Sultan Qaboos University

College of Economic and Political Science

Economic and Finance Department
Capital Structure & Budgeting

Capital Structure of Yanbu Cement

Company

Submitted to: Dr. Sreerama Yalamarthy

Submitted by:
Sheikha Al-Saidi 130403
Fatema Al-Mamari 130219
Iman Al-Ojaili 131815
Section: 20

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Table of content

Introduction ……………………………………………………………………………….3
Data of the company ……………………………………………………………………...4
Before restructuring ………………………………………………………………………5
After restructuring ………………………………………………………………………...6
Scenario 1 ………………………………………………………………………………....6
Scenario 2 …………………………………………………………………………………7
Scenario 3 …………………………………………………………………………………8
Scenario 4 …………………………………………………………………………………9
Diagrams ……………………………………………………………………………...…11
Conclusion ……………………………………………………………………………....14
APPENDIX ………………………………………………………………………...……15

Table of tables

Table 1: Data of the company ……………………………………………………………….…4

Table 2: Before restructuring ………………………………………………………….….…...…5
Table 3: Scenario 1 effects on company ………………………………………………….6
Table 4: Scenario 2 effects on company ………………………………………………….7
Table 5: Scenario 3 effects on company ………………………………………………….8
Table 6: Scenario 4effects on company …………………………………………………..9

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Introduction

We worked on Yanbu Cement Company, which is a Saudi joint stock company

established in 1976. This firm focuses on producing cement and other building materials
products. The company headquarters is in Saudi Arabia, Jeddah. The purpose of this
project is to know the followed capital structure of Yanbu Cement Company and then
change the capital structure for the firm to study the effect of changing the capital
structure on earnings per share, cost of equity, the weighted average cost of capital, and
the overall value of the firm. To know the effect of changing the debt-to-equity ratio, we
build up 4 scenarios. The first scenario has a 0% debt-to-equity ratio, the second scenario
has a 42% debt-to-equity ratio, the third scenario has 79%, and the last scenario has a
136% debt-to-equity ratio. At the end of this project, we will reach the capital structure
that will maximize the firm’s value.

In order to achieve the purpose of this project we will use the following formulas:

1- Interest expenses=EBIT × Interest ratio

EBIT= earnings before interest and taxes

2- Earnings after interest ( EAI )=EBIT −Interest expenses

3- Tax expenses=earnings af ter interest ( EAI ) × tax ratio

4- Earnings after tax ( EAT )=earnings after theinterest (EAI )−tax expenses

EAIT
5- Retain of equity ( ROE )=
Equity

EAIT= earnings after interest and taxes

EAIT
6- Earnings per share ( EPS )=
Number of shares

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 7- Weighted avage cost of capital (WACC )= ( S +B
S
)× Rs+( S+BB ) × RB ×(1−Tc)
S: Equity Rs: Cost of Equity Tc: corporate tax

B: Debt Rb: Cost of Debt

' EBIT × ( 1−T )

8- Fir m s value= + B ×Tax
Ro

9- cost of equity ( Rs )=Ro+ ( BS ) × (1−Tc ) × ( Ro−Rb )

EBIT ( Unlevered )
10- Ro=
Equity ( Unlevere d )

Ro: cost of capital of unlevered firm

11- Tax shiled =B× Tax rate

Data of the company:

Table 1: Data of the company
Yanbu Cement Company
Sales 934,030,000.00
Cost of sales 710,420,000.00
Operating Expenses 47,910,000.00
EBIT 175,700,000.00
Debt 592,980,000.00
Equity 2,794,830,000.00
Average intr. Rate on Existing debt 3%
Interest rate on new debt 4.50%
number of shares outstanding 157,500,000.00
average Tax rate 8%
Debt+ Equity 3,387,810,000.00
EBIT Margin 19%
B/S Ratio 21%
Price per share 17.74495238

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Before restructuring

We constructed three conditions which are recession, expected, and expansion. First,
from the income statement of Yanbu Cement Company, we found that the sales and
EBIT equal 934,030,000 SAR and 175,700,000 SAR, respectively. From these two numbers, we
got the EBIT margin (EBIT/sales) which equals almost 19%. Moreover, as shown in the below
table, we raised the sales in ( expansion) by 50% and reduced it by 50% in (recession). After
that we calculated the EBIT for these two conditions by using these two formulas:
EBIT (in expansion) = sales (in expansion)*(EBIT margin %)
EBIT (in recession) = sales (in recession)*(EBIT margin %)
By applying all the formulas which are mentioned in the introduction section, we got
these results:

