Business Analysis

The Institute of Chartered Accountants in England and Wales
BUSINESS ANALYSIS
Advanced Stage Technical Integration Level
For exams in 2014
Study Manual
www.icaew.com
Business Analysis
ISBN: 978-0-85760-870-3
Previous ISBN: 978-0-85760-473-6
First edition 2007
Seventh edition 2013
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any
form or by any means, electronic, mechanical, photocopying or otherwise, without the prior written permission of
the publisher.
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Welcome to ICAEW
I am delighted to welcome you as a student studying our chartered accountancy qualification, the ACA.
The ACA will open doors to a highly rewarding career as a financial expert or business leader. Once you
are an ICAEW member, you will join over 138,000 others around the world who work at the highest
levels across all industry sectors, providing valuable financial and business advice. Some of our earlier
members formed today's global Big Four firms, and you can find an ICAEW Chartered Accountant on
the boards of 80% of the UK FTSE 100 companies.
We are here to help you every step of the way. As part of a worldwide network of over 19,000 students,
you will have access to a range of resources including the online student community, where you can
interact with fellow students, and our student support team. Take a look at the key resources on page ix.
I wish you the very best of luck with your studies and look forward to supporting you throughout your
career.
Michael Izza
Chief Executive
ICAEW
iii
iv
Contents
Introduction vii
Business Analysis viii
Key resources ix
Skills assessment guide x
Faculties and Special Interest Groups xviii
ICAEW publications for further reading xix
1 Strategic analysis 1
2 Business risk management 71
3 Cost analysis and control 123
4 Investment appraisal 157
5 Business and securities valuation 193
6 Cost of capital and financial structuring 237
7 Financial engineering 311
8 International financial management 363

Mathematical tables 391
Index 397
v
vi
1 Introduction
1.1 What is Business Analysis and how does it fit within the ACA Advanced
Stage?
Structure
The ACA syllabus has been designed to develop core technical, commercial, and ethical skills and
knowledge in a structured and rigorous manner.
The diagram below shows the twelve modules at the ACA Professional Stage, where the focus is on the
acquisition and application of technical skills and knowledge, and the ACA Advanced Stage which
comprises two technical integration modules and the Case Study.
The knowledge level

The Business and Finance paper provides an introduction to how a business is managed and financed,
and the external environment that it faces. It also explains the role of the professional accountant. The
Management Information paper introduces costing and budgeting, and also looks at working capital
and performance management.
Progression to ACA application level
The knowledge base that is put into place here will be taken further in two application stage modules.
The Business Strategy paper looks at how businesses develop their strategies for products, markets and
management of internal resources and risks. The Financial Management paper examines the key
financial decisions that businesses take, relating to investment, financing and dividend payments, and
also how businesses manage their financial risks.
Progression to ACA Advanced Stage
The Advanced Stage papers Business Reporting (BR) and Business Change (BC) then take things
further again. The aims of BR are to ensure that students can apply analysis techniques, technical
knowledge and professional skills to resolve real-life compliance issues faced by businesses. In the BC
paper the aim is to ensure that students can provide technical advice in respect of issues arising in
business transformations eg mergers and acquisitions.
The above illustrates how the knowledge base of accounting gives a platform from which a progression
of skills and technical expertise is developed.
Introduction vii
2 Business Analysis
2.1 Module aim
The aim of the Business Reporting paper is:
To ensure that candidates can apply analysis techniques, technical knowledge and professional
skills to resolve real-life compliance issues faced by businesses.
Candidates may be put, for example, in the role of a preparer of financial statements, or other corporate
reports such as on sustainability and corporate responsibility, an advisor or in an assurance role facing
business issues where there are reporting implications. Compliance issues relating to taxation will also
feature in this module.
Candidates will be required to use professional judgement to identify and evaluate alternatives and
determine the appropriate solution(s) to compliance issues, giving due consideration to the commercial
impact of their recommendations.
The aim of the Business Change paper is:
To ensure that candidates can provide technical advice in respect of issues arising in business
transformations, mergers, acquisitions, alliances and disposals.
Candidates will be required to analyse and interpret both external and internal financial and non-
financial data in order to plan for change and provide advice. In undertaking this analysis candidates will
be expected to evaluate the impact of stakeholder influences on the data, including the impact of
choice of reporting policies.
Taxation and practical business techniques are particularly important in this module, where business
techniques include aspects of business strategy, business finance, performance management and
costing. There will also be financial reporting, assurance, ethical and legal implications to be considered
when developing and assessing strategic and business plans.
2.2 Specification grid

This grid shows the relative weightings of subjects within each module and should guide the relative
study time spent on each. Over time the marks available in the assessment will equate to the weightings
below, while slight variations may occur in individual assessments to enable suitably rigorous questions
to be set.
BR BC
Weighting (%) Weighting (%)
Ethics and law 5 10 5 10
Taxation 20 30 25 35
Audit and assurance 30 40 10 20
Corporate reporting 30 40 15 25
Business analysis 0 30 35
viii Business Analysis

3 Key Resources
STUDENT SUPPORT TEAM
T +44 (0)1908 248 250
E studentsupport@icaew.com
STUDENT WEBSITE
icaew.com/students student homepage
icaew.com/exams exam applications, deadlines, regulations and more
icaew.com/cpl credit for prior learning/exemptions
icaew.com/examresources examiners comments, syllabus, past papers, study guides and more
icaew.com/examresults exam results
TUITION
If you are receiving structured tuition, make sure you know how and when you can contact your tutors
for extra help.
If you aren't receiving structured tuition and are interested in classroom, online or distance learning
tuition, take a look at our tuition providers in your area on icaew.com/exams
ONLINE STUDENT COMMUNITY
The online student community allows you to ask questions, gain study and exam advice from fellow
ACA and CFAB students and access our free webinars. There are also regular Ask an Expert and Ask a
Tutor sessions to help you with key technical topics and exam papers. Access the community at
icaew.com/studentcommunity
THE LIBRARY & INFORMATION SERVICES (LIS)
The Library and Information Service (LIS) is ICAEW's world-leading accountancy and business library.
You have access to a range of resources free of charge via the library website, including the catalogue,
LibCat. icaew.com/library
Introduction ix
4 Skills assessment guide
4.1 Introduction
As a Chartered Accountant in the business world, you will require the knowledge and skills to interpret
financial and other numerical and business data, and communicate the underlying issues to your clients.
In a similar way to the required knowledge, the ACA syllabus has been designed to develop your
professional skills in a progressive manner. These skills are broadly categorised as:
Assimilating and using information
Structuring problems and solutions
Applying judgement
Drawing conclusions and making recommendations
4.2 Assessing your professional skills
Initial Professional Development
BR
BC
Advance Stage
TAX FR technical integration
FA A&A
Professional Stage
application level
ETHICS Case Study
FM
Technical
Professional Stage BS
knowledge level
Skills
The work experience requirements for students provide a framework to develop appropriate work
experience, completion of which is essential in order to qualify for membership. Work experience is also
an essential component for examination preparation.
The work experience framework is built around five key skills:
Business awareness being aware of the internal and external issues and pressure for change facing
an organisation and assessing an organisation's performance.
Technical and functional expertise applying syllabus learning outcomes and where appropriate,
further technical knowledge to real situations.
Ethics and professionalism recognising issues, using knowledge and experience to assess
implications, making confident decisions and recommendations.
Professional judgement making recommendations and adding value with appropriate, targeted
and relevant solutions.
x Business Analysis
Personal effectiveness developing, maintaining and exercising skills and personal attributes
necessary for the role and responsibilities.
The examinations, and in particular the Advanced Stage, embrace all of these skills.
The link between work experience and the examinations is demonstrated by the skills development
grids produced by the examiners.
This will help students see that their practical knowledge and skills gained in the workplace feed back
into the exam room and vice-versa.
4.3 Assessment grids

The following pages set out the learning outcomes for Business Analysis that are addressed under each
of the four skills areas. In addition, for each skills area, there is a description of:
The specific skills that are assessed
How these skills are assessed
Using these grids will enable you to determine how the examination paper will be structured and to
consider whether your knowledge of Business Analysis is sufficiently strong to enable you to apply it in
the required manner.
Introduction xi
xii Business Analysis
4.4 Technical knowledge
The table contained in this section shows the technical knowledge covered in the ACA Syllabus by
module.
For each individual standard the level of knowledge required in the relevant Professional Stage module
and at the Advanced Stage is shown.
The knowledge levels are defined as follows:
Level D
An awareness of the scope of the standard.
Level C
A general knowledge with a basic understanding of the subject matter and training in its application
sufficient to identify significant issues and evaluate their potential implications or impact.
Level B
A working knowledge with a broad understanding of the subject matter and a level of experience in the
application thereof sufficient to apply the subject matter in straightforward circumstances.
Level A
A thorough knowledge with a solid understanding of the subject matter and experience in the
application thereof sufficient to exercise reasonable professional judgement in the application of the
subject matter in those circumstances generally encountered by Chartered Accountants.
Key to other symbols:
the knowledge level reached is assumed to be continued
Business Analysis
Professional Stage
Advanced Stage
Management
Management
Information
Business &
Financial
Strategy
Business
Finance
Topic
STRATEGIC ANALYSIS
Environmental and market analysis tools
PESTEL analysis C A
Porter's five forces B A
Product life cycle B A
Boston consulting group matrix B A
Competitor analysis B A
Positional and other analysis tools
Resource audit C A
Resource-based strategy C A
Value chain analysis B A
SWOT analysis C A
Gap analysis C A
Marketing analysis A
Competitive advantage A
Benchmarking A
Directional policy matrix B
Business process analysis B A
Strategic risk analysis A
Balanced scorecard C A
Introduction xiii
Professional Stage
Advanced Stage
Management
Management
Information
Business &
Financial
Strategy
Business
Finance
Topic
STRATEGIC CHOICE
Strategy formulation, evaluation and choice C A
Business risk management C A
Financial analysis and data analysis A
Stakeholder analysis B A
Objectives and stakeholders preferences C B
Corporate responsibility and sustainability C B A
STRATEGIC IMPLEMENTATION
Business plans C B A
Organisational structure C B A
Information management C B A
Change management A
Project management A
COST ANALYSIS FOR DECISION MAKING
Costing
Cost classification A
Costing systems direct, marginal, absorption B
Activity based costing (ABC) C B
Break even analysis B A
Multi-product break even analysis B
Budgeting and performance management B A
Pricing
Pricing decisions B A
Transfer pricing B A
BUSINESS AND SHAREHOLDER VALUE
Valuation Techniques
Income dividend yield B A
Income P/E B A
Income discounted cash flow B A
Asset based measures B A
Options approach
Shareholder value
Value based management (VBM)
Value drivers B A
Shareholder value analysis (SVA) B A
Short and long term growth rates and terminal values A
Economic profit A
Cash flow return on investment (CFROI) A
Total shareholder return (TSR) A
Market value added (MVA) A
INVESTMENT APPRAISAL AND BASIC RISK ANALYSIS
Project appraisal
NPV B A
IRR B A
Payback B A
Relevant cash flows A
Tax and inflation A
Replacement Analysis A
Capital rationing A
Adjusted present value (APV) A
Assessing risk
xiv Business Analysis

Professional Stage
Advanced Stage
Management
Management
Information
Business &
Financial
Strategy
Business
Finance
Topic
Project appraisal and sensitivity analysis B A

Project appraisal and simulation B A
Expected values B A
Scenario planning A
Gap analysis B
Continuous vs. event risk B
FINANCIAL ANALYSIS
Cost of capital
Cost of equity B A
Cost of debt B A
Cost of preference shares B A
Cost of bank loans B A
Weighted average cost of capital (WACC) B A
Effective interest rates A
Splitting convertibles into equity and debt elements A
Public sector discount rates A
Portfolio theory and CAPM
Portfolio theory B A
CAPM B A
APT and MCPM A
CAPM and cost of capital B A
International cost of capital A
Bonds
Bond pricing using NPV A
Yields to maturity A
Duration and price volatility A
Convexity A
Term structure of interest rates A
Corporate borrowing and default risk A
SOURCES OF FINANCE AND FINANCING ARRANGEMENTS
Short, medium and long term sources of finance B A
Loan agreement conditions (warranties; covenants;
guarantees) B A
Raising capital B A
Gearing and capital structure A
Loan agreements and covenants A
Dividend policy A
Financing reconstructions (eg: group reconstruction, spin B A
off, purchase of own shares, use of distributable profits)
Working capital management C A
FINANCIAL ENGINEERING
Futures, options and swaps
Options B A
Interest rate futures B A
Interest rate options B A
Interest forward rate agreements (FRAs) B A
Interest rate swaps B A
Foreign exchange
Currency forward contracts B A
Currency money market cover B A
Currency options B A
Introduction xv
Professional Stage
Advanced Stage
Management
Management
Information
Business &
Financial
Strategy
Business
Finance
Topic
Currency swaps B A
Operational techniques for managing currency risk B A
Theoretical determinants of foreign exchange rates B A
Option value
Value of a call and put option C
Black Scholes option pricing model B
Binomial Option Pricing Model B
Real options C B
xvi Business Analysis

Ethics Codes and Standards
Ethics Codes and Standards Level Professional Stage modules
IFAC Code of Ethics for Professional Accountants A Assurance

(parts A, B and C and Definitions) Business and Finance
Law
Principles of Taxation
ICAEW Code of Ethics A Audit and Assurance
Business Strategy
Financial Reporting
Taxation
APB Ethical Standards 15 (revised) A Assurance
Provisions Available to Small Entities (revised) Audit and Assurance
Introduction xvii
5 Faculties and Special Interest Groups
The faculties and special interest groups are specialist bodies within the ICAEW which offer members
networking opportunities, influence and recognition within clearly defined areas of technical expertise.
As well as providing accurate and timely technical analysis, they lead the way in many professional and
wider business issues through stimulating debate, shaping policy and encouraging good practice. Their
value is endorsed by over 40,000 members of ICAEW who currently belong to one or more of the seven
faculties:
Audit and Assurance
Corporate Finance
Finance and Management
Financial Reporting
Financial Services
Information Technology
Tax
The special interest groups provide practical support, information and representation for chartered
accountants working within a range of industry sectors, including:
Charity and Voluntary sector
Entertainment and Media
Farming and Rural Business
Forensic
Healthcare
Interim Management
Non-Executive Directors
Public Sector
Solicitors
Tourism and Hospitality
Valuation
Students can register free of charge for provisional membership of one special interest group and
receive a monthly complimentary e-newsletter from one faculty of your choice. To find out more and to
access a range of free resources, visit icaew.com/facultiesandsigs
xviii Business Analysis

6 ICAEW publications for further reading
ICAEW produces publications and guidance for its students and members on a variety of technical and
business topics. This list of publications has been prepared for students who wish to undertake further
reading in a particular subject area and is by no means exhaustive. You are not required to study these
publications for your exams. For a full list of publications, or to access any of the publications listed
below, visit the Technical Resources section of the ICAEW website at icaew.com
ICAEW no longer prints a Members Handbook. ICAEW regulations, standards and guidance are
available at icaew.com/regulations This area includes regulations and guidance relevant to the regulated
areas of audit, investment business and insolvency as well as materials that was previously in the
handbook.
The TECH and AUDIT series of technical releases are another source of guidance available to members
and students. Visit icaew.com/technicalreleases for the most up-to-date releases.
Audit and Assurance Faculty icaew.com/aaf

