How financial leverage boosts returns from new ships
Use of leverage to increase returns
Because ships are tangible assets, shipping companies can take out loans to fund new ship builds. This is similar to how Amazon Inc. (AMZN) can use debt because of its inventories and storage houses, as opposed to Ebay, which is more of an online marketplace where people negotiate and make transactions. As long as the cost of debt is lower than the return on each invested capital (debt or equity), using debt can boost return on equity and free cash flow to shares.
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Cost of debt for Navios Maritime Acquisition Corp. (NNA)
A simple way to find the cost of debt is to look at the company’s most recent credit financing activities, which will appear in earnings transcripts or press releases. These interest expenses will often show as a fixed rate, or a variable rate pegged to the libor. A recent transaction shows that Navios has drawn credit from Navios Holdings for an interest charge of libor + 300 bps (basis points) in margin.
Cost of debt for Scorpio Tankers Ltd. (STNG)
Scorpio also recently received credit facility (the option to borrow) of $525 million with interest charge of libor + 350 bps. Recent debt costs are used because they reflect the most up-to-date fundamental outlook of the respective shipping company, which is important for debt investors since it tells whether the borrower will be able to pay the interest and the principal. Factors such as negative earnings outlook, excess leverage, or lack of capital supply can increase the cost of debt.
Incremental return from new ships much higher than current returns
Based on the debt funding assumption of roughly $1 billion for Scorpio and $190 million for Navios, interest expense will bring the EBIT (earnings before interest and tax) of the two companies down by ~$42.0 million and $7.0 million, respectively. EBT (earnings before tax) for the two companies that can be generated by all the new ships will result in $25.5 million for Navios and $85.9 million for Scorpio.
With the remaining amount funded by equity of ~$722 million for Scorpio and ~$91 million for Navios, the returns that these two companies can generate (ignoring taxes) based on contributed equity will be 20.15% and 11.89%. This is much higher than what the companies are currently generating based on current earnings and historical book cost.