1. Salalah Fisheries SAOG company is specialised in the manufacturing of processed see food products for domestic and overseas market. Currently the company is a debt free company and hence, capital structure is ungeared. The Salalah Fisheries is planning to change its capital structure into a leverage capital structure as they believe having a debt component in its capital structure will be beneficial to the shareholders. The company total capital is RO 30 million which is totally contributed by the equity shareholders. The company is contemplating for buyback its share from the open market to move into a leverage capital structure. The following are the two options for financing of buyback its share from the open market:

Option 1: Converting 25% of its equity capital to debt capital at an interest rate of 6%.

Option 2: Converting 50% of its equity capital to debt capital at an interest rate of 7%

The company makes an estimation of profits before interest and tax (PBIT) under three different scenarios in the coming year. If the market is considered to be weak in the coming year, the PBIT will be RO 3 million, if the market is average the PBIT will be 50% greater than the weak scenario; and if the market is considered to be strong PBIT will be 75% greater than week scenario. The probability for the market to be weak is 0.3, average 0.5 and strong 0.2. The current applicable tax rate is 15%

Required:

a) Calculate expected annual return on equity (ROE) under each option (the current, option I and option II) under week, average and strong scenarios

b) Calculate expected average annual return on equity (ROE) considering all scenarios together.

c) Evaluate the benefits and drawbacks of Salalah Fisheries SAOG 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 Salalah Fisheries SAOG should go for under a normal situation? And substantiate your advice with suitable reasons.

d) Evaluate the factors that Salalah Fisheries SAOG should consider when evaluating its capital structure policy.