Right First Time with the Clarified ISAs, ICAEW 2010, ISBN 978-0-85760-063-9
Clarified ISAs provide many opportunities for practitioners in terms of potential efficiencies, better
documentation, better reporting to clients, and enhanced audit quality overall.
This modular guide has been developed by ICAEW's ISA implementation sub-group to help
medium-sized and smaller firms implement the clarified ISAs and take advantage of these
opportunities. This modular guide is designed to give users the choice of either downloading the
publication in its entirety, or downloading specific modules on which they want to focus.
An international edition is also available.
Quality Control in the Audit Environment, ICAEW 2010, ISBN 0-497-80857-605-5
The publication identifies seven key areas for firms to consider. Illustrative policies and procedures
are provided for selected aspects of each key area, including some examples for sole practitioners.
The guide also includes an appendix with answers to a number of frequently asked questions on
the standard.
The Audit of Related Parties in Practice, ICAEW 2010, ISBN 978-1-84125-565-6
This practical guide to the audit of related party relationships and transactions is set in the context
of the significant change in approach that is required under the revised ISA and highlights the
importance of planning, the need to involve the entire audit team in this, to assign staff with the
appropriate level of experience to audit this area and upfront discussions with the client to identify
related parties.
Alternatives to Audit ICAEW, 2009, ISBN 978-1-84152-819-9
In August 2006, the ICAEW Audit and Assurance Faculty began a two-year consultation on a new
assurance service (the ICAEW Assurance Service), an alternative to audit based on the idea of
limited assurance introduced by the International Auditing and Assurance Standards Board (IAASB).
This report presents findings from the practical experience of providing the ICAEW Assurance
Service over the subsequent two years and views of users of financial information that help in
assessing the relevance of the service to their needs.
Companies Act 2006 Auditor related requirements and regulations third edition March
2012 ICAEW, 2012, ISBN 978-0-85760-442-2
This third edition of the guide provides a brief summary of the key sections in the Companies Act
2006 (the Act) which relate directly to the rights and duties of auditors. It covers the various types
of reports issued by auditors in accordance with the Act. It is designed to be a signposting tool for
Introduction xix
practitioners and identifies the other pieces of guidance issued by ICAEW, APB, FRC, POB and
others to support implementation of the Act.
Auditing in a group context: practical considerations for auditors ICAEW, 2008, ISBN 978-1-
84152-628-7
The guide describes special considerations for auditors at each stage of the group audit's cycle.
While no decisions have been taken on UK adoption of the IAASB's clarity ISAs, the publication also
covers matters in the IAASB's revised and redrafted 'ISA 600 Special Considerations Audits of
Group Financial Statements (Including the Work of Component Auditors)'. The revised publication
contains suggestions for both group auditors and component auditors.
Corporate Finance Faculty icaew.com/corpfinfac

Private equity demystified an explanatory guide Second Edition, Financing Change Initiative,
ICAEW, March 2010, John Gilligan and Mike Wright
This guide summarises the findings of academic work on private equity transactions from around
the world. Hard copies of the abstract and full report are free and are also available by download
from icaew.com/thoughtleadership
Best Practice Guidelines
The Corporate Finance Faculty publishes a series of guidelines on best-practice, regulatory trends
and technical issues. Authored by leading practitioners in corporate finance, they are succinct and
clear overviews of emerging issues in UK corporate finance. icaew.com/corpfinfac
Corporate Financier magazine, ISSN 1367-4544
The award-winning Corporate Financier magazine is published ten times a year for members,
stakeholders and key associates of ICAEW's Corporate Finance Faculty.
Aimed at professionals, investors and company directors involved in corporate finance, it covers a
wide range of emerging regulatory, commercial and professional development issues.
The magazine includes features, news, analysis and research, written by experts, experienced
editors and professional journalists.
In 2011, three major themes were introduced: Innovation & Corporate Finance; Financing
Entrepreneurship; and Deal Leadership.
Corporate governance icaew.com/corporategovernance

The UK Corporate Governance Code 2010
The UK Corporate Governance Code (formerly the Combined Code) sets out standards of good
practice in relation to board leadership and effectiveness, remuneration, accountability and
relations with shareholders. All companies with a Premium Listing of equity shares in the UK are
required under the Listing Rules to report on how they have applied the UK Corporate Governance
Code in their annual report and accounts.
The first version of the UK Corporate Governance Code was produced in 1992 by the Cadbury
Committee. In May 2010 the Financial Reporting Council issued a new edition of the Code which
applies to financial years beginning on or after 29 June 2010.
The UK Corporate Governance Code contains broad principles and more specific provisions. Listed
companies are required to report on how they have applied the main principles of the Code, and
either to confirm that they have complied with the Code's provisions or where they have not to
provide an explanation.
Internal Control: Revised Guidance on Internal Control for Directors on the Combined Code
(now the UK Corporate Governance Code)
Originally published in 1999, the Turnbull guidance was revised and updated in October 2005,
following a review by the Financial Reporting Council. The updated guidance applies to listed
companies for financial years beginning on or after 1 January 2006.
xx Business Analysis
The FRC Guidance on Audit Committees (formerly known as The Smith Guidance)
First published by the Financial Reporting Council in January 2003, and most recently updated in
2010. It is intended to assist company boards when implementing the sections of the UK
Corporate Governance Code dealing with audit committees and to assist directors serving on audit
committees in carrying out their role. Companies are encouraged to use the 2010 edition of the
guidance with effect from 30 April 2011.
The UK Stewardship Code
The UK Stewardship Code was published in July 2010. It aims to enhance the quality of
engagement between institutional investors and companies to help improve long-term returns to
shareholders and the efficient exercise of governance responsibilities by setting out good practice
on engagement with investee companies to which the Financial Reporting Council believes
institutional investors should aspire.
A report summarising the actions being taken by the Financial Reporting Council and explaining
how the UK Stewardship Code is intended to operate was also published in July 2010.
Corporate responsibility icaew.com/corporateresponsibility

Sustainable Business January 2009
The new thought leadership prospectus acts as a framework for the work that ICAEW do in
sustainability/corporate responsibility. It argues that any system that is sustainable needs accurate
and reliable information to help it learn and adapt, which is where the accounting profession plays
an important role. A downloadable pdf is available at icaew.com/sustainablebusiness
Environmental issues in annual financial statements ICAEW, May 2009, ISBN 978-1-84152-610-2
This report is a joint initiative with the Environment Agency. It is aimed at business accountants
who prepare, use or audit the financial statements in statutory annual reports and accounts, or
who advise or sit on the boards of the UK companies and public sector organisations. It offers
practical advice on measuring and disclosing environmental performance. A downloadable pdf is
available at icaew.com/sustainablebusiness
ESRC seminar series When worlds collide: contested paradigms of corporate responsibility
ICAEW, in conjunction with the British Academy of Management, won an Economic and Social
Research Council grant to run a seminar series which aims to bring academics and the business
community together to tackle some of the big challenges in corporate responsibility.
icaew.com/corporateresponsibility
The Business Sustainability Programme (BSP)
The Business Sustainability Programme is an e-learning package for accountants and business
professionals who want to learn about the business case for sustainability. The course is spread
across five modules taking users from definitions of sustainability and corporate responsibility,
through case studies and finally towards developing an individually tailored sustainability strategy
for their business. The first two modules are free to everyone. For more information and to
download a brochure visit icaew.com/bsp
Ethics icaew.com/ethics
Code of Ethics
The Code of Ethics helps ICAEW members meet these obligations by providing them with ethical
guidance. The Code applies to all members, students, affiliates, employees of member firms and,
where applicable, member firms, in all of their professional and business activities, whether
remunerated or voluntary.
Instilling integrity in organisations ICAEW June 2009
Practical guidance aimed at directors and management to assist them in instilling integrity in their
organisations. This document may also be helpful to audit firms discussing this topic with clients
and individuals seeking to address issues in this area with their employers.
Introduction xxi
Reporting with Integrity ICAEW May 2007, ISBN 978-1-84152-455-9
This publication brings ideas from a variety of disciplines, in order to obtain a more comprehensive
understanding of what is meant by integrity, both as a concept and in practice. Moreover, because
this report sees reporting with integrity as a joint endeavour of individuals, organisations and
professions, including the accounting profession, the concept of integrity is considered in all these
contexts.
Finance and Management Faculty icaew.com/fmfac

Finance's role in the organisation November 2009, ISBN 978-1-84152-855-7
This considers the challenges of designing successful organisations, written by Rick Payne, who
leads the faculty's finance direction programme.
Investment appraisal SR27: December 2009, ISBN 978-1-84152-854-4
This special report looks at the key issues and advises managers on how they can contribute
effectively to decision making and control during the process of investment appraisal.
Starting a business SR28: March 2010, ISBN 978-1-84152-984-2
This report provides accountants with a realistic and motivational overview of what to consider
when starting a business.
Developing a vision for your business SR30: September 2010, ISBN 978-0-85760-054-7
This special report looks at what makes a good vision, the benefits of having one, the role of the FD
in the process, leadership, storytelling and the use of visions in medium-sized businesses.
Finance transformation the outsourcing perspective SR31: December 2010, ISBN 978-0-
85760-079-0
The authors of this outsourcing special report share their expertise on topics including service level
agreements, people management, and innovation and technology.
The Finance Function: A Framework for Analysis September 2011, ISBN 978-0-85760-285-5
This report is a source of reference for those analysing or researching the role of the finance
function and provides a foundation for considering the key challenges involved, written by Rick
Payne, who leads the faculty's finance direction programme.
Financial Reporting Faculty icaew.com/frfac

EU Implementation of IFRS and the Fair Value Directive ICAEW, October 2007, ISBN 978-1-
84152-519-8
The most comprehensive assessment to date of compliance with the requirements of IFRS and the
overall quality of IFRS financial reporting.
The Financial Reporting Faculty makes available to students copies of its highly-regarded factsheets
on UK GAAP and IFRS issues, as well as its journal, By All Accounts, at icaew.com/frfac
Financial Services Faculty icaew.com/fsf

Audit of banks: lessons from the crisis, (Inspiring Confidence in Financial Services initiative)
ICAEW, June 2010 ISBN 978-0-85760-051-6
This research has looked into the role played by bank auditors and examined improvements that
can be made in light of lessons learned from the financial crisis. The project has included the
publication of stakeholder feedback and development of a final report.
Measurement in financial services, (Inspiring Confidence in Financial Services initiative) ICAEW,
March 2008, ISBN 978-1-84152-546-4
This report suggests that more work is required on matching measurement practices in the
financial services industry to the needs of different users of financial information, despite the fact
xxii Business Analysis

that the financial services industry has the greatest concentration of measurement and modelling
skills of any industry. A downloadable pdf is available at icaew.com/thoughtleadership
Skilled Persons' Guidance Reporting Under s166 Financial Services and Markets Act 2000
(Interim Technical Release FSF 01/08)
This interim guidance was issued by ICAEW in April 2008 as a revision to TECH 20/30 to assist
chartered accountants and other professionals who are requested to report under s166 Financial
Services and Markets Act 2000. A downloadable pdf is available at icaew.com/technicalreleases
Information Technology Faculty icaew.com/itfac

The IT Faculty provides ongoing advice and guidance that will help students in their studies and their
work. The online community (ion.icaew.com/itcountshome) provides regular free updates as well as a
link to the faculty's Twitter feed which provides helpful updates and links to relevant articles. The
following publications should also be of interest to students:
Make the move to cloud computing ICAEW, 2012, ISBN 978-0-85760-617-4
Cloud computing in its purest form is pay-as-you-go IT, online and on demand. The IT capabilities
provided as a service to businesses include: single software applications or software suites; online
software development platforms; and virtual computing infrastructure, ranging from data storage
to computer grids.
Bringing employee personal devices into the business - a guide to IT consumerisation ICAEW,
2012, ISBN 978-0-85760-443-9
The gap between business and consumer technology has been growing over the last few years,
with the consumer market now leading in terms of ease of use and portability.
Making the most of social media - a practical guide for your business ICAEW, 2011, ISBN 978-
0-85760-286-2
This guide will enable the business manager to develop a philosophy that allies social media's
potential with the business's objectives and capabilities, to set objectives and protect against
pitfalls, and then to take the first practical steps in a mass communications medium very different
from any that British business has encountered before.
Tax Faculty icaew.com/taxfac

The Tax Faculty runs a Younger Members Tax Club which provides informal presentations, discussions
and socialising. All young professionals interested in tax are welcome to attend. See the website for
more details icaew.com/taxfac
Tax news service
You can keep up with the tax news as it develops on the Tax Faculty's news site
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xxiv Business Analysis

CHAPTER 1
Strategic analysis
Introduction
Topic List
1 Overview of analysis tools
2 Overview of data analysis
3 Overview of strategic implementation
4 Ethics and corporate responsibility issues
5 Integrating the use of analysis tools in a complex scenario
Summary and Self-test
Answers to Self-test
Answers to Interactive questions
1
Introduction
Learning objectives Tick off
Demonstrate a detailed understanding and application of the analysis tools studied at the
Professional stage
Demonstrate the ability to integrate business strategy with financial strategy in a complex
scenario
Demonstrate detailed understanding of how business strategy decisions can impact on
financial strategy decisions in a complex scenario
Demonstrate a detailed understanding and application of the management of strategic
implementation studied at the Professional stage
2 Business Analysis
1 Overview of analysis tools C
H
A
Section overview P
T
This section reviews the analysis tools that were covered in the Professional stage Business Strategy E
paper. Detailed knowledge of these techniques is critical at the Advanced stage and you should R
refer to earlier materials for an in-depth analysis of each of them. Project management techniques
were not covered in earlier material.
1
Most of the critical tools for strategic analysis were covered in detail at the Professional stage. You
are likely to be required to demonstrate your knowledge and application of the techniques
reviewed in this section in a more integrated scenario.
1.1 Environmental and market analysis tools
1.1.1 PESTEL analysis

The PESTEL framework is used to analyse the macro-environment into the following segments:
Political
Economic
Socio-cultural
Technological
Environmental protection
Legal
This analysis is a useful checklist for general environmental factors, although in the real world they are
obviously all interlinked. Any single environmental development can have implications for all six PESTEL
segments. In particular, political, social and economic affairs tend to be closely intertwined. Given that
case studies at this level are likely to be quite involved, you should not waste time trying to impose
unnecessary divisions on any environmental analysis the important thing is substance.
Case example: Greece

We shall cover the Euro crisis in more detail later in the text. For now, Greece is an obvious example of
how PESTEL factors are interlinked. Greece's future within the Euro (and the economic impacts of its
departure and the wider uncertainties about the Euro's future that will result) will depend on the ability
of its government to deliver an economic package that satisfies financial market opinion. The political
situation in Greece is in turn influenced by the level of social discontent and the social impacts of the
reduction of economic activity within the country.
1.1.2 Porter's five forces

The competitive environment is structured by five forces:
Threat of new entrants
Threat of substitute products or services
Bargaining power of customers
Bargaining power of suppliers
Rivalry amongst current competitors in the industry
These forces influence the state of competition in an industry, which collectively determine the profit
potential of the industry as a whole.
A word of caution about using the five forces model though its very comprehensiveness can
encourage users to feel that all factors have been duly considered and dealt with. Unfortunately, this is
never the case. Any analysis must pursue as high a degree of objectivity as possible. If there is too
much subjectivity unfounded complacency will result.
Strategic analysis 3
Interactive question 1: The tea industry [Difficulty level: Intermediate]
The tea industry is characterised by oversupply, with a surplus of about 80,000 tonnes a year. Tea
estates 'swallow capital, and the return is not as attractive as in industries such as technology or services'.
Tea is auctioned in London and prices are the same in absolute terms as they were 15 years ago. Tea is
produced in Africa and India, Sri Lanka and China. Because of the huge capital investment involved, the
most recent investments have been quasi-governmental, such as those by the Commonwealth
Development Corporation in ailing estates in East Africa. There is no simple demarcation between
buyers and sellers. Tea-bag manufacturers own their own estates, as well as buying in tea from outside
sources.
In 1997 tea prices were described in India at least, as being 'exceptionally firm ... The shortage and high
prices of coffee have also raised demand for tea which remains the cheapest of all beverages in spite of
the recent rise in prices. Demand from Russia, Poland, Iran and Iraq are expected to rise.'
Requirements
(a) Carry out a five forces analysis.
(b) Thinking ahead, suggest a possible strategy for a tea-grower owning a number of estates which has
traditionally sold its tea at auction.
See Answer at the end of this chapter.
1.1.3 Product life cycle

