Question

Please I need it urgently

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.

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

Answer 1

Hi, Friend,

Please refer to the Answer provided for (C) theory portion and (D) part below and for rest, please refer to the attachments. Thanks.

(C) Advantages of adding debt in equity-based capital Structure

• Retain control. When you agree to debt financing from a lending institution, the lender has no say in how you manage your company. You make all the decisions. The business relationship ends once you have repaid the loan in full.
• Tax advantage. The amount you pay in interest is tax-deductible, effectively reducing your net obligation.
• Easier planning. You know well in advance exactly how much principal and interest you will pay back each month. This makes it easier to budget and make financial plans.

Disadvantages of adding debt in equity-based Capital Structure

Debt financing has its limitations and drawbacks.

• Qualification requirements. You need a good enough credit rating to receive financing.
• Discipline. You’ll need to have the financial discipline to make repayments on time. Exercise restraint and use good financial judgment when you use debt. A business that is overly dependent on the debt could be seen as ‘high risk’ by potential investors, and that could limit access to equity financing at some point.

Collateral. By agreeing to provide collateral to the lender, you could put some business assets at potential risk. You might also be asked to personally guarantee the loan, potentially putting your own assets at risk.

(D) Factors that Hassen construction should consider when evaluating its capital structure policy.        

Some of the Inter Factors affecting the capital structure decisions of a company are: –

1. Financial Leverage 2. Risk 3. Growth and Stability 4. Retaining Control 5. Cost of Capital 6. Cash Flows 7. Flexibility 8. Purpose of Finance 9. Asset Structure.

And some of the External Factors affecting the capital structure decisions of a firm are:-

1. Size of Company 2. Nature of Industry 3. Investors 4. Cost of Floatation 5. Legal Requirements 6. Period of Finance 7. Level of Interest Rate 8. Level of Business Activity 9. Availability of Funds 10. Taxation Policy 11. Level of Stock Prices

Additionally, some of the general factors in this regard could be summed as:-

1. Control 2. Risk 3. Income 4. Tax Consideration 5. Cost of Capital 6. Trading on Equity 7. Investors’ Attitude 8. Flexibility 9. Timing 10. Legal Provisions 11. Profitability 12. Growth Rate 13. Government Policy 14. Marketability 15. Company Size 16. Maneuverability 17. Financing Purpose