Introduction
Primarily any business' aim is to remain in business while maximizing the welfare of its shareholders. To start and continue its operations without hitches, companies usually require funding. The funds needed are either short-term or long-term (Carey and Essayyad, 2015). Sources of short-term funding include overdraft, short-term loan, trade credit and lease finance. These sources are repayable within a period of one year. Due to the volatility in the interest rates associated with the short-term funding, they represent high risks for the borrower (James, 2000). However, they are less expensive and more flexible (Chahyadi, 2000)
Long-term funding, on the other hand, is obtained to finance long-term assets (Jung-Senssfelder, 2006). This type of financing is used for the funding of activities such as (Chahyadi, 2000): purchasing non-current assets, expansion of facilities, large scale construction projects and purchasing of permanent current assets (Baker and Martin, 2011). Sources of long-term funding are debt finance, equity finance, lease finance, venture finance and the preference shares (Longenecker, 2009). Noteworthy is the fact that long-term funds acquired by the entity are supposed to be repaid after one year from the date of acquisition (Chahyadi, 2000)
Sources of long-term funding
The sources of finance available to a company in the shipping industry can be broadly categorized as debt and equity funding
Debt financing
It is one of the most flexible sources of finance available to a shipping company. Unlike equity financing, it does not involve the transfer of ownership to the lender. They take the forms of
1. Commercial bank loans/ export credit banks
This is probably the most readily available and common form of ship finance available to companies. Commercial bank debts are the foundation of most shipping companies’ capital structure due to the inexpensive and flexible natures. The borrowing company applies for a loan from a bank providing all the relevant information documents. The bank conducts a credit risk analysis and upon approval, the banks draft the offer letter which stipulates all the terms applicable to the loan agreement. The offer letter outlines the length of the loan, loan to value of asset ratio, repayment schedule, currency, interest rates, commission, syndication, security, representations and warranties and covenants. There can be a situation where a group of lenders finances a single borrower or a bilateral set up where a single lender provides funds to an individual borrower.
The advantages of debt financing include: the owner does not give up any ownership or future profits of his business, the lender has no control over how the business is run, and interest on the loan is treated as tax deductible. The borrowed money helps in obtaining business assets hence allowing the company to keep business profits in the enterprise.
The disadvantages of debt financing are (McLean, 2003): the company must have sufficient cash flows to repay the debt, a business with a lot of debts may have cash flow problems, and the riskier loans attract higher interest rates. Also, too much debt may impair the ability to raise money in the future, loans require collateral, and tedious process of dealing with lenders and their criteria to obtain loans. For instance, it would be impossible for a company that is shipping dry bulk like DryShips to acquire and sustain debt financing due to the slump in earnings and the losses it is reporting
2. Lease finance
In leases, the owner of the assets the lessor passes the possession of the property to the lessee who continues to enjoy the benefits from the asset in return for the payment of a rental (Chandraiah, 2004). Lease agreements do not pass the title of the property to the user hence the room for repossession (Boobyer, 2003). The types of leases available to a shipping company are bareboat charters, finance leases, operating leases, hire purchase, and voyage charters (Armitage, 2005).
A shipping company can acquire the right to use an asset in a lease arrangement. Such an arrangement is referred to as an operating lease. Shipping companies usually use operating leases to acquire equipment on a short-term basis.
The advantages of lease financing are: the amount is paid to the lessor at the beginning he avoids the hassle of the collection, and the lessee can acquire an asset even without security. Also, the lessee does not bear the risk of obsolescence and the lessor earns reasonable income and gets capital allowances when calculating tax (Boobyer, 2003)
3. Bonds
The use of bonds to finance operations in the shipping industry has gained popularity in the recent years. A bond implies a piece of paper issued by a company (issuer) to another instructing them to repay the borrowed money at a particular date and rate of interest to the holder of the paper.
4. Venture capital
This is capital put in by investors in a more risky business (Milesi-Ferretti, Lane and Milesi-Ferretti, 2000). The investors take the risks knowingly with the hope of realizing high returns and/or stake of ownership in the company (Jung-Senssfelder, 2006). The risk may be since the business is new, the product is based on a new and untested technology, or business is struggling for some other reason (Longenecker, 2009).