The product life cycle concept holds that products have a life cycle and that a product demonstrates
different characteristics of profit and investment at each stage in its life cycle. The life cycle concept is a
model, not a prediction (not all products pass through each stage of the life cycle). It enables a firm to
examine its portfolio of goods and services as a whole.
The stages in a product's life cycle are:
Introduction
Development and growth
Maturity
Decline
During strategic planning, products should be assessed in three ways:
The stage of the life cycle the product has reached
The product's remaining life (how much longer will it contribute to profits)
How urgent is the need to innovate (to develop new and improved products)
Case example: Volkswagen

Under Ferdinand Piech, the desire to make rapid progress led to two important products the Golf and
the Passat, which moved through their model life cycles in parallel. They were redesigned together and
reached obsolescence at the same time. This led to overload in showrooms when the new products
were launched.
4 Business Analysis
1.1.4 Boston matrix C
The Boston Consulting Group developed a matrix that assesses businesses in terms of potential cash H
A
generation and cash expenditure requirements. Strategic business units are categorised in terms of P
market growth rate and relative market share. T
E
The matrix is as follows. R
Market share
High Low 1
Market High Stars Question marks

growth Low Cash cows Dogs
A company's portfolio should be balanced, with cash cows providing finance for stars and question
marks, and a minimum of dogs.
One of the main problems with the matrix is that it is built around cash flows but innovative capacity
may be the critical resource, particularly in such industries as electronics and cars.
The BCG matrix can be paralleled with the product life cycle as products develop from question marks,
through stars and then cash cows as they enter maturity and finally dogs as the product declines. Such a
development is clearly very stylised.
1.1.5 Competitor analysis

As the name suggests, competitor analysis is an assessment of the strengths and weaknesses of current
and potential competitors. This is an important strategic tool it helps management to understand
their competitive advantages or disadvantages relative to competitors and provides an informed basis to
develop strategies to create or strengthen future competitive advantage.
The main challenge with competitor analysis is determining how to obtain critical information that is
reliable, up-to-date and available legally!
Interactive question 2: Competitor analysis [Difficulty level: Intermediate]

LBG is a manufacturer of specialist stage cosmetics that are specifically targeted at the theatre and film
industries. Recent developments in the quality of the chemicals used in these products have enabled
LBG to expand its product range and to price the products at a premium level.
However, LBG is concerned about the rapid growth of this specialist industry. New competitors have
been attracted by the premium prices charged by existing players to the extent that over capacity is an
increasing threat.
LBG is keen to protect its market leader status, and its current market share of approximately 40%,
despite evidence that the market is maturing. LBG feels it should know more about its competitors, both
new and existing in order to maintain its industry status.
Requirements
(a) In what ways would LBG benefit from conducting a formal competitor analysis?
(b) What are the main stages in conducting a formal competitor analysis and what important
information should be obtained by LBG at each stage of the analysis?
1.2 Positional and other analysis tools
1.2.1 SWOT analysis
SWOT analysis strengths, weaknesses, opportunities, threats combines environmental analysis with
internal appraisal to assess the firm's current and future strategic fit (or lack of it) with the environment.
A complete awareness of the organisation's environment and its internal capacities is necessary for a
rational consideration of future strategy, but it is not sufficient. The threads must be drawn together so
that potential strategies may be developed and assessed.
Strengths Weaknesses
Internal
to the M
company a Conversion
t
c
h
i
Exist n
independently g Conversion
of the
company
Opportunities Threats
Remember that strengths and weaknesses identified by internal personnel are only relevant if they are
perceived as such by the organisation's consumers. Strengths that cannot be matched with an available
opportunity are of limited value and likewise with opportunities that cannot be matched with strengths.
Threats can sometimes be converted into opportunities which can then be matched with strengths.
Weaknesses may also be converted into strengths which can be matched with opportunities.
1.2.2 Resource audit

As the name suggests, resource audits identify the resources available to an organisation. These
resources can be categorised as financial, human, intangible or physical. By determining what resources
they have, companies can identify what additional resources are required to pursue its chosen strategy.
1.2.3 Value chain analysis

The value chain describes those activities of the organisation that add value to purchased inputs.
Primary activities are involved in the production of goods and services; support activities provide
necessary assistance; and linkages are the relationships between activities.
As well as using the value chain to establish where it creates value for the customer, an organisation can
also use the model in other strategically valuable ways, including the identification of critical success
factors and opportunities to use information strategically. For example, an organisation can use the
value chain to secure competitive advantage by inventing new or better ways to perform tasks;
combining activities in new or better ways; managing the linkages in its own value chain; or by
managing the linkages in the value system.
1.2.4 Gap analysis

This tool enables organisations to study what they are doing currently and where they want to go in the
future. Gap analysis can be conducted from the perspective of the organisation, the direction of the
business, the processes of the business and information technology. It provides a starting point for
measuring the amount of time, money and human resources required to achieve a particular outcome.
It can also be used for new products, to identify gaps in the market.
1.2.5 Benchmarking
Benchmarking enables organisations to meet industry standards by copying others. It is less valuable as
a source of innovation but is a good way to challenge existing ways of doing things. It involves
6 Business Analysis
comparing your own performance with recognised targets, such as industry averages, and allows you to
identify areas where you are performing relatively well and areas where your relative performance is C
below expectations. H
A
When carrying out benchmarking exercises, you should be asking such questions as: P
T
Why are these products or services provided at all? E
Why are they provided in that particular way? R
What are the examples of best practice elsewhere?
How should activities be reshaped in the light of these comparisons?
1
1.2.6 Directional policy matrix

This matrix resembles the Boston matrix but measures the attractiveness of the market and your
company's strength to pursue it. Recommendations based on the position of these two elements are
shown below.
Business strengths
High Low
Market High Invest Grow

attractiveness Low Harvest Divest
1.2.7 Business process analysis

This tool helps organisations improve how they conduct their functions and activities with a view to
reducing costs, improving the efficient use of resources and giving better support to customers. The
idea is to concentrate on and re-think activities that create value for customers whilst removing any
activities that do not add value.
1.2.8 Strategic risk analysis

This involves recognising and assessing risks faced by the organisation, developing strategies to manage
them and mitigating risks using managerial resources. Strategies include transferring risk to other
parties, avoiding the risk altogether, reducing negative effects of the risk and accepting some or all of
the consequences of a particular risk.
1.2.9 Balanced scorecard

The balanced scorecard emphasises the need for a broad range of key performance indicators (KPIs) and
builds a rational structure that reflects longer-term prospects as well as immediate performance.
The balanced scorecard focuses on four different perspectives.
Perspective Question Explanation
Customer What do existing and Gives rise to targets that matter to customers:
new customers value cost, quality, delivery, inspection, handling and
from us? so on.
Internal What processes must we Aims to improve internal processes and decision
business excel at to achieve our making.
financial and customer
objectives?
Innovation Can we continue to Considers the business's capacity to maintain its
and learning improve and create future competitive position through the acquisition of
value? new skills and the development of new products.
Financial How do we create value Covers traditional measures such as growth,
for our shareholders? profitability and shareholder value but set
through talking to the shareholder or
shareholders directly.
The scorecard is balanced in the sense that managers are required to think in terms of all four
perspectives to prevent improvements being made in one area at the expense of another.
1.2.10 Corporate responsibility

An important element of assessing a business may be the extent to which it fulfils corporate
responsibility targets that it sets itself, or which society expects it to achieve.
Carroll & Buchholtz (2000, cited in Jobber, 2007) argued that there are four main 'layers' of corporate
responsibility.
Economic responsibilities
Companies have economic responsibilities to shareholders demanding a good return, to employees
wanting fair employment conditions and customers seeking good-quality products at a fair price.
Businesses are formed to be properly functioning economic units and so economic responsibilities form
the basis of all others.
Legal responsibilities
Since laws codify society's moral views, obeying these laws must be the foundation of compliance with
social responsibilities. Although in all societies corporations will have some legal responsibilities, there is
perhaps more emphasis on them in continental Europe than in the Anglo-American economies. In
Anglo-American economies the focus of discussion has often been whether many legal responsibilities
are unnecessary burdens on business.
Ethical responsibilities
These are responsibilities that require corporations to act in a fair and just way even if the law does not
compel them to do so.
Philanthropic responsibilities
According to Carroll & Buchholtz (2000), these are desired rather than being required of businesses.
They include charitable donations, contributions to local communities and providing employees with
the chances to improve their own lives.
Sustainability
Much of the discussion about corporate responsibility has focused on businesses' commitment to
sustainability, ensuring that development meets the needs of the present without compromising the
ability of future generations to meet their own needs.
The influential Brundtland report of 1987 emphasised that sustainability should involve developing
strategies so that the organisation only uses resources at a rate that allows them to be replenished (in
order to ensure that they will continue to be available). At the same time emissions of waste should be
confined to levels that do not exceed the capacity of the environment to absorb them.
The Brundtland report defined sustainable development as 'not a fixed state of harmony, but rather a
process of change in which the exploitation of resources, the direction of investments, the orientation of
technological development and institutional change are made consistent with future as well as present
needs.'
We shall consider corporate responsibility and sustainability in more detail in Section 4 of this chapter.
Worked example: Measurement of sustainability

Dow Jones Sustainability Index
The Dow Jones Sustainability Index is one of a number of global indexes that have been developed to
assess corporate sustainability. The creators of the index argue that corporate sustainability is attractive
to investors, because it aims to increase long-term shareholder value by gearing strategies and
management to harness the potential for sustainability products and services whilst also reducing and
avoiding sustainability costs and risks. Companies included in the index as sustainability leaders are
expected to show superior performance and favourable risk and return profiles.
The index is designed to provide quantification of sustainability strategies and management of
sustainability opportunities, risks and costs. A corporate sustainability assessment is carried out, and
8 Business Analysis
companies are ranked and selected for the index if they are among the sustainability leaders in their
field. The assessment uses the following criteria: C
H
Dimension Criteria A
P
Economic Corporate governance T
E
Codes of conduct/Compliance
R
Risk and crisis management
Customer relationship management
1
Innovation management
Industry specific criteria
Environment Environmental management system
Climate strategy
Product stewardship
Biodiversity
Social Human capital development
Talent attraction and retention
Occupational health and safety
Stakeholder engagement
Social reporting
Once the initial assessment has taken place, companies' performance is monitored. They are removed
from the index if their performance is judged unsatisfactory. A key aspect of this monitoring is seeing
how the company copes with crisis situations that carry a serious reputation risk.
Recent supersector leaders in the Dow Jones index have included Pearson, the leader in the Media
sector. Principal areas in which Pearson reports its environmental and sustainability performance
include:
Property management Pearson has targets to reduce energy use and is investing in renewable
energy at some of its sites.
Business travel Ways in which Pearson is trying to reduce air travel include upgrading
video-conferencing facilities.
Climate neutrality Initiatives include a carbon management programme focusing on
energy efficiency in buildings, use of renewable energy sources and
establishing partnerships that deliver carbon offsets.
Supply chain Pearson has introduced various initiatives to improve resource efficiency,
such as using the whole tree rather than part of the tree, reducing the
base weight of papers used and custom publishing. Environmental
responsibility is included in contracts between Pearson and its suppliers.
Pearson collects environmental data on the papers it purchases. It holds
training sessions for production teams around the world and discusses
its approach to paper purchasing with various stakeholders. Pearson has
also sought accreditation from the Forest Stewardship Council.
Employee Green messages are a regular part of Pearson's internal communications.
engagement It uses green teams volunteers working to improve environmental
practice. An intranet site offers ideas for carbon reductions, links to local
green groups and performance reports. Pearson's books, magazines and
newspapers cover climate change.
2 Overview of data analysis
Section overview
This section reviews the data analysis skills that you covered in Business Strategy at the Professional
Stage. These techniques are even more important at the Advanced Stage with its requirements to
analyse more complex scenarios. A lack of meaningful analysis remains a common weakness at the
Advanced Stage.
2.1 Data analysis skills required

The examiners are looking for you to demonstrate the following skills:
Choosing analytical tools that are appropriate in the context of the question eg financial ratios,
KPIs, break-even calculations
Carrying out the relevant calculations
Interpreting the resulting information to demonstrate an understanding of the story behind the
numbers and communicating that analysis succinctly
Analysing the wider consequences and implications of the numerical data, for example a fall in
production costs perhaps harming product quality
Exercising judgement to draw conclusions and/or produce sensible recommendations
Looking beyond the information provided at what additional information may be useful to
generate a better analysis/understanding and at any reservations regarding the
data/techniques/assumptions applied
Linking different pieces of data to explain trends or outcomes
Highlighting weaknesses or omissions in the data provided
Discussing cause and effect relationships eg identifying underlying causes of changes in the data
2.2 Key weaknesses in answers

The following list highlights weaknesses commonly identified in exam answers and suggests ways to
address these:
1 Restating facts or numbers without applying them to the context of the question
A common failing is to explain what has happened rather than why, eg stating that sales have
grown by 15% in the period but not indicating why they have done so.
Solution: Including the word 'because' in your answer changes the 'what' into a 'why'. In most
cases a good answer passes the 'because' test, eg 'Market share has fallen from 35% to 29%
because of the entry of a new lower-cost competitor.'
The 'because' should be related to specific information in the scenario, demonstrating that you
have understood the relationship between the financial/quantitative information and the business
issues.
2 Failing to use the additional information from the scenario in answers, resulting in generic
answers that could apply to any company rather than the one in the scenario
Solution: Make specific points, focusing on the particular organisation and relating to the
circumstances in the scenario.
eg 'falling R&D expenditure may be a problem for XYZ Ltd because it has built market share on the
basis of its innovative products.'
10 Business Analysis
3 Interpreting figures/results in isolation
C
Solution: Link the figures/analysis eg if market share has increased but gross margins have H
decreased, the company may have made a decision to reduce the selling price as part of a market A
penetration strategy. P
T
4 Focusing on a narrow range of measures E
R
Financial measures alone will not provide the full picture and are often the result of other factors,
not the cause.
Solution: Your answer should, where possible, address a variety of performance indicators. Use the 1
balanced scorecard headings to help you consider a wider range of measures. Remember that
these measures will often help you understand what is causing the strategy to succeed or fail.
5 Failing to use numerical analysis to support the rest of your answer
The data analysis element may be one of the first requirements. Conclusions that you draw from
this will help in answering later parts of the question.
Solution: Consider where else in your answer the analysis may be relevant / how you can 'make
the numbers talk'.
Eg if the data analysis shows that the business is currently loss making and that sales and
profitability are forecast to decline further, then the business cannot afford to do nothing. Any new
strategy that is expected to address this decline or increase returns should be acceptable to the
shareholders.
6 Failing to explain trends in the data by identifying cause and effect relationships.
Solution: Examine the information from different perspectives. This may, for example, include
analysing information into ratios or percentages based on the data provided.
Eg where sales revenues are growing by (say) 10% per year but the number of branches/outlets is
growing by 15% per year then calculating the sales per branch/outlet will show that sales per
branch is, on average, falling. Thus, growth in overall sales revenue may be due to investment in
more outlets, rather than generic growth in sales per branch because of improved efficiency or
stronger market conditions. Alternatively sales revenue growth might be analysed in relation to
volume growth, changes in selling prices and changes in sales mix. Analysis of this data may reveal
the relative causes (quantitatively) of sales revenue growth from each of these underlying factors.
7 Failing to achieve a reasonable balance between numerical and descriptive analysis
Some weak answers are almost entirely descriptive. Other weak answers include enough
calculations, but their descriptive analysis is little more than stating which numbers have gone up
and which have gone down.
Solution: Both numerical and descriptive analysis are important and need due emphasis. Two
possible approaches are:
(1) Set out a comprehensive numerical analysis at the beginning of the answer or in an
appendix with workings (eg in a table). Then produce the descriptive interpretation of these
numbers.
(2) Mix the numerical analysis with the descriptive analysis by producing calculations as each
issue arises.
In general approach (1) tends to produce better answers with a more systematic evaluation of the
issues. The numerical analysis tends to be more comprehensive and better thought out, with
clearer workings. However if you use approach (1) make sure that you are careful with your time
allocation. If you spend too much time on calculations, you may not have enough time to produce
sufficient descriptive analysis.
8 Failing to understand how IFRS reported profit may fail to reflect the underlying
performance of the business
Solution: Question whether changes in profit, as measured by IFRS, reflect changes in underlying
performance. Consider for instance that good strategic decisions may take some time to be
reflected in reported profit, which may even fall in the short-term.
2.3 Recommended approach

