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Part of the model answer(B)
Assumptions
1 It is assumed that the asset beta of Morada Co is a weighted average of the asset betas of the travel services and the maintenance services business units, using non-current assets invested in each business unit as a fair representation of the size of each business unit and therefore the proportion of the business risk which business unit represents within the company.2 The assumption of the share price not changing after either proposal is not reasonable. It is likely that due to changes in the business and financial risk from implementing either proposal, the risk profile of the company will change. The changes in the risk profile will influence the cost of equity, which in turn will influence the share price.
3 In determining the financial position of Morada Co, it is assumed that the current assets will change due to changes in the profit after tax figure; therefore this is used as the balancing figure for each proposal.
Question 1. ) I can understand the explanation however I find it hard for assumption sections as always. Could you please give me some tips regarding assumptions?
Recommendation
It is recommended that neither the first director’s proposal nor the second director’s proposal should be adopted. The second director’s proposal results in a lower return on investment and a virtually unchanged cost of capital. So there will not be a meaningful benefit for Morada Co. The first director’s proposal does increase the return on investment but results in a higher cost of capital. If the reason for adopting either proposal is to reduce risk, then this is not achieved. The main caveat here is that where the assumptions made in the calculations are not reasonable, they will reduce the usefulness of the analysis.
Question 2) how can we tell whether a proposal results in a lower or higher return on investment? based on the estimates of cost of capital?
Thank you very much
Question 1:
I wish I could give you a ‘rule’ but it so much depends on the particular question.
All I can say generally is to check how many marks are available – here there are 9 marks available for this part, but most of those marks relate to the first sentence of this requirement (it turns out from the marking scheme that only 2-3 marks were for the assumptions, so not much was expected). Otherwise you need to look back to your calculations of what is being referred to (here the estimates in (b(i) and (b(ii)) and question the figures that you were using.
Apart from that, obviously the more answers you work through the more ‘standard’ sorts of assumptions should become clearer.Question 2:
The calculations of the returns is shown towards the end of part (b) of the report (just before the list of assumptions. They are not related to the cost of capital. All companies would want the returns to be in excess of the cost of capital and would want higher returns and lower cost of capital.
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