Table 2: Before restructuring

RECESSION EXPECTED EXPANSION

Sales 467,015,000.00 934,030,000.00 1,401,045,000.00
EBIT 87,850,000.00 175,700,000.00 263,550,000.00
Interest 17,789,400.00 17,789,400.00 17,789,400.00
EAI 70,060,600.00 157,910,600.00 245,760,600.00
Taxes 5,324,605.60 12,001,205.60 18,677,805.60
EAT 64,735,994.40 145,909,394.40 227,082,794.40
ROE 2.32% 5.221% 8.13%
EPS 0.411022187 0.926408853 1.44179552
Rs 2.28% 5.14% 8.01%
WACC 2.36% 4.73% 7.09%
Tax shield $45,066,480.00 $45,066,480.00 $45,066,480.00
VL 3,432,876,480.00 3,432,876,480.00 3,432,876,480.00

The current B/S Ratio is 21%. The ROE, EPS, and WACC are increasing by moving
from recession to expected (normal) to expansion. This means that shareholders will get
higher earnings in expansion compared to recession and expected (normal) conditions.
The value of the firm is 3,432,876,480 SAR as shown in the above table. It is calculated using
the formula mentioned in the introduction section. In addition, later, we will construct four
scenarios in order to compare these values which are ROE, Rs, EPS, WACC, and VL with them.

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These four scenarios have different debt-to-equity ratios. So, we will study the effect of raising
this ratio on the ROE, Rs, EPS, WACC, and VL.

After restructuring

We will make four different capital structures by changing the debt-to-equity ratio in
every scenario. We will study the changes in the company’s value, cost of capital and
earnings per share under three economic conditions; recession, expected, and expansion,
and compare the results under the proposed capital structures and the current (original)
capital structure.

Scenario 1 (zero debt)

In this scenario, we will reduce the debt level to zero and replace it with equity and
assume it is an all equity firm. Thus, the debt-to-equity ratio is zero. We want to study the
effect of having no debt on the company and compare it with the current capital structure.
The result is illustrated in the table below.

Table 3: Scenario 1 effects on company

B/S Ratio 0
Debt 0
Equity 3,387,810,000.00
Debt+Equity 3,387,810,000.00
Number of shares 190,916,826.78
Interest rate 4.5%
RECESSION EXPECTED EXPANSION
EBIT 87,850,000.00 175,700,000.00 263,550,000.00
Interest - - -
EAI 87,850,000.00 175,700,000.00 263,550,000.00
Taxes 6,676,600.00 13,353,200.00 20,029,800.00
EAT 81,173,400.00 162,346,800.00 243,520,200.00
ROE (R0) (Rs) 2.40% 4.79% 7.19%
EPS 0.425176771 0.850353543 1.275530314
WACC 2.40% 4.79% 7.19%
Vu 3,387,810,000.00 3,387,810,000.00 3,387,810,000.00
As the table above illustrates, after reducing debt to zero, the value of the unlevered firm
became lower than the current value with debt, where it has a value of SAR 3.387 billion,
which is lower than the current value of SAR 3.432 billion. Furthermore, the cost of

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capital (WACC) increased under the proposed capital structure under all economic
conditions from 2.36% to 2.40% under recession, from 4.73% to 4.79% under expected,
and from 7.09% to 7.19% under expansion. In addition, the earnings per share (EPS)
increased under recession only from 0.411 to 0.425 while it decreased under expected
and expansion from 0.92 to 0.85, and from 1.44 to 1.27 respectively. Also, the ROE will
increase during the recession and decrease under expected and expansion. In addition, the
ROE, and R0 are equal to the WACC since there is no debt and it is financed by equity.
Besides, we observed that the earnings after tax (EAT) increased when debt is zero, but
the taxes increased. Altogether, we can say that debt is good during expected and
expansion economic conditions, but it is bad during a recession.

Scenario 2
In this scenario, we will increase the debt from SAR 592 million to SAR 1 billion, thus
the debt-to-equity ratio will increase from 21% in the current capital structure to 42%.
The result is shown in the table below.

Table 4: Scenario2 effects on company

B/S Ratio 42%

Debt 1,000,000,000.00
Equity 2,387,810,000.00
Debt+Equity 3,387,810,000.00
Number of shares 134,562,773.05
Interest rate 4.5 %
RECESSION EXPECTED EXPANSION
EBIT 87,850,000.00 175,700,000.00 263,550,000.00
Interest 45,000,000.00 45,000,000.00 45,000,000.00
EAI 42,850,000.00 130,700,000.00 218,550,000.00
Taxes 3,256,600.00 9,933,200.00 16,609,800.00
EAT 39,593,400.00 120,766,800.00 201,940,200.00
ROE 1.66% 5.058% 8.46%
Rs 1.58% 4.905% 8.23%
EPS 0.294237396 0.897475559 1.500713722
WACC 2.34% 4.68% 7.03%
Tax shield $76,000,000.00 $76,000,000.00 $76,000,000.00
VL 3,463,810,000.00 3,463,810,000.00 3,463,810,000.00