The following is a suggestion for the approach to adopt when tackling data analysis:
Step 1: Review scenario and requirements
Step 2: Decide what analysis is appropriate
Step 3: Produce the necessary calculations
Step 4: Interpret your analysis
Step 5: State the additional information required
The steps that cause most problems are Steps 3 and 4.
2.4 WHAT-HOW-WHY-WHEN-SO WHAT analysis

It is difficult to produce a universal approach but one tool which includes both numerical and
descriptive elements is: WHAT-HOW-WHY-WHEN-SO WHAT Analysis.
WHAT Look at WHAT has happened overall (eg revenue has increased by 21%).
HOW Analyse the available data in more detail to obtain a better understanding of HOW the
WHAT element occurred (eg sales prices have risen by 10% and monthly sales
volumes have risen by 10% following the price change).
WHY Look for the underlying causes of the HOW element, which may be part of the data
provided in the question (eg there have been significant product improvements
introduced during the year with additional features compared to competitors. This
has meant that a higher price can be charged but has also resulted in an increase in
demand despite this increased price).
WHEN If you're assessing the impact of changes in strategy over time or in making
comparisons it is important to know WHEN changes occurred. (eg If the price and
volume changes above occurred half way through the year, then the increase in sales
revenues for the current year may be limited to say 10.5%, but the changes will be
more significant in next year's figures).
SO WHAT The above steps analyse and interpret the nature of the data provided and attempt to
identify and explain the underlying causes of any changes in the data. The next stage
is to ask the question 'so what are the consequences of our analysis for deciding on
the future business strategy?' (eg what are the consequences for profit of the 10%
increases in sales price and sales volume after considering the variable cost increases
arising from the product improvements and volume increases? How have competitors
responded with price changes and improvements in their own products which may
make the consequences next year different from those which occurred this year?).
2.5 Issues with accounts

When carrying out data analysis, you will need to use what you've learnt specifically about analysing
financial statements, in particular:
Distortions and creative accounting policies, such as income smoothing or understated provisions
The factors determining important figures in the accounts, in particular operating profit.
Adjustments may be needed to the figures reported in the financial accounts before data analysis can be
carried out. These may include re-measurement to market value and recognising assets or liabilities that
are not included in the accounts. If you are analysing the income statement you may need to strip out
non-operating or non-recurring items from results to be able to make a fairer comparison over time.
3 Overview of strategic implementation C
H
A
Section overview P
T
This section continues the revision of strategic issues from the Professional Stage Business Strategy E
paper. R
Most of the techniques described were covered in detail in Business Strategy, so you may need to
go back to your materials from that paper. However project management is not currently covered
1
in Business Strategy, and therefore we discuss it here in greater depth.
3.1 Business planning

3.1.1 Strategic planning and business planning
A business's strategic plan or corporate plan provides the long-term framework for its activities.
However if business strategies are to be implemented successfully, the corporate plan needs to be
supported by shorter-term business plans, typically over one year. These short-term plans:
Co-ordinate the roles of different functions so that they are consistent with strategic objectives
Give confidence to stakeholders such as finance providers or important customers
Help to ensure the accountability of operational managers
The planning of implementation should include resource planning, operations planning and
organisation structure and control systems.
3.1.2 Advantages and disadvantages of formal business planning

The advantages of a formal system of business planning are as follows
Advantages Comment
Identifies risks Planning helps in managing these risks.

Forces managers to Planning can encourage creativity and initiative by tapping the ideas
think of the management team.
Forces decision-making Businesses cannot remain static they have to cope with changes in
the environment. A business plan draws attention to the need to
change and adapt, not just to 'stand still' and survive.
Better control Management control can be better exercised if targets are explicit.
Enforces consistency at Long-term, medium-term and short-term objectives, plans and
all levels controls can be made consistent with one another. Otherwise,
strategies can be rendered ineffective by budgeting systems and
performance measures which have no strategic content.
Public knowledge Drucker has argued that an entrepreneur who builds a long-lasting
business has 'a theory of the business' which informs his or her
business decisions. In large organisations, that theory of the business
has to become public knowledge, as decisions cannot be taken only
by one person.
Time horizon Some plans are needed for the long term.
Co-ordinates Activities of different business functions need to be directed towards a
common goal.
Clarifies objectives Managers are forced to define what they want to achieve.
Allocates responsibility A plan shows people where they fit in.
However there are disadvantages of planning for strategy implementation in a structured way. You may
remember that Mintzberg in his book The Rise and Fall of Strategic Planning made a number of criticisms
of a structured approach to planning the implementation of strategy, and these are worth revisiting.
Problem Comments
Practical failure Empirical studies have not proved that formal planning processes
contribute to success.
Routine and Strategic planning occurs often in an annual cycle. But a firm 'cannot allow
regular itself to wait every year for the month of February to address its problems.'
Reduces initiative Formal planning discourages strategic thinking. Once a plan is locked in
place, people are unwilling to question it.
Internal politics The assumption of 'objectivity' in evaluation ignores political battles
between different managers and departments.
Exaggerates Managers are not all-knowing, and there are limits to the extent to which
power they can control the behaviour of the organisation.
3.1.3 Freewheeling opportunism

The opposite approach to formal business planning is freewheeling opportunism. This approach
suggests firms should not bother with formal plans and should exploit opportunities as they arise.
The advantages of this approach are claimed to be that good opportunities are not lost, it is easier to
adapt to change and it encourages a more flexible, creative attitude.
However the lack of formal planning means there is no co-ordinating framework for the organisation,
so that some opportunities get missed anyway. It can also mean that the firm ends up reacting all the
time rather than developing proactively.
3.2 Organisational structure

3.2.1 Purposes of organisational structure
Organisational design or structure implies a framework or mechanism intended to do the following:
Link individuals in an established network of relationships so that authority, responsibility and
communications can be controlled, using the concept of hierarchy.
Group together (in any appropriate way) the tasks required to fulfil the objectives of the
organisation, and allocate them to suitable individuals or groups.
Give each individual or group the authority required to perform the allocated functions, while
controlling behaviour and resources in the interests of the organisation as a whole.
Co-ordinate the objectives and activities of separate units, so that overall aims are achieved
without gaps or overlaps in the flow of work required.
Facilitate the flow of work, information and other resources required, through planning, control
and other systems.
Developing an appropriate structure requires consideration of three areas:
Organisational configuration the primary groupings of staff into departments or divisions.
Centralisation/Decentralisation where the responsibility for decision making lies.
Management systems the make-up of the senior management team, eg the corporate board,
and the methods they use to govern the organisation. This also includes the processes used to
monitor financial results, to arrive at strategic decisions and to manage risk.
3.2.2 Characteristics of organisational structure

Hierarchy
Within the organisation's hierarchy there will be lines of authority or chains of command, running from
senior management vertically downwards through the organisation, connecting the various levels of
managers.
The chain of command not only represents the decision making hierarchy, it also provides a defined
channel for formal communication up and down the organisation. C
H
Decisions on chains of command must also take into account the following issues. A
P
Communications can become distorted as more layers are added to the chain of command. T
E
Long chains of command will increase the amount of time taken for information to reach the R
relevant decision makers.
Long chains of command distance junior managers from thinking and decision making at the
top, and limit development into a general management role. Managers may therefore become 1
frustrated and de-motivated, and may leave the organisation in search of flatter organisations and
greater opportunities for responsibility.
Tall and flat organisations
A tall organisation is one which, in relation to its size, has a large number of management levels. A flat
organisation is one which, in relation to its size, has a smaller number of hierarchical levels.
Chief
executive
MD
Divisional
directors Senior
management
Department
heads
Section
heads Middle
management
Assistants MD
Foremen Department
Supervisory
heads
management
Charge hands
Supervisors
Workers Workers
Tall and flat organisations

A tall organisation structure might be inefficient, despite the advantages of a narrow span of control and
the possibility of graduated promotions. Tall structures can impose rigid supervision and control and
therefore block initiative and ruin the motivation of subordinates.
Flat organisations have become more common as a result of the current fashion for delayering and
empowerment.
Empowerment
Empowerment means making workers (and particularly work teams) responsible for achieving, and
even setting, work targets, with the freedom to make decisions about how they are to be achieved.
Empowerment goes hand in hand with the following developments.
Delayering or a cut in the number of levels (and managers) in the chain of command.
Flexibility, since giving responsibility to the people closest to the products and customer
encourages responsiveness.
New technology, since there are more 'knowledge workers'. Such people need less supervision,
being better able to identify and control the means to clearly understood ends.
Establishing control in an empowered culture can be achieved perhaps through:
Standardisation of processes, with clear guidelines (eg bank lending).
Cultural control, so that everyone accepts the responsibilities that come with empowerment.
Team working.
3.2.3 Structure and strategy

Which comes first, strategy or structure?
The top-down approach says that management decide the strategy then build or revise
organisational structure to implement it.
The bottom-up view is that the strategy a firm follows emerges from, or depends on, its structure
or that the structure limits the choice of strategy.
In practice structure and strategy will feed off each other. Restructuring will be required to implement
new strategies and structures may develop more informally in response to environmental challenges.
Restructuring may also involve new possibilities and business initiatives.
3.2.4 Centralisation of organisations

Centralisation and decentralisation refer to the degree to which authority is delegated in an
organisation, and therefore the level at which decisions are taken in the management hierarchy. There
are several issues.
In some businesses, authority is centralised and decisions are taken at the top. In a small
business, the owner-manager may take all the decisions. However, in a hospital environment, 'life
or death' decisions are taken at 'operations level'.
Some businesses have regional offices with decision autonomy. In other businesses, decisions of
any significance have to be referred back to head office.
Operations might be decentralised, but standards might be set centrally and distributed
throughout the organisation.
Goold and Campbell conducted a study of a large number of high profile diversified companies to
examine how different companies cope with the problem of managing diversity. They discovered
three main philosophies and three corresponding styles of strategic management.
Philosophy Example Style of management
Core businesses 'The company commits itself to a few Strategic planning style
industries and sets out to win big in those
industries.'
Manageable businesses 'The emphasis is on selecting businesses for Financial control style
the portfolio which can be effectively
managed using short-term financial
controls...' The businesses have few linkages
with each other, should be in relatively
stable competitive environments and
should not involve large or long-term
investment decisions.
Diverse businesses 'The centre seeks to build a portfolio that Strategic control style
spreads risk across industries and
geographic areas as well as ensuring that
the portfolio is balanced in terms of
growth, profitability and cash flow.'
Goold and Campbell describe the features of the different styles of central management in terms of their
management structures. C
H
Style of central Features A
P
management T
E
Strategic planning Entails the centre participating in, and influencing, the strategies of the core R
businesses. The centre establishes a planning process and contributes to
strategic thinking. Rather less emphasis is placed on financial controls, and
performance targets are set flexibly and reviewed within the context of long- 1
term progress.
Strategic control Concerned with the plans of its business units but believes in autonomy for
business unit managers. Plans are therefore made locally but reviewed in a
formal planning process to upgrade the quality of the thinking. The centre
does not advocate strategies or interfere with major decisions but maintains
control through financial targets and strategic objectives.
Financial control As the name suggests, focuses on annual profit targets. There are no long-
term planning documents and no strategy documents. The role of the centre is
limited to approving budgets and monitoring performance.
3.2.5 Evolution of organisational structures

Organisations are responding to the following developments in the business environment:
Development Features
Growth of knowledge work 'Today's economy runs on knowledge and most companies work
assiduously to capitalise on that fact. They use cross-functional teams,
customer- or product-focused business units, and workgroups.'
(Wenger and Snyder, 2000).
Delayering A reduction in the number of levels in the management hierarchy.
Communications Organisational life has been revolutionised by email and network

technology technology.
Core/periphery Some firms have been changing the structure of their workforces for
the sake of greater flexibility, eg a core of full-time permanent staff
and periphery part-timers and temporary or contract workers.
Business Process Re-engineering (BPR)

Business Process Re-engineering means selection of areas of business activity in which repeatable and
repeated sets of activities are undertaken, and the development of improved understanding of how they
operate and of the scope for radical redesign with a view to creating and delivering better customer
value.
(CIMA Official Terminology)
There are three common themes.
The need to make radical changes to the entire organisation. Changing conditions 'impact all
functions of the company and lead to a radically different way of doing business.'
The need to change functional hierarchies.
The need to address the problem of fragmented staff roles: 'roles have become specialised with
the result that staff are only responsible for a small part of an overall task. This can result in loss of
accountability for a finished task, de-skilling of work and the need for highly complex scheduling
systems.'
Properly implemented BPR may help an organisation reduce costs, improve customer services, cut
down on the complexity of the business and improve internal communication.
(a) At best it may bring about new insights into the objectives of the organisation and how best to
achieve them.
(b) At worst, BPR is simply a synonym for squeezing costs (usually through redundancies). Many
organisations have taken it too far and become so 'lean' that they cannot respond when demand
begins to rise.
The horizontal organisation
Based on business process re-engineering, the horizontal organisation is a technique which breaks down
'vertical' departmental boundaries, and claims to eliminate the hierarchies of command and control.
Instead management is based on processes.
Characteristic Comment
Structure Organisation structure is based on cross-functional processes rather than tasks

or geography.
Team Teams, not individuals, are the basis of this approach.
Ownership A process owner is responsible for the whole process.
Customers Customers drive the process: the process owner puts customer-performance
first.
The process focuses the organisation on the customer. However, the customer may be at the receiving
end of several 'core' processes. Also the process owner should be the person or group that controls the
process. Where, however, a horizontal structure is in place, the responsibility for taking control action is
not always clear.
3.3 Information management

3.3.1 Information at different levels
To function effectively, organisations need different levels of information and therefore must operate
different types of information systems. The activities of strategic planning, management control and
operational control each have their own information requirements. Senior managers need the
operational systems to summarise data to aid their decision-making.
3.3.2 Types of information

Strategic information is used to plan the objectives of the organisation, and to assess whether the
objectives are being met in practice. Such information includes overall profitability, the profitability of
different segments of the business, future market prospects, the availability and cost of raising new
funds, total cash needs, total manning levels and capital equipment needs.
Tactical information is used to decide how the resources of the business should be employed, and
to monitor how they are being employed. Such information includes productivity measurements,
budgetary control or variance analysis reports, cash flow forecasts, staffing levels and profit results within
a particular department of the organisation and short-term purchasing requirements.
Operational information is used to ensure that specific operational tasks are planned and carried out
as intended.
3.3.3 Qualities of good information

