Question

1. “Hassen Constructions SAOG”, the company is situated in Al Khuwair. The organization is specialised in the manufacturing of building materials that are used in construction sites.

Currently the company’s capital structure (total capital) is ungeared. However, the owners of Hassen constructions is planning to change their capital structure into a leverage (geared) capital structure as they believe having a debt component in its capital structure will be beneficial to the organization.

The company total capital is RO 300 million which is an equity-based capital structure. The company has two share buyback options available to move into a leverage(geared) capital structure.

Option 1

The company has an option in converting 30% of its equity capital to debt capital at an interest rate of 7%.

Option 2

The company has an option of converting 50% of its equity capital to debt capital at an interest rate of 7.5%

To evaluate the impact on the alternative policies the financial accountant of the company has presented the following data to evaluate the impact on ROE in the current capital structure and the above two given options.

The financial accountant believes that based on the sales forecast the sales could be either weak, average or strong. The probability for the market to be weak is 0.3, average 0.5 and strong 0.2.

The profits before interest and tax (PBIT) , if the market is considered to be weak is RO 30 million, if the market is average the PBIT is 50% greater than the market is weak and if the market is considered to be strong it is 75% greater than if the market is average.

The current applicable tax rate is 25%

Required:

1. Calculate expected annual return on equity (ROE) under each option (the current, option I and option II)
2. Calculate expected average annual return on equity (ROE) considering all options together.
3. Evaluate the benefits and drawbacks of Hassen constructions in to changing their capital structure from and equity based to leverage. And, advise which of the three options (current or option I or option II) that Hassan Construction SAOG should go for under a normal situation? And substantiate your advice with suitable reasons.

Evaluate the factors that Hassen construction should consider when evaluating its capital structure policy.

Answer 1

Current Equity	300 million
Option A
Equiity	210 million
Debt @ 7%	90 million
Option B
Equity	150 million
Debt @7.5%	150 million
	Probability	PBIT	Prob x PBIT
Weak	0.3	30000000	9000000
Average	0.5	45000000	22500000
Strong	0.2	78750000	15750000
Expected PBIT			47250000
Net profit under various options
	Current	Option A	Option B
PBIT	47250000	47250000	47250000
Less : Interest	0	6300000	11250000
PBT	47250000	40950000	36000000
Less : Tax	11812500	10237500	9000000
Net profit	35437500	30712500	27000000
ROE	11.81%	14.63%	18.00%
B. Average ROE of all three options = (11.81 + 14.63 + 18)/3
		= 14.81%

C. Advantages of a geared capital structure :

1. It increases the return the common shareholders return as seen in the above example.

2. Debt can be issued to buy back a portion of shares outstanding which decreases dilution.

Drawbacks

1. It increases the financial risk of the company. The fixed payments to meet the interest obligations increase which can result to losses during the downturns. It increases the liquidity needs of the company as well.

2. High leverage makes access to future capital more costly as higher the leverage higher the risk of the company and therefore the capital providers require additonal return.

The company should go for Option B as it provides the highest return. The ideal debt to equity ratio is considered to be and option B provides that. As the company has no leverage at the moment it can maximize its return by buying back half od its shares and replacing that with debt.

Factors to keep in mind while deciding a firm's capital structure are follows :

1. Cash flow position : AS debt requires an obligation to pay interest, a company should only go for debt if the liquidity in the company is not an issue. Unable to meet the interest obligation may be very costly for the company and may even result in insolvency.

2. Interest Coverage ratio : The interest coverage ratio tells the number of times a firm's PBIT is in relation to its fixed interest obligations. The higher the number, more the debt company can take.

3. Return on investment : A company should only take on more debt if the return its earning is more than the interest rate of the debt.

4. Tax : As the cost of debt decreases with increase in tax rates as interest expense is a deductible expense, a higher tax rate makes debt an attractive source of capital.

5. Control : If the owners of the company want to increase their control over the company and decrease dilution, debt is the way to go.

6. Risk : Total risk of the firm is a function of business (operating) risk and financial risk. Financial risk is associated with the risk of not meeting the company's fixed charges such a interest payments, lease payments, etc, while the operating risk depends upon the operating costs of the business. Higher the operating cost, higher is the operating risk. If a firm's operating risk is low it can issue more debt but if the operating risk is high it should prefer equity.

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