How Does Capital Structure Affect the Performance of European Shipping Industry?

Research Topic: How does capital structure affect the performance of European shipping industry?

Table of Contents

Introduction:

Research aims and objectives:

Research question:

Research hypotheses:

Purpose of the research:

Literature Review:

Capital Structure theory:

European shipping industry:

Conclusion:

Bibliography:

Introduction:

Shipping industry is considered as the lifeblood of the economy around the globe. Most of the industries in the world rely heavy on the shipping industry, either for export or import of goods and services. Shipping industry is therefore considered as a backbone of global economy (Davis, 2012).

Margaritis, & Psillaki (2010) have presented the fact that more than 80% of the world goods are transported through ships. The shipping industry provides benefits such as the greenest mode of transport, and the cheapest transport solution to the global business. It is because of these privileges attached to transportation of goods through ships majority of the global business consider ships as their first choice for transportation.

The increasing awareness about the benefits of ships as a mode of transport the shipping companies face increasingly fierce national and international competition.  In this scenario, it is important for shipping companies to ensure that they have an effective and efficient capital structure in place so that the performance of the shipping companies are not affected negatively (Drobetz, Gounopoulos, Merikas,& Schröder, 2013).

Capital structure, which means the ratio of debt and equity, is one of the most important aspects for any business. In the case of shipping industry, financing is a sensitive problem. The optimal capital structure has become a serious problem for shipping companies in this fierce global competition. The shipping companies need to produce significant savings from the existing expenditure (cost reduction) and increase competitiveness by increasing the number of fleet. In the theory of Modigliani and Merton Miller (1958), they explained that there was a perfect world (without taxation, without any agency costs, every efficient markets with perfect knowledge and most importantly no bankruptcy distress) because of which there was no relevance of debt and equity or the performance/value of the shipping companies. However the global market is not perfect anymore and in this imperfect market the importance of the optimal capital structure has increased. The shipping companies need to have an optimal mix of capital so that they can maintain the balance between debt and equity. The imbalance (debt more than equity) in the capital structure can lead the shipping company fall behind its competitors (Paun, & Topan,2016).

Research aims and objectives:

The research aims to understand the effect of capital structure on the performance of European shipping industry. With this aim the research looks to achieve the following objectives:

a)     To understand the capital structure in European shipping industry

b)     To understand what makes capital structure optimal in the context of the European shipping industry.

c)     To examine the affect of capital structure on the performance of European shipping industry

Research question:

The main research question of the research is to find out,”How does capital structure affect the performance of European shipping industry?”

Apart from this the sub research questions are:

1. What are the variables that are included in capital structure?
2. How the European shipping companies can make the capital structure optimal?

Research hypotheses:

The theory on capital structure and form performance had been discussed since 1958, when Modigliani and Miller proposed irrelevance theory. There have been significant changes in the market and dynamics of shipping industry. The main theories regarding the optimal capital structure can be divided into “trade off hypothesis” and “pecking order hypothesis”. The “trade off hypothesis” states that an optimal capital structure for a company is based on a trade off between tax shield and costs with financial distress while “pecking order hypothesis” states that there is no optimal capital structure for companies because the companies need to establish a continuous balance between internal and external financings based on the need and also availability of the cash flow in the companies (Zeitun, & Tian, 2014).

 In order to reassess these and get the answer for the research questions the following alternative hypotheses are tested:

H_1a  The size of the shipping company has positive impact on the financial leverage of  that company

H_2a  The profitability of the shipping company has positive impact on the financial leverage of  that company

H_3a  The tangible assets of the shipping company has positive impact on the financial leverage of  that company

H_4a  The growth potential of the shipping company will decrease the financial leverage of  that company

H_5a  The higher non debt tax shield of the shipping company will decrease the financial leverage of  that company

H_6a  The higher tax rate of the shipping company will increase the financial leverage of  that company

The null hypothesis are;

H_1o  The size of the shipping company has positive impact on the financial leverage of  that company

H_2o  The profitability of the shipping company has positive impact on the financial leverage of  that company

H_3o  The tangible assets of the shipping company has positive impact on the financial leverage of  that company

H_4o  The growth potential of the shipping company will decrease the financial leverage of  that company

H_5o  The higher non debt tax shield of the shipping company will decrease the financial leverage of  that company

H_6o  The higher tax rate of the shipping company will increase the financial leverage of  that company

Purpose of the research:

The purpose of the research is to understand the effect of capital structure on the performance of European shipping industry. The shipping industry is considered as a sensitive economic sector. The industry requires high capital for investment in the fixed assets such as shops and vessels so that the shipping companies can expand their operations. In order to do so the shipping companies need to establish an optimal capital structure system so that they have important financing sources and financing strategies. Shipping industry is considered as a backbone of global economy and there is a need to strengthen this backbone so that the global economy is not impacted negatively. Apart from this, the shipping companies face increasingly fierce national and international competition, so in an individual level the companies need to ensure that they have an effective and efficient capital structure in place so that the performance of the shipping companies are not affected negatively.

The study contributes to the previous literature of capital structure and performance of firms through the example of shipping companies. The research explains the impact of capital structure on the performance of shipping companies through various variables such as size of the company, profitability, assets, growth potential, non debt tax shield, and tax rate (Xiaoyue, & Xiaodong,2001). 

Literature Review:

Capital Structure theory:

The studies of capital structure started with the Modigliani and Miller’s irrelevance theory. They explained that there was a perfect world (without taxation, without any agency costs, every efficient markets with perfect knowledge and most importantly no bankruptcy distress) because of which there was no relevance of debt and equity or the performance/value of the shipping companies. However, there is more and more market imperfection, which is explained, in different variables such as bankruptcy costs, agency costs, taxation, asymmetrical information and shipping industry related factors (Berger & Di Patti, 2006).