You may remember the mnemonic ACCURATE as an easy way to remember the qualities of good
information. ACCURATE can also be used as a framework when describing how poor information can be
improved.
Feature Examples of possible improvements
C
Accurate Use computerised systems with automatic input checks rather than manual H
A
systems. P
Allow sufficient time for collation and analysis of data if pinpoint accuracy is T
E
crucial. R
Incorporate elements of probability within projections so that the required
response to different future scenarios can be assessed.
1
Complete Include past data as a reference point for future projections.
Include any planned developments, such as new products.
Information about future demand would be more useful than information
about past demand.
Include external data.
Cost-beneficial Consider whether the benefit of having the information is greater than the cost
of obtaining it.
User-targeted Summarise information and present it together with relevant ratios or
percentages.
Relevant Define the purpose of the report clearly. It may be trying to fulfil too many
purposes at once. Perhaps several shorter reports would be more effective.
Include exception reporting, where only those items that are worthy of note
and the control actions taken by more junior managers to deal with them are
reported.
Authoritative Use reliable sources and experienced personnel.
Explain the method of derivation if some figures are derived from other figures.
Timely Speed up Information collection and analysis by production managers,
probably by the introduction of better information systems.
Easy-to-use Use graphical presentation, allowing trends to be quickly assimilated and
relevant action decided upon.
Devise a 'house style' for reports.
3.3.4 Information strategies

The information systems (IS) strategy refers to the long-term plan concerned with exploiting IS and IT
either to support business strategies or create new strategic options. It needs to ensure that information
is obtained, retained, distributed and made available for implementing strategy in all areas of an
organisation's activities.
The IS strategy is supported by:
The information technology (IT) strategy which involves deciding how information needs will be
met by balancing supply and demand of funds and facilities, and the development of programmes
to supply IT.
The information management (IM) strategy which aims to ensure that information is provided
to users and that redundant information is not being produced.
A coherent strategy is required because information technology is a high cost activity. IT costs include
hardware and software costs, implementation costs associated with a new systems development and
day-to-day costs such as salaries and accommodation. Many organisations invest large amounts of
money in IS, but not always wisely. The unmanaged proliferation of IT is likely to lead to expensive
mistakes.
More fundamentally an organisation's information systems may not only support corporate and
business strategy. They may also help determine corporate/business strategy. For example:
IS/IT/IM may provide a possible source of competitive advantage. This could involve new
technology not yet available to others or simply using existing technology in a different way.
The information system may help in formulating business strategy by providing information from
internal and external sources.
Developments in IT may provide new channels for distributing and collecting information, and /or
for conducting transactions eg the internet.
Some common ways in which IS/IT/IM have had a major impact on organisations are explained below.
(a) The type of products or services that are made and sold
For example, industrial markets have seen the emergence of robots and local area networks for
office information systems. Technological changes can be relatively minor, such as the introduction
of tennis and squash rackets with graphite frames, fluoride toothpaste and turbo-powered car
engines.
(b) The way in which products are made
There is a continuing trend towards the use of automation and computer aided design and
manufacture. The manufacturing environment is undergoing rapid changes with the growth of
advanced manufacturing technology.
(c) The way in which services are provided
High-street banks encourage customers to use 'hole-in-the-wall' cash dispensers, or telephone or
internet banking. Most shops now use computerised Point of Sale terminals at cash desks. Many
organisations use e-commerce: selling products and services over the internet.
(d) The way in which markets are identified
Database systems make it much easier to analyse the market place.
(e) The way in which employees are mobilised
Technology encourages workforce empowerment. Using technology frequently requires changes
in working methods.
(f) The way in which firms are managed
An empowered workforce often leads to the 'delayering' of organisational hierarchies (in other
words, the reduction of management layers).
3.4 Change management

3.4.1 Factors promoting change
Strategic analysis may identify material changes in the business environment to which an organisation
has to respond, including changes in competitor behaviour, customer buying patterns or technology.
These will feed through into changes the organisation makes or the services it provides.
There may also be powerful internal drivers of change including changes in leadership style. Internal
change may also be required to respond to external challenges, for example greater centralisation to
allow more efficient decision-making.
3.4.2 Types of change

Change can take the form of a series of small steps (incremental change). At the other extreme it could
be transformational change, characterised by major, significant change being introduced relatively
quickly. Change may follow a series of carefully planned steps or it may consist of continuous
adjustment to the environment.
3.4.3 Focus of change
C
Change may focus at one of three main levels. H
A
Organisational culture the focus is on the social and informal processes that promote the ethos P
of the organisation. T
E
Restructuring covering reporting lines and how people work together. R
Individual emphasis on improving individual skill levels, attitudes and motivation.
1
3.4.4 Change processes
The following steps will normally apply in any process of major change.
Step 1
Determine need or desire for change in a particular area.
Step 2
Prepare a tentative plan. Brainstorming sessions are a good idea, since alternatives for change should be
considered.
Step 3
Analyse probable reactions to the change.
Step 4
Make a final decision from the choice of alternative options. The decision may be taken either by group
problem-solving (participative) or by a manager on his own (coercive).
Step 5
Establish a timetable for change.
'Coerced' changes can probably be implemented faster, without time for discussions.
Speed of implementation that is achievable will depend on the likely reactions of the people
affected.
Identify those in favour of the change, and perhaps set up a pilot programme involving them. Talk
with any others likely to resist the change.
Step 6
Communicate the plan for change. This is really a continuous process, beginning at Step 1 and going
through to Step 7.
Step 7
Implement the change.
Step 8
Review the change. This requires continuous evaluation.
Alternatively the Lewin/Schein three-stage model of change identifies key steps as unfreeze, move and
refreeze.
UNFREEZE MOVE
REFREEZE
Existing behaviour Attitudinal/behavioural
New behaviour
change
Step 1
Unfreeze is concerned mainly with selling the change, giving individuals or groups a motive for
changing their attitudes, values, behaviour, systems or structures.
Step 2
Move is the second stage, mainly concerned with identifying what the new, desirable behaviour or
norm should be, communicating it and encouraging individuals and groups to 'own' the new attitude or
behaviour. This might involve the adoption of a new culture.
Step 3
Refreeze is the final stage, implying consolidation or reinforcement of the new behaviour. Positive
reinforcement (praise and reward) or negative reinforcement (sanctions applied to those who deviate
from the new behaviour) may be used.
3.4.5 Strategic change

Gouillart and Kelly's Gemini 4Rs framework demonstrates how strategic change can be worked through
all aspects of an organisation's identity.
Reframing involves fundamental questions about what the organisation is and what it is for:
Achieve mobilisation: Create the will and desire to change.
Create the vision of where the organisation is going.
Build a measurement system that will set targets and measure progress.
Restructuring is about the organisation's structure, but is also likely to involve cultural changes:
Construct an economic model to show in detail how value is created and where resources should
be deployed.
Align the physical infrastructure with the overall plan.
Redesign the work architecture so that processes interact to create value.
Revitalising is the process of securing a good fit with the environment:
Achieve market focus.
Invent new businesses.
Change the rules of competition by exploiting technology.
Renewal ensures that the people in the organisation support the change process and acquire the
necessary skills to contribute to it:
Create a reward system in order to motivate.
Build individual learning.
Develop the organisation and its adaptive capability.
3.5 Project management

3.5.1 What is a project?
Definitions
A project is 'an undertaking that has a beginning and an end and is carried out to meet established
goals within cost, schedule and quality objectives'. (Haynes, Project Management)
Resources are the money, facilities, supplies, services and people allocated to the project.
In general, the work which organisations undertake involves either operations or projects. Operations
and projects are planned, controlled and executed. So how are projects distinguished from 'ordinary
work'?
Projects Operations
Have a defined beginning and end On-going

Have resources allocated specifically to them, Resources used 'full-time'
although often on a shared basis
Are intended to be done only once (eg organising A mixture of many recurring tasks
the 2010 London Marathon the 2011 event is a
separate project)
Follow a plan towards a clear intended end-result Goals and deadlines are more general
Often cut across organisational and functional lines Usually follows the organisation or
functional structure
Common examples of projects include:
C
Producing a new product, service or object H
Changing the structure of an organisation A
Developing or modifying a new information system P
T
Implementing a new business procedure or process
E
R
3.5.2 What is project management?
1
Definition
Project management is the combination of systems, techniques, and people used to control and
monitor activities undertaken within the project. Project management co-ordinates the resources
necessary to complete the project successfully.
Objective Comment
Quality The end result should conform to the project specification. In other words,
the result should achieve what the project was supposed to do.
Budget The project should be completed without exceeding authorised expenditure.
Timescale The progress of the project must follow the planned process, so that the
'result' is ready for use at the agreed date. As time is money, proper time
management can help contain costs.
Projects present some management challenges.
Challenge Comment
Teambuilding The work is carried out by a team of people often from varied work and
social backgrounds. The team must 'gel' quickly and be able to
communicate effectively with each other.
Expected Expected problems should be avoided by careful design and planning
problems prior to commencement of work.
Unexpected There should be mechanisms within the project to enable these problems
problems to be resolved quickly and efficiently.
Delayed benefit There is normally no benefit until the work is finished. The 'lead in' time to
this can cause a strain on the eventual recipient who is also faced with
increasing expenditure for no immediate benefit.
Specialists Contributions made by specialists are of differing importance at each
stage.
Potential for Projects often involve several parties with different interests. This may lead
conflict to conflict.
Project management ensures responsibilities are clearly defined and that resources are focussed on
specific objectives. The project management process also provides a structure for communicating
within and across organisational boundaries.
All projects require a person who is ultimately responsible for delivering the required outcome. This
person (whether officially given the title or not) is the project manager.
3.5.3 The project life cycle
The life cycle concept can be useful in the management of projects, since it breaks the whole down into
more easily manageable parts. This is particularly applicable to the allocation and management of
resources, since their type and quantity vary from phase to phase.
Maylor (Project Management) describes four phases or stages: this is the 4D model.
Stage in project life cycle Component Activities

Define the project Conceptualisation Produce a clear and definitive statement
of needs
Analysis Identify what has to be done and check
its feasibility
Design the project Planning Show how the needs will be met
Justification Compute costs and benefits
Agreement Obtain sponsor agreement
Deliver the project Start up Assemble resources and people
(Do it!)
Execution Carry out planned project activities
Completion Success or abandonment
Handover Output passed to sponsor/user
Develop the process Review Identify outcomes for all stakeholders
Feedback Document lessons and improvements for
future use
(1) Define the project

Larger projects are likely to involve the creation of a project brief or terms of reference for
discussion. A project initiation document may be prepared, if it is decided to continue with the
project. This will include a statement of requirements, a statement of the vision for the project
and a business case.
(2) Design the project
There are several techniques used for scheduling and time planning, such as network analysis and
Gantt charts (diagram below). This stage also deals with the need to plan for cost, quality and risk
using techniques such as risk assessment, resource budgeting, and cost budgeting.
Month January February

Activity w/c 7 14 21 28 4
Week 1 2 3 4 5
Plan
Actual
Gantt chart
(3) Deliver the project
C
This is the operational phase of the project. Planning will continue as required in order to control H
agreed changes and to deal with unforeseen circumstances, but the main emphasis is on getting A
the work done. P
T
There are several important themes. E
R
Management and leadership: People management assumes a greater importance as the size
of the project work force increases.
Control: Time, cost and quality must be kept under control, as must the tendency for 1
changes to proliferate.
Supply chain: All the aspects of logistics management must be implemented, especially with
projects involving significant physical output.
Problems and decisions: Problems are bound to arise and must be solved sensibly and
expeditiously. Complex problems will require careful analysis using the scientific tools of
decision theory.
(4) Develop the process
Improve the way the organisation and project teams cope with projects:
Completion: All activities must be properly and promptly finished; care must be taken that
contractors do not either leave small things undone or, if paid by time, spin things out for as
long as possible.
Documentation must be completed: This is important on any project but it is vital if there are
quality certification issues or it is necessary to provide the user with operating documentation.
Project systems must be closed down, but in a proper fashion: In particular, the project
accounts and any special accounting systems must remain in operation and under control
until all costs have been posted but must then be closed down to avoid improper posting.
Handover must take place where the project has been managed for a client under contract:
At some point the client must formally accept that the contract is complete and take
responsibility for any future action that may be required, such as the operation and
maintenance of a system.
Immediate review is required to provide staff with immediate feedback on performance and
to identify short-term needs such as staff training or remedial action for procedure failures.
3.5.4 The role of the project manager
Definition
Project manager: The person who takes ultimate responsibility for ensuring the desired result of the
project is achieved on time and within budget.
The duties of a project manager are summarised below.
Duty Comment
Outline planning Project planning (eg targets, sequencing):

Developing project targets such as overall costs or timescale needed
(eg project should take 20 weeks).
Dividing the project into activities and placing these activities into
the right sequence.
Developing a framework for procedures and structures needed to
manage the project.
Detailed planning Break work into pieces, scheduling, assessing resource requirements.
Duty Comment
Obtain necessary Resources may already exist within the organisation or may have to be
resources bought in. Resource requirements unforeseen at the planning stage will
probably have to be authorised separately by the project board or
project sponsor.
Team building Build cohesion and team spirit.
Communication The project manager must let superiors know what is going on, and
ensure that members of the project team are properly briefed.
Co-ordinating project Between the project team and users, and other external parties (eg
activities suppliers of hardware and software).
Monitoring and The project manager should estimate the causes for each departure from
control the standard, and take corrective measures.
Problem-resolution Even with the best planning, unforeseen problems may arise.
Quality control There is often a short-sighted trade-off between getting the project out
on time and the project's quality.
3.5.5 Network or critical path analysis

Network or critical path analysis (CPA) may be defined as a diagrammatic representation of the
interrelation over time of the activities involved in a project and the subsequent analysis of those
activities in terms of time, cost and risk.
fill boil add
1 2 4 water 5
kettle water
get cup add coffee
3
Network for black coffee, no sugar
The figure above shows an extremely simple network diagram for making a cup of coffee. It shows that
some activities logically follow others (boil water after filling kettle) and some can take place at the same
time (getting cup and adding coffee while water is boiling).
Obviously in the case of a complex project there would be far more activities and a far more complex
network, but the principle is the same.
CPA allows the network to be analysed in the first instance in terms of time, which enables the
minimum project time to be determined and the critical path, ie the longest path through the network.
Any delays to activities on the critical path delay the whole project. Subsequently the network can be
analysed in terms of cost, eg the effect on cost of accelerating activities.
The basic analysis assumes the times for each activity are known with certainty. Variability in activity
times (ie risk) can be analysed using PERT (project evaluation and review technique) which can forecast
likely outcomes and the probability of a particular outcome occurring. This is particularly useful when
trying to assess the impact of potential delays in terms of time and cost.
4 Ethics and corporate responsibility issues C
H
A
Section overview P
T
In this section we recap the factors you need to consider if any questions in your exam include E
ethical issues. This section therefore deals with the Accountant in Business. Further ethical issues R
are covered in an Auditing context in the Audit and Assurance learning materials. Corporate social
responsibility and sustainability issues are covered in the Business Strategy learning materials.
1
Advanced Stage will include more complex ethical dilemmas than Professional Stage, for example
where the ethical issue and the appropriate course of action involve multiple considerations.
Nevertheless much of the basic guidance still applies.
4.1 Ethical stances of organisations

Ethics can be defined as the moral principles that determine individual or business conduct, or
behaviour that is deemed acceptable in the society or context.
An organisation can adopt a range of ethical stances:
Meet minimum legal obligations and concentrate on short-term shareholder interests.
Recognise that long-term shareholder wealth may be increased by well-managed relationships with
other stakeholders.
Go beyond minimum legal and corporate governance obligations to include explicitly the interests
of other stakeholders in setting mission, objectives and strategy. In this context issues such as
environmental protection, sustainability of resources, selling arms to tyrannical regimes, paying
bribes to secure contracts, using child labour etc would be considered.
Public sector organisations, charities, etc where the interests of shareholders are not relevant.
4.2 Regulating ethical behaviour

