on real options theory and prospect theory. We use real options theory to capture the flexibility and value of deferring or abandoning the investment under uncertainty, and prospect theory to account for the behavioral biases and preferences of investors in different market scenarios. We apply our model to a case study of investing in a Capesize vessel in the dry bulk sector, using historical data from 2018 to 2023. We compare the net present value (NPV) and the option value (OV) of investing in a second hand vessel versus a newly built vessel, under different assumptions of freight rates, vessel prices, discount rates, and risk attitudes. We find that the investment decision depends on both objective and subjective factors, and that there is no clear-cut optimal choice between the two alternatives. However, we identify some general trends and insights that can guide investors in making more informed and rational decisions.

Keywords: dry bulk shipping; investment decision; real options theory; prospect theory; second hand vessel; newly built vessel

Introduction
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Dry bulk shipping is the transportation of homogeneous commodities such as coal, iron ore, grain, and cement by sea. It is one of the oldest and largest segments of the maritime industry, accounting for about 40% of the world seaborne trade by volume in 2023 [1]. Dry bulk shipping is also one of the most volatile and cyclical segments, experiencing frequent fluctuations in supply and demand, freight rates, vessel prices, operating costs, and environmental regulations [2]. These factors create significant uncertainty and risk for investors in the dry bulk sector, who have to make long-term capital commitments with high sunk costs and low salvage values [3].

One of the most important strategic decisions that investors in the dry bulk sector face is whether to invest in a second hand vessel or a newly built vessel. A second hand vessel is an existing vessel that is purchased from another owner or from the resale market. A newly built vessel is a new vessel that is ordered from a shipyard and delivered after a certain period of time. Both alternatives have advantages and disadvantages that depend on various factors such as cost, performance, environmental impact, and market conditions [4]. For example, a second hand vessel may have a lower initial cost, a shorter delivery time, and a higher resale value than a newly built vessel, but it may also have lower fuel efficiency, higher maintenance costs, and lower compliance with environmental standards [5]. A newly built vessel may have higher initial cost, longer delivery time, and lower resale value than a second hand vessel, but it may also have higher fuel efficiency, lower maintenance costs, and higher compliance with environmental standards [6].

The choice between a second hand vessel and a newly built vessel is not only influenced by objective factors such as cost-benefit analysis or net present value (NPV) calculation, but also by subjective factors such as behavioral biases or risk preferences [7]. Investors may have different expectations, perceptions, attitudes, and emotions that affect their decision making process under uncertainty [8]. For example, investors may exhibit loss aversion, which means that they weigh losses more than gains of equal magnitude; or they may exhibit optimism bias, which means that they overestimate the probability of favorable outcomes or underestimate the probability of unfavorable outcomes [9]. These behavioral factors may lead to suboptimal or irrational decisions that deviate from the standard normative models based on expected utility theory or NPV maximization [10].

In this paper, we propose a model to assess the investment decision in the dry bulk sector,based on real options theory and prospect theory. Real options theory is an extension of financial options theory that applies to real assets or projects with embedded flexibility or managerial discretion [11]. Real options theory recognizes that investors can adapt their decisions to changing market conditions by exercising options such as deferring, expanding, contracting, switching, or abandoning their investments [12]. Real options theory can capture the value of flexibility and uncertainty in investment projects that are not reflected by NPV calculation [13]. Prospect theory is an alternative to expected utility theory that describes how people make decisions under risk or uncertainty [14]. Prospect theory assumes that people evaluate outcomes relative to a reference point, and that they exhibit different risk attitudes depending on whether the outcomes are gains or losses [15]. Prospect theory can account for the behavioral biases and preferences of investors that are not captured by expected utility theory [16].

We use real options theory to model the flexibility and value of deferring or abandoning the investment in a second hand vessel or a newly built vessel under uncertainty. We use prospect theory to model the behavioral biases and preferences of investors in different market scenarios. We apply our model to a case study of investing in a Capesize vessel in the dry bulk sector, using historical data from 2018 to 2023. We compare the NPV and the option value (OV) of investing in a second hand vessel versus a newly built vessel, under different assumptions of freight rates, vessel prices, discount rates, and risk attitudes. We find that the investment decision depends on both objective and subjective factors, and that there is no clear-cut optimal choice between the two alternatives. However, we identify some general trends and insights that can guide investors in making more informed and rational decisions.

The rest of the paper is organized as follows. Section 2 reviews the literature on investment decision models in the dry bulk sector. Section 3 presents the methodology and data of our model. Section 4 reports the results and analysis of our case study. Section 5 concludes the paper and provides some implications and suggestions for future research.

