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 companys 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.