Ethical business regulation operates in two ways:
1 Forbidding or constraining certain types of conduct or decisions: eg most organisations have
regulations forbidding ethically inappropriate use of their IT systems. Similarly many will forbid the
offering or taking of inducements in order to secure contracts.
2 Disclosure of certain facts or decisions: eg because the board sets its own pay they disclose it,
and sometimes the reasons behind the awards, to shareholders in the final accounts.
The following codes are potentially binding on you as a trainee Chartered Accountant.
The Auditing Practices Board (APB)
Ethical standards for Auditors concerned with assuring their integrity and independence in the
audit of financial statements and in how fees are levied.
Ethical standards for Reporting Accountants concerned with the integrity and independence of
accountants involved in writing investment circulars.
The ICAEW Code of Ethics for members
Five fundamental principles:
1 Integrity: Straightforward and honest in business and professional relationships.
2 Objectivity: Not allow bias, conflict of interest or influence of others to override professional or
business judgement.
3 Professional competence and due care: Be aware of all prevailing knowledge necessary to give
professional service and apply the same diligently to affairs of clients in accordance with technical
and professional standards.
4 Confidentiality: Respect the confidentiality of information acquired as a consequence of
professional or business engagements and not use the information for personal advantage or that
of third parties.
5 Professional behaviour: Comply with laws and regulations and not discredit the profession.
4.3 ICAEW Code of Ethics for Professional accountants working in business

Investors, creditors, employers, the business community, government and the public may rely on the
work of professional accountants in business in the context of:
Preparation and reporting of financial and other information
Providing effective financial management
Competent advice on a variety of business-related matters
The more senior the position held, the greater the ability and opportunity to influence events, practices
and attitudes.
A professional accountant in business is expected to encourage an ethics-based culture in an
employing organisation, which emphasises the importance that senior management places on ethical
behaviour.
4.3.1 Threats
The Code outlines areas where there may be conflict for professional accountants in business between
furthering the legitimate aims of their organisation and their absolute duty to comply with the
fundamental principles:
(a) Self-interest Financial interests, loans or guarantees; incentive compensation arrangements;
inappropriate personal use of corporate assets; concern over employment security; commercial
pressure from outside the employing organisation.
(b) Self-review Business decisions or data being subject to review and justification by the same
professional accountant in business responsible for making those decisions or preparing that data.
(c) Advocacy When furthering the legitimate goals and objectives of their employing organisations,
professional accountants in business may promote the organisation's position, provided any
statements made are neither false nor misleading. Such actions generally would not create an
advocacy threat.
(d) Familiarity A professional accountant in business in a position to influence financial or non-
financial reporting or business decisions having an immediate or close family member who is in a
position to benefit from that influence; long association with business contacts influencing business
decisions; acceptance of a gift or preferential treatment, unless the value is clearly insignificant.
(e) Intimidation Threat of dismissal or replacement of the professional accountant or a close or
immediate family member, over a disagreement about the application of an accounting principle
or the way in which financial information is to be reported; a dominant personality attempting to
influence the decision making process, for example with regard to the awarding of contracts or the
application of an accounting principle.
4.3.2 Safeguards
To comply with the Code, professional accountants are required to consider whether their actions or
relationships might constitute threats to their adherence to the fundamental principles. Where these are
significant, they must implement safeguards.
These safeguards might be generic, created by the profession or regulation, or be developed in the
working environment by the individual or their organisation.
If effective safeguards are not possible, professional accountants are required to refrain from the action
or relationship in question.
The Code sets out the types of safeguards in the work environment which might be applied to
overcome these threats:
The employing organisation's systems of corporate oversight or other oversight structures.
The employing organisation's ethics and conduct programmes.
C
Recruitment procedures in the employing organisation emphasising the importance of employing H
high calibre competent staff. A
P
Strong internal controls. T
E
Appropriate disciplinary processes. R
Leadership that stresses the importance of ethical behaviour and the expectation that employees
will act in an ethical manner.
1
Policies and procedures to implement and monitor the quality of employee performance.
Timely communication of the employing organisation's policies and procedures, including any
changes to them, to all employees, and appropriate training and education on such policies and
procedures.
Policies and procedures to empower and encourage employees to communicate to senior levels
within the employing organisation any ethical issues that concern them without fear of retribution.
Consultation with another appropriate professional accountant.
4.3.3 Action required in unethical circumstances

In circumstances where a professional accountant in business believes that unethical behaviour or
actions by others will continue to occur within the employing organisation, they should consider
seeking legal advice.
In extreme situations where all available safeguards have been exhausted and it is not possible to reduce
the threat to an acceptable level, a professional accountant in business may conclude that it is
appropriate to disassociate from the task and/or resign from the employing organisation.
4.4 Impact of ethics on strategy

Ethics may impact upon strategy in various ways:
In the formulation of strategic objectives, some firms will not consider lines of business for ethical
reasons.
External appraisal will need to consider the ethical climate in which the firm operates. This will raise
expectations of its behaviour.
Internal appraisal: Management should consider whether present operations are 'sustainable', ie
consistent with present and future ethical expectations.
Strategy selection: Management should consider the ethical implications of proposed strategies
before selecting and implementing them.
4.4.1 Conflict between ethics and business

Potential areas for conflict between ethics and business strategy include:
Cultivating and benefiting from relationships with legislators and governments: Such
relationships may lead politicians to ignore the national interest (eg of the people who elected
them) to further their own personal interests.
Fairness of labour contracts: Firms can use their power to exploit workers, including child labour,
and subject them to unethical treatment in areas where jobs are scarce.
Privacy of customers and employees: Modern databases enable tracking of spending for
marketing purposes or discriminating between customers on basis of their value. Staff can be
subject to background checks and monitored through their use of email and the location of their
mobile phones.
Terms of trade with suppliers: Large firms may pay poor prices or demand long credit periods
and other payments from weak suppliers. This has been a particular criticism of large retail food
stores in North America and Europe, who are blamed for the impoverishment of farmers at home
and in developing countries.
Product and production problems: These include the environmental impacts of the production
itself, product testing on animals or humans, the manufacture of products with adverse impacts
on health and the impact on the environment when products are thrown away.
Prices to customers: Powerful suppliers of scarce products such as energy, life saving drugs or
petrol, are able to charge high prices that exclude poorer individuals or nations. Examples here
include anti-aids drugs to Africa or purified water to developing countries.
Managing cross cultural businesses: Different countries of operation or different ethnic groups
within the domestic environment can present ethical issues affecting what products are made, how
staff are treated, dress conventions, observance of religion and promotional methods.
Marketing. There is the basic argument that marketing persuades people to buy what they don't
need. However this stance assumes superiority of judgement over the consumers who buy the
products. A key issue is the ends to which marketing is put. Marketing can be used to promote
ecologically responsible ways of life, but it can also be used to promote unhealthy products such as
cigarettes, alcohol and fatty foods. Some promotion techniques have also been criticised for
attempting to brainwash consumers, encouraging anti-social behaviour and upsetting observers.
4.5 What will the ethics requirement involve?

Possible ethical problems that you may find in questions include:
The impact of ethics on strategies and strategic choice, as discussed above
Conflicts of interest amongst stakeholders
Attempts to mislead key stakeholders (by disclosure or non-disclosure of information)
Doubtful accounting or commercial business practices
Facilitation of unethical strategies
Inappropriate pressure to achieve results
Conflict between the accountant's professional obligations and the responsibilities to the
organisation
Lack of professional independence eg personal financial interest in business proposals
Actions contrary to law, regulation and/or technical and professional standards
Some of these issues are not clear-cut. You need to develop a balanced argument, using appropriate
ethical language and discussing relevant professional principles.
4.6 Recommended approach

The following is a suggested list of factors to consider when tackling questions involving ethical issues:
(1) Is there a legal issue (criminal or civil law)?
(2) Do any other codes or professional principles apply? (eg is the individual with the ethical dilemma
a professional accountant?)
(3) Upon which stakeholders does the decision/action impact?
(4) What are the implications in terms of:
Transparency
Effect
Fairness
(5) If the proposed action/decision is not taken, what are the issues?
(6) What are the alternative actions that could be taken and what are the consequences of each course
of action ?
(7) Are there any sustainability issues?
Key weaknesses in answering ethical questions include:
C
(1) Failing to identify the ethical issue (eg transparency) H
(2) Failing to use ethical language A
P
(3) Quoting chunks of the ICAEW's ethical code without applying it to the scenario T
E
(4) Failing to identify appropriate safeguards
R
(5) Applying professional accountants' ethical codes to individuals in the scenario who are not
accountants
(6) Failing to distinguish between the ethical responsibilities of the individual and those of the 1
organisation
(7) Concluding by asserting an opinion that is not supported by clear justification on ethical grounds
stating 'X should be done because it is right' is insufficient
4.7 Corporate responsibility

4.7.1 Reasons for pursuing corporate responsibility
We mentioned corporate responsibility (CR) or corporate social responsibility earlier in this chapter.
Businesses face a number of pressures to widen the scope of their accountability.
(a) Stakeholder pressures
Businesses face pressures from various different stakeholder groups to consider their wider
responsibilities. Stakeholders include communities (particularly where operations are based),
customers (product safety issues), suppliers and supply chain participants and competitors. Issues
such as plant closures, pollution, job creation, sourcing, etc can have powerful social effects for
good or ill on these stakeholders. Without the support of stakeholders a business will find its ability
to operate is impaired and this will damage performance. Stakeholders also include governments
facing political pressures. Adopting CR voluntarily may be more flexible, and in the end less costly,
than having it imposed by statute.
(b) Corporate reputation
Increasingly a business must have the reputation of being a responsible business that enhances
long-term shareholder value by addressing the needs of its stakeholders employees, customers,
suppliers, the community and the environment. Sponsorship and community involvement can
reflect well on the business and attract ethical customers.
(c) Staff motivation
A commitment to CR helps establish values and mission within the organisation, which may help
attract and retain staff.
(d) Business issues
CR initiatives may provide opportunities to enter new markets or build new core competencies.
Businesses can achieve lower costs through using resources more efficiently, and not having to
incur costs of remediation if they have negatively affected the environment.
4.7.2 Scope of corporate responsibility

The scope of CR varies from business to business. Factors frequently included are:
Health and safety: This includes workplace injury, customer and supplier injury and harm to third
parties.
Environmental protection: Energy use, emissions (notably carbon dioxide), water use and
pollution, impact of product on environment, recycling of materials and heat.
Staff welfare: Issues such as stress at work, personal development, achieving work/life balances
through flexibility, equal opportunities for disadvantaged or minority groups.
Customer welfare: Through content and description of products, non-exclusion of customer
groups, fair dealing and treatment.
Supply-chain management: Insisting that providers of bought-in supplies also have appropriate
CR policies, ethical trading, elimination of pollution and un-recycled packaging, eliminating
exploitative labour practices amongst contractors.
Ethical conduct: Staff codes for interpersonal behaviour, prohibitions on uses of data and IT,
management forbidden from offering bribes to win contracts, ensuring non-exploitation of staff.
Engagement with social causes: This includes secondment of management and staff, charitable
donations, provision of free products to the needy, involvement in the local community, support
for outreach projects such as cultural improvement or education.
4.7.3 Strategic approaches to corporate responsibility

An organisation can adopt different strategic approaches to corporate responsibility:
Proactive strategy A business is prepared to take full responsibility for its actions. For example a
company which discovers a fault in a product and recalls the product without being
forced to, before any injury or damage is caused, acts in a proactive way.
Reactive strategy This involves allowing a situation to continue unresolved until the public,
government or consumer groups find out about it.
Defence strategy This involves minimising or attempting to avoid additional obligations arising from
a particular problem.
Accommodation This approach involves taking responsibility for actions, perhaps when one of the
strategy following occurs:
Encouragement from special interest groups
Perception that a failure to act will result in government intervention
Case example: Approaching corporate responsibility

The Deloitte (2008) guide 'The risk intelligent approach to corporate responsibility and sustainability'
suggests that corporate responsibility can be approached from a perspective of risk management, seeing
corporate responsibility issues as providing opportunities as well as dangers. This should in turn mean
that the organisation's approach to these issues is aligned and integrated with strategic initiatives in
other parts of the business.
Deloitte recommends a nine stage approach:
1 Understanding the This includes assessing regulatory trends, benchmarking against

present competitor activity, finding out what is important to stakeholders,
understanding all the CR activity currently happening in the
organisation
2 Envisioning the future Assessing the legacy the organisation wishes to leave. This will mean
integrating CR activities with business strategies, for example a
publishing company sending its employees to libraries and schools,
or donating books
3 Planning the journey CR issues should be prioritised using a gap analysis between current
and future states, and the organisation and its competitors. Assess
opportunities for action, risks of inaction and not achieving objectives
4 Planning and building The human resource element is vital, including example set and
oversight by senior management. CR achievements should be built
into performance reviews and remuneration. Assess availability of
grants and tax concessions for green behaviour. Also consider
broadening stakeholder base and organisation's ethical culture
5 Execution Develop in controlled fashion, enhancing governance procedures
related to implementation
6 Review and revision Develop metrics to measure activities. Use hard data rather than
impressions, though stakeholder feedback is important
7 Reporting and A CSR development programme may mean reporting on CR needs to
communicating be revamped. The organisation could report in accordance with C
H
various external reporting standards or produce customised reports
A
8 Assuring internally Adapt measures used internally to assess CR development to monitor P
T
how the organisation is doing. Use internal resources such as internal
E
audit, legal, health and safety and human resources to assist in R
development
9 Assure externally When CR reaches a certain level, seek verification from outside the
organisation of assertions in CR report 1
Case example: Corporate responsibility programme
Scottish Power's corporate responsibility programme has been developed from multi-stakeholder
consultation. The stakeholders emphasised the need for the company to prioritise its most significant
social and environmental impacts. This consultation identified 12 impacts, and Scottish Power's
corporate responsibility report detailed what had been done to address these:
(a) Provision of energy
Scottish Power was involved in a competition to develop carbon capture and storage. It spent 456
million in refurbishing its electrical network and committed 20 million investment to its
hydroelectric plant.
(b) Health and safety
The Lost-Time Accident rate fell for the fifth successive year. Its Children's safety education
programme won two major awards.
(c) Customer experience
Scottish Power achieved the highest satisfaction rating for on-line energy service in the market and
was ranked the second UK gas supplier. Its customer base increased by 4%.
(d) Climate change and emission to air
Scottish Power's Green Energy Trust awarded 232,809 to 20 small renewable energy projects. It
entered a contract to supply all Debenhams' properties with electricity generated from green
sources and met 57% of its carbon emission reduction programme through customer energy
efficiency programme.
(e) Waste and resource usage
Scottish Power increased its investment in oil containment and received a Queen's Award in the
Sustainable Development category.
(f) Biodiversity
The company took steps to allow the public to watch wildfowl. A cable pipeline was drilled below
the Dovey Estuary to avoid disturbance to a site of Special Scientific Interest.
(g) Sites, siting and infrastructure
Scottish Power completed connections to more renewable energy sources and implemented a
programme to keep parts of its network underground in Snowdonia.
(h) Employee experience
The company launched two new employee share plans. Staff participated in community
development programmes that provided training for young people.
(i) Customers with special circumstances
Scottish Power contributed 1 million to the Scottish Power Energy People Trust. It launched a new
social tariff that combined low prices with energy efficiency advice and measures to take vulnerable
customers out of fuel poverty.
(j) Community
Over 58,000 primary schoolchildren benefited from Powerwise, Scottish Power's classroom safety
education programme.
(k) Procurement
Scottish Power developed a group-wide responsible procurement policy and spent 74 million on
customer energy efficiency measures.
(l) Economic
Scottish Power provided employability training to 68 Skillseekers during the year.
4.8 Corporate citizenship