Equity finance
This is the money raised through the issue of ordinary shares to investors. It may occur through a rights issue, placing, public offer, stock exchange listing among others (Milesi-Ferretti, Lane, and Milesi-Ferretti, 2000). There are two forms of equity prevalent in the shipping industry that is private equity and public equity. Private equity funding is not so popular due to the inefficiencies experienced in the process of acquiring capital, low returns and bad corporate structures (Milesi-Ferretti, Lane and Milesi-Ferretti, 2000). Private equity funding can take the forms of
Management Buy-Out: a situation where the management brings in private equity financier to help the buy large number of shares from the existing shareholder
Leveraged Buy-Out (Swanson, Srinidhi and Seetharaman, 2003): involves a situation where the external investor secures a loan using the assets of the target company and uses the same loan to buy the company
Leveraged Buy-Out (Swanson, Srinidhi and Seetharaman, 2003): involves a situation where the external investor secures a loan using the assets of the target company and uses the same loan to buy the company
Backing proven management team: a situation where an outside equity provider agrees to finance transactions that are carried out by the management team (Swanson, Srinidhi and Seetharaman, 2003)
Equity financing has the following advantages over debt financing: the equity contributions do not have to be paid back if the company goes bankrupt, and the business assets do not have to be pledged as collateral to obtain equity funding. Besides companies with sufficient capital are more attractive to the lenders, investors and the IRS and it results in the business having more cash as there is no debt repayment involved (Swanson, Srinidhi and Seetharaman, 2003).
The disadvantages of equity funding in comparison to debt financing in the shipping industry are: the company has to relinquish ownership and a share of the business profits of the new equity investors, and other owners may come with conflicting ideas regarding the operations of the company. Also, the dividends paid to investors are not taxable (Milesi-Ferretti, Lane and Milesi-Ferretti, 2000).
Choosing between debt and equity financing
In practice, most businesses use a blend of debt and equity financing. If the company has too much debt, it may overextend its ability to service it, and can, therefore, be vulnerable to business downturns and changes in interest rates (MacKenzie, 2006). On the other hand, too much equity dilutes the ownership interest of the existing shareholders. The choice between debt and equity depends on the type of business, age, and specific factors such as:
Risk- The directors have to analyze the uncertainty in the shipping company’s environment (Culp, 2002). If the company is sensitive to the uncertain environment, then the risk has to be confirmed concerning the company’s investment opportunities.
Ownership and control: Significant injection of capital by shareholders can dilute the ownership and oversight exercised by the parent owners (Funke, 2007). Smaller family firms may prefer to take in debt for this reason. Debt carries no voting rights, so the only diminution in control is imposed by the incorporation of restrictive covenants in the loan agreement (Funke, 2007).
Duration: finance raised should correspond to the use for which it is raised. If the investment is not expected to generate profits in the early years, then equity may be preferred. However, if benefits are expected from the outset, then debt may be suitable (James, 2000). Similarly, it would be wrong to raise a long-term debt if the investment has a short lifespan.
Gearing effect: concerning debt capacity, a company’s existing gearing levels will impact the perceptions (and pricing) of potential lenders, as will the type of industry in which it operates. Nature and the quality of any security the firm can offer and the variability of its expected cash flows also affect the gearing levels(Focardi and Fabozzi, 2004).
Impact of Capital Structure on Firms Financial Performance and Shareholders Wealth
The level of gearing of a company affects its profitability as well as its risk profile. The capital structure decision evaluates the makeup of the capital regarding what proportion should be financed through debt and equity (Focardi and Fabozzi, 2004). A business that is funded mainly through debt is considered highly geared. In the majority of cases, since debt funding is cheaper than equity finance managers may decide to maximize on the debt element of the capital structure. However if a company increases gearing (the debt component of its funding), with the hope of increasing profitability, it simultaneously increases the risk involved. High dependence on borrowed funds makes the company vulnerable to some risks.
A financial manager has to strike a balance and determine the optimum capital structure. In his analysis, he weighs the effect of the proposed decision on the shareholders’ wealth maximization of which is the prime objective of financial management the risks associated with high levels of gearing are financial risks, the potential for bankruptcy, credibility risks, and business risks.
Recommendations
Modigliani and Miller put forward an argument (1958) that there exists an optimal capital structure that balances the risk of bankruptcy with the benefit of tax savings (Bierman, 2003). The capital structure will give higher returns to the equity holders than they would receive from a company with only equity capital.
Use of debt imparts a gearing effect to the shareholder profits, under which an increase in activity and sales revenue of a given proportion will have a more than relative impact (James, 2000). The use of debt is, therefore, excellent when companies expand but the reverse applies in diverse trading conditions. The use of debts can have dire consequences if there is a recession (McLean, 2003).
Also, if the environment that the entity is operating in is uncertain and changing rapidly, then equity would be a better choice. This is because equity investors may demand dividends or a portion of the annual profits. For example, it would be dangerous for AP Moller-Maersk to acquire debt funding having predicted falling activity levels in the global trade by October 2015 (Brown, 2016). On the other hand, if the company opts for debt financing then it has to meet agreed interest and principal payments regardless of the cash flow position (Culp, 2002).
Conclusion
The choice of the capital structure by a company should be one that suits the needs and interests of the company shareholders. Firms have to find the optimal capital structure with the right mix of debt and equity (Baker and Martin, 2011).
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