2017 Management Accounting 3 (M2) Question 2 Decision Trees (25 marks: 45 minutes)

Mr Mathalane has inherited R1 000 000 from his grandfather. He is considering two alternatives, namely: Alternative 1: He is considering opening a sound equipment business at a cost of R800 000, and must decide whether only to sell and repair sound equipment, or also to include the sale and repair of musical instruments. If he has only sale and repair of sound equipment, he has a 70% chance of earning R250 000 per annum, otherwise he will earn R200 000 per annum. If he includes the sale and repair of musical instruments, which will cost an additional R25 000, he has a 60% chance of earning R275 000, otherwise he will earn R180 000. Alternative 2: He also has the option of buying an existing shop at a cost of R850 000, which sells and repairs musical instruments, and has a conditional profit of R220 000 per annum. If he decides to buy the shop, he can also add the sale and repair of sound equipment at an additional cost of R40 000, which will have additional fixed costs of R2 500 per month. Without considering the additional costs, he has a 20% chance of earning R300 000 per annum, otherwise he will earn R280 000 per annum. The fair rate of return for the opening of the new business is 25% before taxation, and that of the purchasing of the existing business is 30%.

Required: (a) Advise Mr Mathalane on what course of action he should take. (20)

(b) Determine which of the alternatives will render an estimated return in excess of that required in terms of the respective fair rates of return. (5)