As shown in the table above, when we increase the debt, the value of the firm increases
from SAR 3.432 billion to SAR 3.463 billion under the proposed capital structure.
Moreover, the cost of capital (WACC) decreases during all economic conditions, where it

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is 2.34% lower than the current 2.36% during a recession, 4.68% lower than the current
4.73% during expected, and 7.03% lower than the current 7.09% during expansion. In
addition, the earnings per share (EPS) increased during expansion from 1.44 to 1.50 but
decreased during the recession and expected economic conditions from 0.41 to 0.29 and
from 0.92 to 0.89 respectively. Also, the ROE will decrease during all economic
conditions from 2.32% to 1.66% during the recession, from 5.22% to 5.06% during
expected, and from 8.13% to 8.46% during expansion. Besides, the taxes will decrease
and the earnings after tax will decrease too due to the increase in debt. Furthermore, the
cost of equity Rs increases when the economy increases from rescission to expected and
to expansion. Moreover, the tax shield increased from SAR 45 million to SAR 76 million
which means that the value of the firm increased by this amount compared to not using
debt, and it saved this amount of taxes by using debt. Overall, we can say that increasing
the debt is a good option during expansion and a bad option during a recession.

Scenario 3
In this scenario, we will add more debt to reach SAR 1.5 billion, resulting in an increase
in the debt-to-equity ratio from the existing capital structure's 21% to 79%. The effects of
the change are illustrated in the table below.
Table 5: Scenario 3 effects on company
B/S Ratio 79%
Debt 1,500,000,000.00
Equity 1,887,810,000.00
Debt+Equity 3,387,810,000.00
Number of shares 106385746.2
Interest rate 4.5%

RECESSION EXPECTED EXPANSION

EBIT 87,850,000.00 175,700,000.00 263,550,000.00
Interest 67,500,000.00 67,500,000.00 67,500,000.00
EAI 20,350,000.00 108,200,000.00 196,050,000.00
Taxes 1,546,600.00 8,223,200.00 14,899,800.00
EAT 18,803,400.00 99,976,800.00 181,150,200.00
ROE 1.00% 5.30% 9.60%
Rs -0.24% 6.77% 9.16%
EPS 0.176747362 0.94 1.70
WACC 1.71% 5.61% 6.95%
Tax shield 114,000,000.00 114,000,000.00 114,000,000.00

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 VL 3,501,810,000.00 3,501,810,000.00 3,501,810,000.00

As the table above illustrates, the value of the firm increases from SAR 3.432 billion
under the current capital structure to reach SAR 3.501 billion under the proposed capital
structure where the debt increases even more, almost 3 times the current debt.
Additionally, the WACC decreases during the recession from 2.36% to 1.71%, it
increases during the expected economic condition from 4.73% to 5.61% and decreases
during the expansion from 7.09% to 6.95%. As for the earnings per share (EPS), it
decreases significantly during a recession from 0.41 to 0.17 but increases during expected
and expansion economic conditions from 0.92 to 0.94 and from 1.44 to 1.70 respectively.
In addition, the cost of equity R s increases when the economy increases, and it increases
when the debt increases more. Both taxes and earnings after tax decrease significantly
due to the increase in debt. Furthermore, the tax shield will increase even more from SAR
45 million to SAR 114 million because of the high increase in debt. Overall, we can
claim that rising debt is a good option during an expansion and a bad option during a
recession.

Scenario 4
In this scenario, we will increase the debt even more from SAR 592 million in the current
capital structure to SAR 1.95 billion, raising the debt-to-equity ratio from 21% in the
current capital structure to 136%. The table below provides an illustration of the effects.
Table 6: Scenario 4 effects on company
B/S Ratio 136%
Debt 1,950,000,000.00
Equity 1,437,810,000.00
Debt+Equity 3,387,810,000.00
Number of shares 81,026,422.00
Interest rate 4.5%

RECESSION EXPECTED EXPANSION

EBIT 87,850,000.00 175,700,000.00 263,550,000.00
Interest 87,750,000.00 87,750,000.00 87,750,000.00
EAI 100,000.00 87,950,000.00 175,800,000.00
Taxes 7,600.00 6,684,200.00 13,360,800.00

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 EAT 92,400.00 81,265,800.00 162,439,200.00
ROE 0.01% 5.65% 11.30%
Rs -0.24% 5.16% 10.56%
EPS 0.001140369 1.00295432 2.004768272
WACC 2.29% 4.58% 6.87%
Tax shield 148,200,000.00 148,200,000.00 148,200,000.00
VL 3,536,010,000.00 3,536,010,000.00 3,536,010,000.00