Literature Review
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The literature on investment decision models in the dry bulk sector can be divided into two main streams: one based on NPV calculation, and one based on real options theory. NPV calculation is a traditional method that compares the present value of expected cash flows from an investment project with its initial cost [17]. NPV calculation assumes that the investment decision is irreversible and that the cash flows are deterministic or follow a known probability distribution [18]. NPV calculation can provide a simple and intuitive criterion for evaluating investment projects: if the NPV is positive, the project should be accepted; if the NPV is negative, the project should be rejected [19].

Several studies have applied NPV calculation to compare the profitability of investing in different types of vessels or different segments of the dry bulk sector. For example, Alizadeh and Nomikos [20] compared the NPV of investing in Capesize, Panamax, Handymax, and Handysize vessels under different assumptions of freight rates, vessel prices, operating costs, and discount rates. They found that Capesize vessels had the highest NPV among all segments, followed by Panamax, Handymax, and Handysize vessels. They also found that NPV was sensitive to changes in freight rates, vessel prices, and discount rates. Similarly, Stopford [21] compared the NPV of investing in new or second hand vessels in different segments of the dry bulk sector under different scenarios of demand growth, supply growth, and operating costs. He found that second hand vessels had higher NPV than new vessels in most scenarios, and that smaller vessels had higher NPV than larger vessels in low demand growth scenarios.

However, NPV calculation has some limitations that may underestimate or overestimate the true value of investment projects in the dry bulk sector. First, NPV calculation ignores the flexibility and uncertainty inherent in investment projects, such as the ability to defer or abandon the investment depending on market conditions [22]. Second, NPV calculation relies on subjective assumptions or estimates of future cash flows, which may be inaccurate or biased due to uncertainty or lack of information [23]. Third, NPV calculation assumes that investors are rational and risk-neutral, which may not reflect their actual behavior or preferences under risk or uncertainty [24].

Real options theory is an alternative method that overcomes some of the limitations of NPV calculation by incorporating flexibility and uncertainty into investment decision models [25]. Real options theory treats investment projects as financial options that give investors Real options theory is an alternative method that overcomes some of the limitations of NPV calculation by incorporating flexibility and uncertainty into investment decision models [25]. Real options theory treats investment projects as financial options that give investors the right, but not the obligation, to undertake certain actions in the future, such as expanding, contracting, or abandoning a project [26]. By applying real options theory, investors can value the potential benefits of waiting for more information before making irreversible decisions, and also account for the strategic interactions with competitors and other market players [27].

One of the main advantages of real options theory is that it can capture the value of managerial flexibility, which is often ignored or underestimated by traditional NPV methods. Managerial flexibility refers to the ability of managers to adapt and respond to changing market conditions and new information by altering the scale, scope, or timing of their investment projects [28]. For example, a firm may have the option to defer an investment project until the uncertainty about the future cash flows is resolved, or to abandon a project if it becomes unprofitable. These options can increase the value of the project and reduce the risk of investing in uncertain environments [29].

Another advantage of real options theory is that it can incorporate the effects of market imperfections and strategic interactions on investment decisions. Market imperfections, such as asymmetric information, transaction costs, or market power, can create barriers to entry or exit, and affect the profitability and feasibility of investment projects [30]. Strategic interactions, such as competition, cooperation, or signaling, can influence the behavior and expectations of other market participants, and affect the value and timing of investment opportunities [31]. Real options theory can model these complex factors by using game-theoretic frameworks and stochastic processes, and provide more realistic and dynamic valuations of investment projects [32].

However, real options theory also has some limitations and challenges that need to be addressed. One of the main limitations is the difficulty of identifying and quantifying the real options embedded in investment projects. Unlike financial options, which are standardized contracts traded in markets, real options are often implicit and specific to each project and firm [33]. Therefore, investors need to use subjective judgments and assumptions to estimate the parameters and variables that determine the value of real options, such as volatility, exercise price, or expiration date [34]. This can introduce errors and biases in the valuation process, and reduce the reliability and validity of real options theory [35].

Another limitation of real options theory is the lack of empirical evidence and practical applications. Despite its theoretical appeal and potential benefits, real options theory has not been widely adopted by practitioners and policymakers in making investment decisions [36]. One reason is that real options theory requires sophisticated mathematical models and computational techniques that are often beyond the capabilities and resources of most investors [37]. Another reason is that real options theory may not always provide clear and consistent guidance for decision making, especially when there are multiple or conflicting real options involved in a project [38]. Therefore, more empirical research and case studies are needed to test and demonstrate the usefulness and applicability of real options theory in different contexts and scenarios [39].