Corporate citizenship is the business strategy that shapes the values underpinning a company's mission
and the choices made each day by its executives, managers and employees as they engage with society.
Three core principles define the essence of corporate citizenship, and every company should apply them
in a manner appropriate to its distinct needs: minimizing harm, maximizing benefit, and being
accountable and responsive to stakeholders. (Boston Center for Corporate Citizenship)
Much of the debate in recent years about corporate responsibility has been framed in terms of
corporate citizenship, partly because of unease about using words like ethics and responsibility in the
context of business decisions. Discussion of corporate citizenship also often has political undertones,
with corporations acting instead of governments that cannot or will not act to deal effectively with
problems.
Case examples: Corporate citizenship
Companies have devised a number of different definitions of corporate citizenship.
Abbott Laboratories
Global citizenship reflects how a company advances its business objectives, engages its stakeholders,
implements its policies, applies its social investment and philanthropy, and exercises its influence to
make productive contributions to society.
At Abbott, global citizenship also means thoughtfully balancing financial, environmental and social
responsibilities with providing quality health care worldwide. Our programmes include public
education, environment, health and safety, and access to health care. These efforts reflect an
engagement and partnership with stakeholders in the pursuit of sustainable solutions to challenges
facing the global community.
AT&T
For AT&T, corporate citizenship means caring about the communities it is involved with, keeping the
environment healthy, making AT&T a safe and rewarding place to work and behaving ethically in all its
business dealings.
Coca-Cola
Responsible corporate citizenship is at the heart of The Coca-Cola Promise, which is based on four core
values in the marketplace, the workplace, the environment and the community:
Marketplace. We will adhere to the highest ethical standards, knowing that the quality of our
products, the integrity of our brands and the dedication of our people build trust and strengthen
relationships. We will serve the people who enjoy our brands through innovation, superb customer
service, and respect for the unique customs and cultures in the communities where we do business.
Workplace. We will treat each other with dignity, fairness and respect. We will foster an inclusive
environment that encourages all employees to develop and perform to their fullest potential, C
consistent with a commitment to human rights in our workplace. The Coca-Cola workplace will be H
A
a place where everyone's ideas and contributions are valued, and where responsibility and
P
accountability are encouraged and rewarded. T
E
Environment. We will conduct our business in ways that protect and preserve the environment. R
We will integrate principles of environmental stewardship and sustainable development into our
business decisions and processes.
1
Community. We will contribute our time, expertise and resources to help develop sustainable
communities in partnership with local leaders. We will seek to improve the quality of life through
locally-relevant initiatives wherever we do business.
DHL
DHL takes its definition of Corporate Citizenship from the World Economic Forum: Corporate citizenship
is about the contribution a company makes to society through its core business activities, its social
investment and philanthropy programs, and its engagement in public policy.
Texas Instruments
Beyond the bottom line, the worth of a corporation is reflected in its impact in the community. At TI,
our philosophy is simple and dates back to our founding fathers. Giving back to the communities where
we operate makes them better places to live and work, in turn making them better places to do
business. TI takes its commitment seriously and actively participates in community involvement through
three ways philanthropy, civic leadership and public policy and grass roots efforts.
4.9 Sustainability
We defined sustainability earlier in this chapter, using the widely accepted Brundtland report definition
of ensuring that the needs of the present are met without compromising the ability of future
generations to meet their own needs.
One approach to sustainability is known as the triple bottom line (or 'TBL', '3BL', or 'People, Planet,
Profit') approach.
People means balancing up the interests of different stakeholders and not automatically
prioritising shareholder needs.
Planet means ensuring that the business's activities are environmentally sustainable.
Profit is the accounting measure of the returns of the business.
A similar approach to thinking about sustainability issues is to differentiate three different types of
sustainability:
Issues Examples
Social Health and safety, workers' rights (in the business itself and its supply chain), pay
and benefits, diversity and equal opportunities, impacts of product use, responsible
marketing, data protection and privacy, community investment, and
bribery/corruption
Environmental Climate change, pollution, emissions levels, waste, use of natural resources, impacts
of product use, compliance with environmental legislation, air quality
Economic Economic stability and growth, job provision, local economic development, healthy
competition, compliance with governance structures, transparency, long-term
viability of businesses, investment in innovation/NPD
4.10 Environmental and social reporting
A business may provide social and environmental data as part of its external reporting. Reports generally
include narrative and numerical information about impact. Narrative information includes objectives,
explanations and reasons why targets have or have not been achieved. Reports can also address
concerns of specific internal or external stakeholders. Useful numerical measures can include pollution
amounts, resources consumed or land use.
Case example: Environmental and social reporting
BT's Social and Environmental Report for the year ended 31 March 2011 complies with the Global
Reporting Initiative Guidelines (discussed below). To give an overview of the company's social and
environmental performance, the report selects 12 non-financial key performance indicators.
(a) Customer service 3% increase in service quality
(b) Employee engagement index (measure of success of BT's relationship with employees) a small rise
to 3.61 out of 5
(c) Diversity BT maintains a top 10 placement in 4 out of 5 major diversity benchmarks
(d) Health and safety lost time injury rate up from 0.209 cases per 100,000 working hours to 0.225
cases per 100,000 working hours
(e) Health and safety sickness and absence rate down from 2.46% calendar days lost due to
sickness/absence to 2.41% calendar days lost
(f) Supplier relationship success 86% satisfaction
(g) Ethical trading (a measure of the application of BT's supply chain human rights standard) 70 risk
assessments with 100% follow-up
(h) Community effectiveness (such as charity partnerships and support for learning and skills and
helping people get on-line) rated at 98%
(i) BT's investment in community improvements is 1.9% of pre-tax profits
(j) Global warming CO2 emissions fell from 653,000 to 628,000 tonnes
(k) Waste to landfill and recycling (a measure of use of resources) reduction of 69%
(l) Ethical performance a small increase to 4.16 out of 5 in a measure designed to assess employee
awareness and training, compliance with the company's ethical code and behaviour with integrity
4.10.1 Global Reporting Initiative

Earlier papers covered The Global Reporting Initiative (GRI), a reporting framework that arose from the
need to address the failure of current governance structures to respond to changes in the global
economy.
The GRI aims to develop transparency, accountability, reporting and sustainable development. Its vision
is that reporting on economic, environmental and social importance should become as routine and
comparable as financial reporting.
The GRI published revised guidelines in 2006.
The main section of the Guidelines sets out the framework of a sustainability report. It consists of five
sections.
(a) Strategy and analysis. Description of the reporting organisation's strategy with regard to
sustainability, including a statement from the CEO. In addition, there should be a description of key
impacts, risks and opportunities. This section should focus firstly on key impacts on sustainability
and associated challenges and opportunities, and how the organisation has addressed the
challenges and opportunities. It should secondly focus on the impact of sustainability risks, trends
and opportunities on the long-term prospects and financial performance of the organisation. C
H
(b) Organisational profile. Overview of the reporting organisation's structure, operations, and A
markets served and scale. P
T
(c) Report parameters. Details of the time and content of the report, including the process for E
R
defining the report content and identifying the stakeholders that the organisation expects to use
the report. Details should also be given of the policy and current practice for seeking external
assurance for the report.
1
(d) Governance, commitments and engagement structure and management systems. Description
of governance structure and practice, and statements of mission and codes of conduct relevant to
economic, environmental and social performance. The report should give a description of charters,
principles or initiatives to which the organisation subscribes or which the organisation endorses.
The report should also list the stakeholder groups with which it engages and detail its approaches
to stakeholder engagement.
(e) Performance indicators. Measures of the impact or effect of the reporting organisation divided
into integrated indicators.
The GRI structures performance indicators according to a hierarchy of category and aspect.
Category Aspect
Environmental Materials
Water
Biodiversity
Emissions, effluents, and waste
Products and services
Compliance
Transport
Overall
Human rights Investment and procurement practices
Non-discrimination
Freedom of association and collective
bargaining
Child labour
Forced and compulsory labour
Security practices
Indigenous rights
Scale of assessment
Remediation of grievances
Labour practices and decent work Employment
Labour/management relations
Occupational health and safety
Training and education
Diversity and equal opportunity
Equal remuneration for women and men
Society Local community
Corruption
Role in public policy
Anti-competitive behaviour
Compliance
Product responsibility Customer health and safety
Products and service labelling
Marketing communications
Customer privacy
Compliance
Category Aspect
Economic Economic performance
Market presence
Indirect economic impacts
4.10.2 Integrated reporting

In September 2011 the International Integrated Reporting Council launched a discussion document
st
Towards Integrated Reporting Communicating Value in the 21 Century.
The aim of integrated reporting that the document promoted was to demonstrate the linkage between
strategy, governance and financial performance and the social, environmental and economic context
within which the business operates. By making these connections, businesses should be able to take
more sustainable decisions, helping to ensure the effective allocation of scarce resources. Investors and
other stakeholders should better understand how an organisation is really performing. In particular they
should make a meaningful assessment of the long-term viability of the organisation's business model
and its strategy.
Integrated reporting should also achieve the simplification of accounts, with excessive detail being
removed and critical information being highlighted.
Integrated reporting is designed to make visible the capitals (resources and relationships) on which the
organisation depends, how the organisation uses those capitals and its impact upon them.
Capital
Financial Funds available for use in production obtained

through financing or generated through
operations
Manufactured Manufactured physical objects used in

production or service provision:
Buildings
Equipment
Infrastructure
Human Skills, experience and motivation to innovate:
Alignment and support for organisation's

governance framework and ethical values
Ability to understand and implement
organisation's strategies
Loyalties and motivations for improvements
Intellectual Intangibles providing competitive advantage:
Patents, copyrights, software and

organisation systems
Brand and reputation
Capital
C
H
Natural Input to goods and services and what activities
A
impact: P
T
Water, land, minerals and forests E
R
Biodiversity and eco-system health
Social Institutions and relationships within each
community stakeholder group and network to 1
enhance well-being:
Common values and behaviours

Key relationships
Social licence to operate
A number of guiding principles underpin the content and presentation of an integrated report:
Strategic objectives Insights into strategic objectives, strategies and

how they relate to other components in
business model. Report also how organisation
uses resources and relationships.
Connectivity of information Links between different components of business

model, external factors and resources and
relationships upon which organisation depends.
Examples include how changes in market
environment influence strategy and how
strategies link to key performance and risk
indicators and remuneration.
Future orientation Management expectations about the future and

other information to help organisation's users
assess prospects. Information should include
balancing of short- and long-term interests,
where organisation will go and how it will get
there, and critical enablers, challenges and
barriers.
Responsiveness and stakeholder inclusiveness Insight into organisation's relationships with

stakeholders and how organisation takes
account of and responds to their needs.
Conciseness, reliability and materiality Provision of important and reliable information

with less significant information being disclosed
elsewhere.
The content elements follow on from the guiding principles:
Organisational overview and business model

Operating context, including risks and opportunities, resources and relationships
Strategic objectives and strategies including risk management, and also the extent to which
sustainability considerations are embedded into strategy to provide clear advantage
Governance and remuneration
Performance against strategic objectives, impacts on resources and relationships and external factors
impacting on performance
Future outlook, including how well organisation is equipped to respond to future environment,
repercussions of future plans, actions required and uncertainties
4.11 Auditing environmental sustainability
An environmental audit is an evaluation of how well an entity, its management and equipment are
performing, with the aim of helping to safeguard the environment by facilitating management control
of environmental practices and assessing compliance with entity policies and external regulations.
Environmental auditing is also used for auditing the truth and fairness of an environmental report rather
than the organisation itself.
An environmental audit may be undertaken as part of obtaining or maintaining external accreditation,
such as the BSI's ISO 14001 standard.
In practice environmental audits may cover a number of different areas, The scope of the audit will
depend on each individual organisation. Often the audit will be a general review of the organisation's
environmental policy. On other occasions the audit will focus on specific aspects of environmental
performance (waste disposal, emissions, water management, energy consumption) or particular
locations, activities or processes.
There are other specific aspects of the approach to environmental auditing which are worth mentioning.
(a) Environmental Impact Assessments (EIAs)
These are required, under an EU directive, for all major projects which require planning permission
and have a material effect on the environment. The EIA process can be incorporated into any
environmental auditing strategy.
(b) Environmental surveys
These are a good way of starting the audit process, by looking at the organisation as a whole in
environmental terms. This helps to identify areas for further development, problems, potential
hazards and so forth.
(c) Environmental SWOT analysis
A 'strengths, weaknesses, opportunities, threats' analysis is useful as the environmental audit
strategy is being developed. This can only be done later in the process, when the organisation has
been examined in much more detail.
(d) Environmental Quality Management (EQM)
This is seen as part of TQM (Total Quality Management) and it should be built into an
environmental management system. Such a strategy has been adopted by companies such as IBM,
Dow Chemicals and by the Rhone-Poulenc Environmental Index, which has indices for levels of
water, air and other waste products.
(e) Eco-audit
The European Commission has adopted a proposal for a regulation for a voluntary community
environmental auditing scheme, known as the eco-audit scheme. The scheme aims to promote
improvements in company environmental performance and to provide the public with information
about these improvements. Once registered, a company will have to comply with certain on-going
obligations involving disclosure and audit.
(f) Eco-labelling
Developed in Germany, this voluntary scheme will indicate those EU products which meet the
highest environmental standards, probably as the result of an EQM system. It is suggested that
eco-audit must come before an eco-label can be given.
(g) BS 7750 Environmental Management Systems
BS 7750 also ties in with eco-audits and eco-labelling and with the quality BSI standard BS 5750.
Achieving BS 7750 is likely to be a first step in the eco-audit process.
(h) Supplier audits
They ensure that goods and services bought in by an organisation meet the standards applied by
that organisation.
4.11.1 Environmental audit stages
C
There are three main stages in most environmental audits. H
A
(a) Establishing the metrics P
T
The greater the variety of metrics, the more information provided. However measuring against a E
number of metrics could result in a costly audit. R
(b) Measuring planned or desirable performance against actual performance

This is an important aspect of a system. Some metrics will be objective, for example the level of 1
carbon emissions or plastic bag issues can be measured. However other aspects, for example public
perceptions, cannot be measured objectively and may therefore be difficult to measure precisely.
(c) Reporting the results of the audit

Important decisions will include the form of the report and how widely it should be distributed, in
particular whether the organisation's annual report should include a report by the auditors.
4.11.2 Auditor concerns

(a) Board and management having good understanding of the environmental impact and related
legislation of the organisation's activities in areas such as buildings, transport, products, packaging
and waste.
(b) Adoption and communication of adequate policies and procedures to ensure compliance with
relevant standards and laws.
(c) Adoption of appropriate environmental information systems.
(d) Adoption and review of progress against quantifiable targets.
(e) Assessment of whether progress is being made economically and efficiently.
(f) Implementation of previous recommendations of improvements to processes or systems.
(g) True, fair and complete reporting of environmental activities.
5 Integrating the use of analysis tools in a complex scenario
Section overview
In reality, analysis tools will not be used in isolation. At the Advanced stage, you will be expected
to demonstrate your ability to use several tools to evaluate a complex scenario. This section
makes use of a lengthy exam-standard case study to integrate the use of a number of tools. The
case study also contains financial elements, illustrating how business strategy integrates with
financial strategy.
At this Advanced level of your studies, you are expected to have gained a detailed understanding
of the tools that were reviewed in Section 1. The important skills you are now required to
demonstrate are how to apply these models in a complex scenario and integrate them with other
strategies in order to mirror a real life situation.
5.1 Preparing to tackle a case study

