DETERMINING THE COST OF EQUITY

Part 2 of 2

By Geoff Uttmark

Part 1 of this article (MM Vol. 16, Number 9) presented the primary sources of capital for shipping and their relative cost. In most cases, debt is the preferred finance vehicle due to the higher return on equity that is possible from using leverage, the inability of many shipping company balance sheets to finance all-cash acquisition of vessels and the fungiblity of assets that makes ship finance attractive to lenders. Ship owners can compare their fleets and balance sheets to similarly sized companies to garner the feasibility and approximate cost of a particular debt instrument in the current lending climate. A technique was presented using historic data for MIF, Ltd. to calculate the contribution (or cost) to earnings from debt financed assets. Debt is carried, of course, on the balance sheet, but the effect of debt is more pronounced on the income statement of companies in cyclical industries like shipping. This is the point, obviously, of leverage, provided managers get the timing right, but “point” may not be exactly the right word to use. Better maybe to call it a fulcrum, since in the present ship finance climate, bankers are looking for equity on the balance sheet. Compared to pricing debt, pricing equity is more quantitative than qualitative, and only by knowing how to run all the numbers can a ship owner be confident of his competitive standing on the CAPEX front. As noted in Part 1 of this article, CAPEX, in the form of debt service, is often an owner’s single greatest expense item. It is also a fixed expense. The pivotal role played by equity in ship finance hence is critical, as it is the component of CAPEX that carries no fixed charges and is leverageable.

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