Finance and Risk Management, Shipping Finance - Essay Example

Insert Insert Grade Insert Insert Finance and Risk Management, Shipping Finance Introduction During the period before the Second World War private equity was the major way of financing the acquisition of ships. The shipping market was characterized by fluctuations and this discouraged financial institutions from participating in financing them. The following decades saw the growth of the global economy and the need for larger cargo carrying ships that required capital investment that was above private equity. The banks’ role in financing ships commenced to increase in the 1960’s when owners of ships were in possession of oil charters for oil companies that could cover the best part of the repayment period. Financing the ship industry has always evolved with the prevailing market conditions. More investment has always been required in the industry above the owner’s potential to finance hence the need for banks. The industry has its strengths and weaknesses, there have been opportunities, and it has also seen threats. This paper examines the relationship between shipping financing and shipping markets, the major sources of capital available in the shipping industry, the strengths and weaknesses, opportunities and threats (SWOT) in the industry. SWOT analysis of the Shipping Industry Strengths The shipping industry represents a substantial percentage of the world trade. The industry is one of the most effective forms of transport and the costs are relatively low. It costs 11 percent and 20 percent of the transportation cost on roads and rails respectively. If the business is doing well it can have a high capital return of about 25 percent per annum ( Nizam and Ghanem 15). Shipping industry is also a dynamic industry; there is continual investment in research and development of new technology. This contributes to the global technological growth. Weaknesses This industry is cyclical and relies on the changes of the global market. This makes the industry to be uncertain. The industry also experiences a shortage of skilled labour and management because there are few people who are professionals in this field. The image of this industry is poor; people tend to perceive the industry to be archaic and therefore outdated. Vessels also cause pollution of the environment through emission of CO2 and noise. Opportunities There are initiatives to make ships more environmentally friendly. This will make ships more acceptable. There is also a long term plan to recruit, educate, and train skilled seafarers. This will close the gap pertaining to lack of skilled labour. There is an initiative to improve propulsion technology of ships through building bigger ships, nuclear powered ships, E-navigation, efficient engines and improved computerized cargo handling. Threats If recession in global markets is prolonged, the ship industry will adversely be affected. Political instability may also affect the ship market. There is also a security threat due to pirates hijacking ships in the oceans. The increase in oil cost is also likely to increase the operating cost of ships. As the markets stabilize there is also a likelihood of oversupply and this may lead to stiff competition. The Relationship between Shipping Financing and Shipping Markets Shipping markets are volatile and have many uncertainties, and this factor needs to be considered before making investment in the industry. The market is uncertain because of varying factors ranging from markets being sensitive to economic growth, to changing ship prices and vessel rates. The huge income required to invest in the industry can lead to many financial risks. The shipping companies must therefore employ optimal financing and capital structure. The shipping companies are always changing with the markets and so are the financial instruments available for the companies. The shipping companies are shifting from profit maximization to increasing of companies’ market value. To achieve this, ship firms must adopt plans that bring back returns on the investment and encourage the company to grow. Competition in the shipping markets has led companies to adopt flexibility in their operations, efficiency in their management and robustness in their financial liquidity. Shipping firms can grow either by following external growth path or adopting an internal growth path. Basing on the prevailing market conditions the ship firms can expand their fleet by buying second hand ships or building their own vessels. Mergers, strategic alliances and acquisitions can also be options for growth. All the strategies adopted require large capital investment and careful financing planning. Two approaches are adopted in ship financing and they are: internal financing and external financing. These financing options are discussed in the next section. Capital Facilities Available to the Shipping Industry Shipping business involves large capital investments. Personal equity can be a source of capital but plays a much lesser role than credit facilities. Personal equity was majorly used when the economic growth was still low and did not require larger vessels. As seen in the preceding sections, both the investors and the banks need to make an informed decision because any mistake can lead to losing a substantial amount of money (O’Callahan 10-15). Financing the shipping industry needs to be flexible and changeable as the markets change. That is why every time there are new methods of providing finance to the industry (Orfanidis 42). The traditional ways of providing funds are through stock markets, subsidies, equities and loans. Newer methods have been invented such as maritime joint ventures, leasing, securitization offshore companies, mezzanine finance and venture capitals. The most important source of income for companies to finance shipping is issue of stock. The second best option is debt, in this case the company promises the lending institution to pay the amount with an interest. The lenders cannot claim to own the company due to its debt. The interest rate payable is normally deducted before taxing the income. This acts as a subsidy to companies (Brealey and Myers 394). These loans are issued with securities. Commercial Bank Loans The shipping business is a capital intensive business. The large amounts of capital required