Great Zimbabwe University

Munhumutapa School of Commerce

Department of Accounting and Information Systems

Course advanced ACCOUNTING

AND FINANCial reporting

Course CODE MPAC512

lecturer mr matungamire

Willard chivinda m216030

Due date 14 june 2022

Assignment 2
Question 1(a)

Calculation of cost of equity for Comus Ltd according to the dividend growth model

MPV = Dividend per share(1+g)/Ke-g

Where Mpv is the market price of share

Ke = cost of capital

g = growth of dividends

Mpv = $4

Dps = $0.08(1+0.1) =$0.088

g = 10%

Ke = to be calculated

4 = $0.088/Ke-0.1

Ke = $0.088/$4 +0.1

Ke = 0.122% = 12.2%

Therefore the market value of share for Rex ltd can be calculated as follows as the cost of
equity is the same.

Mpv = Dps(1+g)/Ke-g

Dps =$0.1(1+0.08)=0.108

Ke = 12.2%

g = 0.08%

Mpv = 0.108/0.122-0.08

MPV=0.108/0.042
Mpv = $2.57

Question 1(b)

Exchange ratio using market values (ER) = Market value of target company/Market value of
acquiring company

ER= 2.57/4= 0.64

The highest offer is calculated as ER x Number of shares of the target company

= 0.64 x 150 000 = 96 000 shares before the offer results in diluting the earnings per share of
Comus.

The earnings per share will increase from $0.2 to $0.21.

Earnings per share after the combination will be = (40 000 + 22 500)/(200 000 + 96 000)

=62500/296 000 = $0.21 per share

The total number of shares that does not dilute the earnings per share of $0.2 is calculated as
follows, using the earnings per share exchange ratio:

Exchange ratio = E.P.S of Target company/EPS of Acquiring company

=$0.15/$0.2=0.75

The number of shares offered by Comus is = E.R x Number of shares of the acquired
company

= 0.75 x 150 000 = 112 500 shares

Question 1(c)

The merchant bank has noted that the large proportion of the assets of Rex ltd are in the form
of land and buildings and they have a convinient location in a desirable commercial district of
a town, which will result in Comus enjoying synergistic effect benefits after the merger. The
final merger price will be determined by bargaining.Synergy is described as 2+2= 5 effect,
that is the whole is greater than the sum of its parts. Comus should consider synergistic
effects when bargaining for the merger price. Synergies are economies realized in the merger
through increased revenues and or cost reduction. Comus should consider the valuation of
assets both tangible and intangible assets of Rex Ltd. This will enable Comus to calculate the
most appropriate offer price which will not result in dilution of earnings per share of the
shareholders. Comus have to assess whether the assets are owned by Rex Ltd and the assets
are not attached to any loans taken by Rex ltd as collateral security. The ownership of non-
current assets can be verified before the offer is made through checking of title deeds, lease
agreements and insurance cover on non-current assets. The bargaining offer will be based
upon the following factors:

a) The dividends per share of the target company and the acquiring company
b)The valuation of the shares based upon the value of the underlying assets, including
goodwill if applicable
c)The market value of shares of the acquiring company and the target company
d)The earnings per share of the acquiring company and the target company

Question 1(d)

Calculation of free cashflows for Rex Ltd

Free cashflow is = Profit after tax + depreciation – capital expenditure

Year 1 free cashflow = 25 + 7 – 20 = 12

Year 2 free cashflow = 30 + 8 – 25 = 13

Year 3 free cashflow = 35 + 10 – 15 = 30

Year 4 free cashflow = 40 + 11 – 14 = 37

Year 5 free cashflow = 45 + 12 – 14 = 43

Calculation of the minimum price that Rex shareholders likely to accept.

Year Cashflow PVIF@8% PV

1 12 0.9259 11.11

2 13 0.8573 11.15

3 30 0.7938 23.81
4 37 0.7350 27.20

5 43 0.6806 29.27

Perpetuity 537.5 0.6806 365.81

(43/0.08)

Minimum Price is = 11.11+11.15+23.81+27.20+29.27+365.81= $468.35 = $ 468 350

Question 2(a)

One of the techniques used in Divisional performance evaluation is ROI.Giving relevant

examples , explain the distinct advantages of ROI system and the problems / limitations of
the ROI system.

Return on investment (ROI) is a financial ratio used to calculate the benefit an investor will
receive in relation to their investment cost. It is most commonly measured as net
income divided by the original capital cost of the investment.

There are multiple methods for calculating ROI. The most common is net income divided by
the total cost of the investment, or ROI = Net income / Cost of investment x 100.

A cost-benefit analysis of this kind helps managers find out the rate of return that can be
expected from different investment proposals. This allows them to choose an investment that
will enhance both divisional and organisational profit performance as well as enable effective
utilisation of existing investments.The following are the advantages of ROI.

Better Measure of Profitability:

It relates net income to investments made in a division giving a better measure of divisional
profitability. All divisional managers know that their performance will be judged in terms of
how they have utilized assets to earn profit, this will encourage them to make optimum use of
assets. Also, it ensures that assets are acquired only when they are sure to give returns in
consonance with the organisation’s policy.For example Nash paints have two different
divisions specializing in paint and furniture there are able to measure divisional profitability.