The shipping industry is considered as a dynamic, capital concentrated and recurrent business. It is because of the dynamic, capital concentrated and recurrent nature of shipping industry this industry need financing alternatives to ensure the availability of important capital resources for longer period of time.  The shipping companies need to produce significant savings from the existing expenditure (cost reduction) and increase competitiveness so that the shipping companies have financing sources to expand and also competitive advantage among their competitors (Majumdar, & Chhibber,1999). The shipping industry has changed a lot in recent times. There is a huge growth in the shipping industry as the shipping companies provide benefits such as the greenest mode of transport, and the cheapest transport solution to the global business. Apart from that the industry is considered as the lifeblood of the economy around the globe as more than 80% of the world goods are transported through ships (Hadi, 2016).

The shipping industry has transformed into more globalised industry, fuel cost sensitive industry, high tangibility of assets, and business with high leverage.  The access of credit is limited to the shipping companies because of the external factors such as financial crisis, and environmental calamities. The banks are financial institutions are reluctant to finance in the adverse economic climate and even the promoters and investors limit their financing during the off seasons. The shipping companies need to have other financing sources so that they can have access to long-term finance. The role of capital structure is very important in getting the shipping companies the access to long-term finance (Bowen, Daley & Huber,2008).

The theory of capital structure as the Modigliani and Miller’s irrelevance theory stated that there is no relationship between a firm’s capital structure and its performance. Modigliani and Miller (1963) further revised their theory and stated that the effect of corporate tax and tax deduction have impact on the performance of the firm. The firm’s performance is increased when the debt of the firm is increased and this increasing amount is also the value of the tax shield. This essentially suggests that the firms will have more benefit from taking more debt as it increases the leverage of the firm. However this theory is applicable only for imperfect market (El-Sayed Ebaid, 2009).

The imperfect market includes various variables such as bankruptcy costs, agency costs, taxation, asymmetrical information and shipping industry related factors.

The theory of capital structure and performance of firms further developed “trade off hypothesis” and “pecking order hypothesis”.  The “trade off hypothesis” states that an optimal capital structure for a company is based on a trade off between tax shield and costs with financial distress while “pecking order hypothesis” states that there is no optimal capital structure for companies because the companies need to establish a continuous balance between internal and external financings based on the need and also availability of the cash flow in the companies.

After “trade off hypothesis” and “pecking order hypothesis” were developed in Kraus and Litzenberger (1973) and Myers (1984) respectively. Jensen and Meckling (1976) come up with the agency theory. The agency cost theory explained that due to division of control and ownership the agency of firm would not always work for the benefits of the shareholders. When a firm raises the debt there are chances of conflict between shareholders and other party of the firm. The situation of conflict would result into added cost for the firm in operating, investing and financing activities. The increase of debt might help the firm to leverage but the managers who are interested into personal benefits might not be happy leading to a situation of conflict in the firm.

European shipping industry:

The European shipping industry is a global leader in the shipping business. The European union is the home to the world largest shipping. The European shipping industry controls more than 40% of the global tonnage. The industry is also the world’s youngest and the most innovative shipping industry, which has more than 23,000 vessels ((ECSA,2018).

In terms of economic contribution, the European shipping industry contributed more than €145 billion to the GDP (Gross domestic product) of European union (EU) in 2012 . The European shipping industry had also created 2.3 million jobs in EU region in 2012. The European shipping companies transport more than 90% of the products such as clothes, oil, gas, cars, electrical appliances and many other items. Since the European shipping industry not only contributes to the GDP of EU but also create employment for the people of EU , the industry is considered as backbone of not only EU economy but also that of globalised economy (IMDO Strategic Review of Irish Maritime Transport Sector, 2018).

The European shipping industry is not only the cheapest transport solution to the global business but also the greenest mode of transport. The size of the vessels and even improving efficiency in the European shipping industry are the two important factors which allows the European shipping industry to ship at a minimal cost of 2% of the shelf price of any product.

The shipping industry has been the facilitator of trade all these years and in order to remain the facilitator of trade the European shipping industry need to compete among the all the global shipping and establish an effective and efficient capital structure so that the European shipping industry has the access to finance for longer period of time. 

Conclusion:

The European shipping industry is a global leader in the shipping business and considered to be the backbone of EU economy because the industry had contributed more than €145 billion to the GDP (Gross domestic product) of European union (EU) and also created 2.3 million jobs in EU region in 2012.  Since the shipping industry has transformed into more globalised industry, fuel cost sensitive industry, high tangibility of assets, and business with high leverage the importance of access of credit has increased. The shipping companies need to produce significant savings by cost reduction and increase competitiveness so that the shipping companies have financing sources to expand and also competitive advantage among their competitors.

The shipping industry is considered as a dynamic, capital concentrated and recurrent business. It is because of the dynamic, capital concentrated and recurrent nature of shipping industry this industry need financing alternatives to ensure the availability of important capital resources for longer period of time. Apart from that the shipping companies face increasingly fierce national and international competition, so in an individual level the companies need to ensure that they have an effective and efficient capital structure in place so that the performance of the shipping companies are not affected negatively.

The shipping industry has travelled a long way from being a perfect market to an impact market. The imperfect market includes various variables such as bankruptcy costs, agency costs, taxation, asymmetrical information and shipping industry related factors. It is because of these changes in the nature of the business there have been various theories that are proposed to establish effect of the capital structure on performance of firms. From the perfect market to imperfect market there have been various factors such as size of the company, profitability, assets, growth potential, non-debt tax shield, and tax rate that should be considered while examining the e impact of capital structure on the performance of shipping companies.

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