As the table above shows, when we increase the debt significantly, the value of the
company increases greatly from SAR 3.432 billion in the current capital structure to SAR
3.536 billion under the proposed capital structure. The cost of capital (WACC) will
decrease in all economic conditions from 2.36% to 2.29% during a recession, from 4.73%
to 4.58% during the expected economic condition and from 7.09% to 6.87% during an
expansion. Furthermore, the earnings per share (EPS) will decrease dramatically during a
recession from 0.41 to 0.001 but increase in expected and expansion from 0.92 to 1 and
from 1.44 to 2 respectively. Besides, the cost of equity R s increases as the economy
increases, and the more the debt increase the higher the cost of equity increases. The
taxes will decrease dramatically from 5.324, 12.001 and 18.677 in million to 0.0076,
6.684 and 13.360 in million during a recession, expected and expansion economic
conditions respectively. Moreover, the tax shield will increase significantly from SAR 45
million to SAR 148.2 million due to the significant rise in debt. Overall, we can conclude
that rising debt is a great decision during an expansion and a terrible decision during a
recession.

Diagrams

 Breakeven point

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This figure shows the effect of financial leverage. In this figure, the financial leverage
depends on the earnings before interest. The red line is reflecting the case when the
leverage exists (current structure) and the blue line represents the case of no leverage
(Scenario 1). The blue line starts from the point of origin indicating that when the
earnings before interest are equal to zero, the earnings per share will also equal zero. As it
showed in the graph, there is a positive relationship between the earnings before interest
and the earnings per share. The red line is the line when the firm will add debt to its
structure. The earnings per share will have a negative value if the firm has zero earnings
before interest. Thus the interest must be paid regardless of the firm’s profit. The firm
will generate more advantages from adding debt if the earnings before interest are higher
than 101,634,300 SAR, but if the EBIT are less than 101,634,300 SAR, the firm will
have a better structure, if there is no debt. In both cases, the firm will produce 0.53 SAR
per share when the earnings before interest equal 101,634,300 SAR, which is the
breakeven point, the point where both capital structures have the same EBIT and EPS.

- The break-even point:

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 Earni ngs per share for unlevered firm=Earnings per share for leverd firm(Current
structure)

¿¿

( EBIT −0)(1−8 %) ( EBIT −17,789,400)(1−8 % )

=
190,916,826.78 157,500,000
EBIT (BEP )=¿101,634,300 SAR

EPS (BEP) = (101,634,300/ 190,916,826.78)

EPS= 0.53 SAR

 Behavior of cost of capital

In a world with tax, the theory argues that as we increase the level of borrowing (debt)
and Debt to Equity ratios, the level of risk will increase to shareholders. As a result, they
will require higher returns. So, the cost of equity (Rs) will increase. The weighted
Average Capital Cost (WACC), in contrast, will decrease due to the benefit of the tax
shield.

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In practice, based on the above chart, we plot the values of Rb, Rs, and WACC which we
have calculated and mentioned in the above scenarios (in the tables) and this is what
happens after increasing the level of B/S Ratio. To illustrate, the Rs is increasing,
whereas WACC is decreasing. The cost of debt (Rb) is constant at 4.5%.

 Behavior of value of firm

The structure policy influences the firm’s value. As it appears from the chart above, there
is a positive relationship between the amount of debt used and the firm’s value. The more
the firm use debt the more the firm value increases. Debt is cheaper than equity, and the
interest payment amounts are tax deductible. Therefore, the more the company uses debt,
the return on equity that goes to the owners will also increase, and this will enhance the
firm value. The other side of debt is that increasing the amount of debt means increasing
the risk. So, there is an optimal level of leverage where the firm’s value increases by
increasing the amount of debt. Beyond this optimal level, the firm’s value will decrease,
if the debt increases.

Conclusion

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Should the company continue with current capital structure? What changes
do you suggest and why?

Well, based on the results, we recommend Yanbu Cement Company to not continue
operating with its current capital structure (B/S Ratio = 21%) because there is another
opportunity to raise its firm value than now. Moreover, the capital structure that we
recommend is one where B/E Ratio equals 136% because the firm value will increase
from 3,432,876,480 SAR to 3,536,010,000 SAR. So, this will match shareholders'
concerns who always try to maximize their benefits by increasing the firm’s value. Not
only that, the shareholders will become very happy because their EPS will increase from
0.926408853 SAR to 1.00295432 SAR, as well as the ROE and Rs will increase from
5.221% to 5.65%, and from 5.14% to 5.16%, respectively. Furthermore, the WACC will
decrease from 4.73% to 4.58%. All these values are illustrated in Scenario 4.

On the other hand, the management of Yanbu Cement Company should be aware of the
drawbacks of increasing the amount of debts, the higher the debts the higher the level of
risk and probability of bankruptcy.

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 APPENDIX

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Balance sheet

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Income statement

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