make banks weary of issuing the loans freely. This has led the banks to develop strategies to avoid incurring huge loses. The main strategy is consolidation. In this case a group of maybe five banks come together through one bank called the arranger. They divide the loan into small packages that each bank should issue. Despite the banks taking such a conservative approach, bank loans are the greatest financiers of the shipping industry. However, the number of banks in this business has been decreasing over the years. The consolidation approach has stemmed competition among banks and there are no attractive packages being introduced. The huge capitals involved lead the banks to insist on securities before issuing loans. This is not only important in protecting the banks from losses, but also leads the investors to make careful decisions. In the 1960s the banks accepted mortgages as security but the crisis of the 1970s changed this scenario. Most mortgaged vessels were taken by the lending banks due to non-payment. This led the banks and ship owners both to incur losses leading the banks to develop new strategies in issuing loans. The banks now require owners to provide stable securities such as an assurance of the ship employment for a specific period of time. This is to ensure that the business will ensure re-servicing of the loan. They are also accepting mortgages; in that case if the ship owner fails to pay the loan, the vessel can be taken up by the bank. Equity This is one of the most important means of acquiring ships. In this method the company may use the shares in the company to purchase the ships. This ship will be owned by shareholders, and the profit that will be sourced from this business will be shared according to the stock owned by members. However, this approach should only be taken in an opportunistic market environment and care must be taken not to misuse the investment. There should be clear strategy of exit from the business in order for profits and losses to be shared fairly. Money to fund the investment can also be raised through issue of shares. In this case the company’s shares are sold to the public. This strategy ensures that the owners avoid debts, but diversify the ownership of the company and those who buy the shares may find it hard to sell them in future. The capital market helps companies to raise stock for expansion. This has not been much useful in raising equity for shipping companies. In some cases the shipping companies have been barred from participating in the capital exchange market. However, with technological advancement and the decreasing of banks in the ship investment lending, this is expected to change. Leasing This is considered as the third major source of finance. In this arrangement the leaser purchases the equipment and leases it out to the entrepreneur who uses it. The purchaser remains the owner of the vessel. Leasing requires less security or collateral as compared to bank loans. The owner of the ship enjoys tax benefits because the lease payments are deducted from taxable income and the ship furthermore does not appear in the list of his assets. The leaser, on the other hand, also enjoys tax benefits due to depreciation of the ship which he is not responsible for maintaining (Grammenos and Xilas 14-18). The risks of this source of finance are that you do not have ownership of the vessel, or it can be reclaimed at any time. Bonds Issue In this case, the company issue bonds to lenders who give the company the necessary capital to purchase the ships. Bonds earn interest until their maturity. Most bonds do not require securities giving them an advantage over bank loans. The company does not need to pay regular payments except the annual interests. It only pays the bond at maturity, and this increases the firm’s liquidity (Balz et al 30). The holder of the bond has no decision making power in the company. However, this is a non transparent way of sourcing finance because negotiation in case the company fails to pay the bond is impossible. Islamic Financing Islamic financing is guided by the Shariah law, which prohibits the charging of interests on loans. The capital investment required is normally high in the shipping industry, and most Islamic financing has adopted the leasing approach where they purchase the vessels and lease them out to operators. One such example is the Al Rubban Fund that was established in Kuwait. This fund purchases the ships and leases them out to potential entrepreneurs (Pondikoglou 27). Conclusion Shipping financing has evolved with the prevailing market conditions. Initially, most of the funding came from equity but later was replaced by debt financing. This boosted the business and more investors came in. This was a case where investors grasped the opportunity but failed to check on the risks. Many banks and investors incurred losses due to supply superseding demand. This brought about the idea of risk management. As it has been seen, most banks insist on reliable securities before issuing loans. There has also been evolution of other means of financing, and the shipping industry is expected to do better in the near future than the traditional industry. The industry has its own strengths making it one major contributors of global trade. There are also weaknesses that may lower the image of the industry. However, there are opportunities that if utilized they can make the ship industry more acceptable. There are also threats that must be overcome in the development of the industry. In conclusion, I can say that the shipping market, with adoption of better risk management strategies, is headed for better days. Works Cited Balz, Jorg et al. Ship Financing in Flux. Atlanta: KMPG, 2012. Print. Brealey, Richard, and Myers Stewart. Principles of Corporate Finance. London: McGraw-Hill, 2000. Print. Grammenos, Costas and Xilas, Mihallos. Shipping Investment and Finance. London: City University Business School. Print. Ghanen, Alaa and Nizam, Youssef. The Shipping Industry. Audi: Audi Capital, 2011. Print. O’Callahan, Ted. “What Keeps the World’s Ships Going”. Yale University. 2012. Web. 24th Jan. 2013 Orfanadis, Alex. Shipping Finance. Greece: Athens, 2004. Print. Pandikoglou, Panagiota. “Islamic Finance for Shipping and Aviation Industries”. Erasmus University of Rotterdam. 2004. Web. 24th Jan. 2013. Read More