Achieving Goal Congruence:

ROI ensures goal congruence between the different divisions and the firm. Any increase in
divisional ROI will bring improvement in overall ROI of the entire organization.For example
have made huge investments in their furniture division hence an increase in divisional ROI.

Comparative Analysis:

ROI helps in making comparison between different business units in terms of profitability
and asset utilization. ROI a good measure because it can be easily compared with the related
cost of capital to decide the selection of investment opportunities.

Performance of Investment Division:

ROI is significant in measuring the performance of investment division which focuses on

earning maximum profit and making appropriate decisions regarding acquisition and disposal
of capital assets. Performance of investment centre manager can also be assessed
advantageously with ROI.

 Matching with Accounting Measurements:

ROI is based on financial accounting measurements accepted in traditional accounting. It

does not require a new accounting measurement to generate information for calculating ROI.
All the numbers required for calculating ROI are easily available in financial statements
prepared in conventional accounting system. Some adjustments in existing accounting
numbers may be necessary to compute ROI, but this does not pose any problem in calculating
ROI.

However ROI has some limitations.

Satisfactory definition of profit and investment are difficult to find. Profit has many concepts
such as profit before interest and tax, profit after interest and tax, controllable profit, profit
after deducting all allocated fixed costs. Similarly, the term investment may have many
connotations such as gross book value, net book value, historical cost of assets, current cost
of assets, assets including or excluding intangible assets.

ROI provides focus on short term results and profitability; long term profitability focus is
ignored. ROI considers current period’s revenue and cost and do not pay attention to those
expenditures and investments that will increase long term profitability of a business unit.
Based on ROI, the managers tend to avoid the new investments and expenditure due to
returns being uncertain or return may not be realized for sometime.For example managers
using ROI may cut spending on employee training, productivity improvements, advertising,
research and development with the narrow objective of improving the current ROI. However,
these decisions may impact long term profitability negatively. Therefore, it is advisable for
the investment division or business unit to use ROI as only one parameter of an overall
evaluation criteria to decide the acceptances/rejection of new investment.

Investment Centre managers can influence (manipulate) ROI by changing accounting

policies, determination of investment size or asset, treatment of certain items as revenue or
capital. Sometimes, managers may reduce the investment base by scrapping old machines
that still earn a positive return but less than others. Thus, the practice of abandoning old
machines that are still serviceable may be used by managers to increase their ROI and a series
of such actions may be harmful to the organisation as a whole.

Question 2b(i)

The expected return on asset 1 = ER1:

ER1=(0.1*5%) +(0.3*10%)+(0.5*15%)+(0.1*20%)

=(0.1*0.05)+(0.3*0.1)+(0.5*0.15)+(0.1*0.2)

= 0.005+0.03+0.075+0.02

=0.13*100

ER1=13%

The expected return on asset 2 = ER2:

ER2 = (0.1*0%)+(0.3*8%)+(0.5*18%)+(0.1*26%)

=(0.1*0)+(0.3*0.08)+(0.5*0.18)+(0.1*0.26)

= 0+0.024+0.09+0.026

=0.14*100

ER2= 14%
The standard deviation of the returns on assets 1 = STD1

STD1 = [0.1(5-13)2 +0.3(10-13)2 + 0.5(15-13)2 +0.1(20-13)2 ]

= [(0.1*64)2 + (0.3*9)+(0.5*4)+(0.1*49)]1/2

=
[6.4+ 2.7 + 2 + 4.9]1/2

=4%

Therefore the standard deviation of the return on assets 1 = 4%

The standard deviation of the returns on assets 2 = STD2

STD = [0.1(0-14)2 + 0.3 (8-14)2 + 0.5(18-14)2 + 0.1(26-14)2]1/2

=
[(0.1*196) + (0.3*36) + (0.5*16) + (0.1*144)]1/2

=
[19.6 + 10.8 + 8 + 14.4]1/2

Therefore standard deviation of the return on assets 2 = 7.27%

Question 2(b)(ii)

Calculation of covariance between the returns on assets 1 and 2

State of Probability Return of Deviation Return of Deviation Product of

nature Asset 1 of the Asset 2 of the Deviations
return from Return and
its mean - from its Probability
Asset 1 mean -
Asset 2

1 0.10 5% -8% 0% -14% 11.2

2 0.3 10% -3% 8% -6% 5.4

3 0.5 15% 2% 18% 4% 4

4 0.1 20% 7% 26% 12% 8.4

29.0

The covariance between the returns on assets 1 and 2 (Sum) is 29.0

Answer to Question 2(b)(iii).

Coefficient of Correlation between returns on assets 1 and 2

Coefficient = Covariance between returns on assets 1 and 2

{Standard Deviation on Asset 1 } * {Standard deviation on Asset 2}

= 29

4 *7.27

Coefficient = 0.997

REFERENCES

(1) Bierman, Jr. H. and Dyckman, T.R. (1976) Managerial Cost Accounting, 2nd Edn.
Macmillan, New York. B
(2) Lorsch, J.W. and Allen, S.A. (1973) Managing Diversity and Inter-dependency: An
Organizational Study of Multidivisional Firms. Division of Research Graduate School of
Business Administration, Harvard University.
(3) Lowe, E.A. and Chua, W.F. (1983) Organisation Effectiveness and Management Control,
in Lowe, E.A. and Machin, J.L.J., op. eit.