Companies encounter complex scenarios all the time in real life. The important thing to remember is
that no two cases are ever the same each one must be treated on its own merits. However, there are
some fundamental questions you should ask when reading through the scenario you are faced with in
the exam.
What is the company's main line of business?
What is its current strategy?
What are its long-term objectives?
Are there any global issues to consider?
How is the company performing financially?
Are there any obvious areas for improvement?
Does the company have any particular strengths that could be further exploited?
Are there any limited resources that may affect the company's ability to fulfil its objectives?
What are competitors doing?
Are there any potential conflicts between objectives for example, financial strategy versus
marketing strategy?
As much as possible, try to treat case studies as you would problems in your own workplace or that of a
client think about how decisions taken to solve one problem might impact on other areas of the
business, whether certain decisions will contradict company strategy or affect market perception, the
potential financial implications of different actions, and whether proposed courses of action will align
with company culture. Look for the issues you would normally consider in a work situation. If you are
given financial information, make sure you use it, whether to establish profit margins, growth or general
financial health.
5.2 Worked example

The following case study is an example of how different analytical tools can be used in a business
situation and illustrates the need to use financial information to evaluate company performance.
Worked example: Body Beautiful

John and Kate Dempsey are the joint owners and managers of Body Beautiful Ltd, which is based in the
UK. The firm, which was formed in 20X2, is in the ladies' body care business, buying products from
various manufacturers based almost exclusively outside the UK, including Japan, Malaysia and mainland
China. More recently, the firm has also started to source products from European countries, most
notably France and Spain. The firm concentrates mainly on smaller value items such as body lotions,
nail care products and facial treatments. Its customers are mainly wholesalers and spa facilities in the
UK.
John and Kate borrowed heavily from the bank in order to purchase the business. Due to the success of
Body Beautiful, they have managed to pay off this initial loan, and have expanded their premises
considerably. The main premises are now a state-of-the-art warehouse and distribution centre, through
which all their goods pass this is owned on a freehold basis by the firm, rather than the leased
premises with which it started out.
Business is booming. Sales are now in excess of 15 million per annum, the result of a steady growth of
approximately 30% each year and there are no indications that this will not continue. Despite this,
however, Body Beautiful's sales only account for approximately 45% of the market, so there is
considerable potential for market growth. The firm operates very efficiently with a total of 25 staff
(excluding John and Kate), an increase of 60% on initial employee numbers. All but three of these
employees are warehouse and distribution staff. Kate, the Managing Director, is concerned solely with
the marketing side of the business, using her contacts from her previous role as senior salesperson in the
body care subsidiary of a large group of companies, and is assisted by the three non-warehouse staff
who concentrate on smaller clients. John, the other director, takes care of day-to-day operations,
including administration, warehouse and distribution operations, and financial management. As the
business continues to grow, more staff will be inevitable, particularly to support the distribution
function, and it is estimated that the payroll will comprise 50 (non-director) employees within the next
three years.
Body Beautiful's success can be attributed to several factors. First, Kate is an expert marketer with
numerous contacts in the trade. Her popularity and close working relationship with clients has been a
major contributor to sales growth. Customer loyalty is encouraged by the excellent customer service
that Kate and John provide, through their accessibility and personal attention.
As all products are purchased from foreign manufacturers, it has been essential to keep a close eye on
currency rate movements. John has been especially astute, taking advantage of the relative strength of C
sterling against the euro for European supplies. There have been more problems with the Asian H
A
suppliers however. Most of their products are priced in US dollars and the weakness of this currency
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against sterling has prevented John negotiating low prices. The currency situations are always subject to T
change however, and it is John's task to take appropriate action to protect Body Beautiful from major E
fluctuations. R
Kate has developed strong links with suppliers and until recently has tried to maintain only a small
number to keep lines of communication and control as simple as possible. Most of the suppliers have
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been linked with the firm since its inception in 20X2, thus providing Body Beautiful with reliable and
good quality products. Body Beautiful often has exclusive access to certain products. One example is
its sole UK distribution rights to a French anti-wrinkle cream whose excellent results in product trials
have made it a very sought after product. The success of and demand for this product has further
encouraged customer loyalty. Kate realises that as customer demand for all of their products increases
the firm will have to find additional suppliers and has already started sourcing products from new
manufacturers.
Body Beautiful is in the fortunate position of having no immediate competitors. Many of the small
competitors in the body care industry have opted to concentrate on other aspects of the business, such
as the supply of small electrical items (for example, foot spas and face steamers) or the increasingly
lucrative men's products. Some also sell spa furniture such as massage tables and mobile product
trolleys. A number of small firms have even left the industry altogether. Several large international
companies who manufacture body care products also buy merchandise from Body Beautiful but sell it to
high street retailers for domestic consumer purchase rather than directly to wholesalers and spas. These
companies do not see Body Beautiful as a threat, given their relative sizes.
Rather than using the manufacturers' own brand names and packaging, Body Beautiful has registered its
own brand name for its main products and repackages them in its own distinctive green and gold
wrapping. The directors have found that this has generated even more customer loyalty and has even
allowed them to charge a premium price. Both Kate and John believe that part of the firm's success has
been down to spending minimal amounts on administrative expenses. Most of the products are
outsourced, with value being added mainly through branding and high levels of customer service. Kate
and John believe that strategy is not necessarily about beating the competition but in serving customers'
needs. The firm has also established a strong relationship with a leading chain of health clubs,
providing its clubs with good quality, low cost body lotions and shower gels to be sold under their own-
brand label. Although margins are small, volume more than makes up for this.
Due to the considerable increase in sales, Body Beautiful has had to incur significant investment costs,
including building the new warehouse facilities, increased inventory-holding costs, upgrading computer
systems to handle customers orders, inventory control and financial matters, and despatch vehicles such
as larger delivery lorries and fork-lift trucks for the warehouse. Such expenditure could not be financed
from operating cash flows but the firm's bank was willing to lend the necessary funds given its ability to
pay off previous loans ahead of schedule.
Despite the firm's obvious success so far, Kate and John are still keen to pursue further growth, driven
more by an appetite for enhanced personal reputation rather than wealth accumulation. However, they
are concerned that the rapid growth enjoyed by the firm in the last five years is not sustainable and they
are therefore looking for other ways to expand. Their accountant has produced the following
information for them to consider.
Body Beautiful Ltd Financial and operational details
20X5 20X6 20X7 20X8
(forecast)
'000 '000 '000 '000
Sales 8,402 11,259 15,200 20,064
Cost of sales 5,297 7,474 10,826 14,428
Marketing 840 970 1,064 1,203
Distribution 1,008 1,126 1,216 1,404
Administration 100 113 167 321
Interest on loans 0 281 432 1,128
Operating profit 1,157 1,295 1,495 1,580
Non-current assets 1,826 4,825 8,192 16,854
Inventory 840 1,287 2,124 3,745
Long-term loan 0 3,513 5,088 12,538
Total staff (incl. directors) 20 23 27 40

Number of suppliers 20 30 60 80
Range of products 40 95 120 145
Operating profit % 13.8 11.5 9.8 7.9
Requirements
You are Kate and John's accountant.
(a) Prepare a report which evaluates the current position of the firm and highlights any financial and
strategic issues concerning future development that you believe should be brought to the directors'
attention.
(b) Prepare a report for Kate that identifies and assesses the strategies they might consider in their
quest to further develop the firm.
(c) Kate and John appear to be very keen for the firm to grow even more. Identify reasons for
potential corporate decline and suggest ways that Kate and John could avoid them in the context
of the case study.
(d) At the moment, the firm appears to have been growing steadily and successfully. Demonstrate
how Kate and John have managed to achieve this success using value chain analysis.
Solution
This is a large case study with a lot of information in it. You will need to look carefully at the table of
data in order to get a good grip on this question. You might find that SWOT would form a good basis
for thinking about the information you are given.
The question calls for a report: make sure you write and set out your answer in a suitable format.
It is clear from a glance at the data table that sales, cost of sales and borrowing have all risen rapidly and
are expected to continue to rise. Two minutes with a calculator will reveal the relative rates of increase,
which are very significant indeed. One thing you should always check is whether interest rates change
from year to year and/or as loans get larger.
Make sure you analyse and apply the quantitative data properly. Analysis should extend beyond the
calculation of financial ratios. Obvious and unsupported statements such as asserting that a particular
ratio has increased, should be avoided. Skills at this level should include analysis and interpretation
which explains the data in operational, financial and strategic terms to the full extent of the available
information. Also be prepared to identify possible strategic action that could be taken to resolve any
issues and its potential impact on the data in future.
(a) To: Managing Director, Body Beautiful Ltd
From: Accountant C
Date: December 20X7 H
A
Subject: Body Beautiful Ltd current position and prospects
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1 Current situation T
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Trading R
The last three years' trading results show impressive growth in sales, which is forecast to
continue into 20X8. Unfortunately, cost of sales, which is by far the largest expense item, has
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risen at an even faster rate; this trend is also forecast to continue. The effect of this
disproportionate rate of increase has been ameliorated by lower rates of increase in other costs,
but has led to relatively slow growth in profits as compared to the growth in sales. In fact, the
operating profit percentage is forecast to be only 7.9% in 20X8, whereas in 20X5 it was 13.8%.
Costs
Cost of sales. The relative rise in cost of sales may be caused, at least in part, by the
expansion of the product range, the number of lines having more than trebled since 20X5.
It might be worth examining the margins achieved on each line to establish whether the
product range might be trimmed. This may also have a desirable effect on the amount of
capital tied up in inventories, which has increased by more than 400% since 20X5. Also, as
cost of sales contains some fixed costs, one would expect all other things being equal that
cost of sales would increase more slowly than sales as the business expands.
Distribution and marketing. Distribution and marketing costs have risen much more slowly
than cost of sales and slower even than sales. While the level of marketing costs may be
regarded as subject to some discretion, holding distribution costs down to an increase of only
39% when sales have more than doubled is a significant achievement.
Finance costs. The expansion of the business has largely been financed by borrowing. Total
indebtedness is comfortably lower than the value of non-current assets alone, but the interest
payments have risen to 2.8% of sales and are expected to rise to 5.6% of the much increased
sales forecast for 20X8. This is partly because borrowing itself will more than double, but there
is also an increase in the rate of interest forecast, presumably reflecting the bank's
perception of increasing risk as the company's borrowing expands. This should be borne in
mind if further expansion of premises is considered: leasing may turn out to be cheaper.
Administration. Administration remains the smallest category of cost, though these costs are
expected to increase in line with turnover presumably as a result of the intended growth in
staff numbers.
2 Issues for the future
2.1 Competition
At the moment, Body Beautiful is not significantly challenged by competitors: larger
body care product companies sell into the consumer market and smaller ones specialise
in other product ranges. It would not be wise to plan for the future on the basis that this
will continue indefinitely. Even if the current rate of growth is not maintained, it will not
be long before the company is challenged, either by a start-up business or by an
established company seeking further growth. The company's relationship with the health
club chain will already have brought it to the attention of the larger players.
2.2 Business cycle
You have argued that your market segment is recession-proof. This is unlikely to be the
case. You have not so far encountered a downturn. Much of your trade is in superior
quality, branded products for which you are able to charge premium prices. In the event
of a recession, it is likely that your customers would seek to contain or reduce their
costs by buying cheaper goods. If you were able to supply them, your margins would
be eroded; if you were not you would lose the business altogether.
2.3 Suppliers
The expansion of your product range means that you now deal with four times the
number of suppliers you bought from three years ago. Part of your success has been built
on strong relationships with your suppliers: these relationships will be difficult to establish
with the new suppliers simply because there are so many of them. This may affect the
reliability of your deliveries, the discounts you receive and your access to newly
developed premium products. These effects are particularly likely to occur if competitors
enter your chosen markets.
2.4 Management
The company has expanded to a size many times larger than it was when it was set up,
but the management structure has remained the same. It seems unlikely that this can
continue much longer. The volume of transactions alone is likely to generate a scale of
managerial work that two people cannot handle; there is also the whole field of human
resource management to consider. Staff numbers are planned to increase by 50% in
20X8. Payroll administration, recruitment, selection, and other aspects of personnel
management are likely to become more and more time consuming. It would also be
appropriate to consider the potential for ill-health to affect the smooth operation of the
business: having greater managerial capacity would provide the organisation with the
flexibility to deal with absence through ill-health. It is probably time to think about
taking on at least one person who can undertake some of the more routine management
and administrative functions. This could also have the advantage of releasing some of
your own time to allow consideration of strategic issues in greater depth.
2.5 Currency exchange rates
Most of your purchases are paid for in foreign currency. The dollar and euro exchange
rates have been reasonably stable, but this may not be the case in the future. As the
volume of your business expands, it may become practical for you to use your bank's
services to hedge against unfavourable exchange rate movements.
3 Conclusion
Your business continues to expand, but your cost structures might benefit from close
attention. This is particularly true of cost of sales and finance charges. Management structure
is another matter that needs consideration. There are also a number of possible developments
in the business environment that could affect the continuing success of the business. You
should give some thought to the possibilities of recession, adverse exchange rate movements
and increased competition.
(b) This question lends itself to an answer based on the various strategic option models that you
should be very familiar with. The scenario gives a lot of detail that is relevant when considering the
various possible routes to growth, so a fairly careful answer plan would be a good idea here.
It is important to discuss longer-term strategies as well as quick, tactical courses of action. Focusing
on the long-term future of the business is more realistic and will demonstrate your business
acumen. If you focus only on the short term, this suggests a lack of appreciation for business
planning. Make sure you also integrate potential strategies by considering the financial implications
for many companies, finance is often the stumbling block when putting development proposals
together.
To: Managing Director, Body Beautiful Ltd
From: Accountant
Date: December 20X7
Subject: Body Beautiful Ltd possible development strategies
1 Current limitations
At the moment you have 45% of your chosen market, which must be deemed as a dominant
share. While there is still some potential for further organic growth in like-for-like sales, you are
probably justified in doubting that this could be a major source of expansion. It is likely that
you would have to base such growth on price competitiveness: you may be able to do this
reasonably profitably if you can exploit purchasing economies of scale, but you may feel that
there are more inviting routes to growth than further market penetration based on a cost-
focus.
However, before leaving this topic completely, it is worth mentioning the possibility of a
differentiation focus strategy. I have already remarked on the recent rapid growth in the
number of products you offer and recommended a review of profitability: this might lead
you to concentrate much of your attention on the high margin items you sell under your
own brand. You could aim for a two component business: branded goods selling at high C
prices and your supply of own-brand items in high volumes to your main health club H
customer. A
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2 Product-market options T
E
2.1 Product development R
At the moment, you sell a range of body care items to wholesalers and spa facilities,
mostly for trade use; your product range includes goods sold both under your company's
brand and some sold as own brand items by a leading health club chain. Possible scope 1
for product development lies in the category of goods sold into your market by your
smaller competitors, such as small electrical goods and men's products. These items
would complement your existing range. However, any future introduction of new
products should only be contemplated in the light of the review of profitability already
recommended.
It would be inappropriate for you to contemplate a move into spa furnishings, since
these high-value items are so very different in nature from your existing range. You
would probably have to establish completely new supplier relationships and the items
themselves may incur significant costs in fitting and after-sales service.
More adventurous product development, such as selling a line of hair care products,
would put you in competition with major international companies. You might be able to
source low cost, unbranded supplies, but there could well be product safety issues to
contend with. This option should not be discarded, but needs careful consideration.
2.2 Market development
There are two principal new markets you might consider.
First, you might consider providing other health club chains with goods to sell under
their own brands. You would, of course have to consider how this might affect your
relationship with your existing retail chain customer. This would be low margin business,
but you have already found that the volumes make up for this: an expansion should
increase your purchasing power and enhance your margins by reducing your purchase
costs. This strategy could also be applied to supermarket and department store chains.
Second, you might consider international expansion. This would require some careful
market research to assess such things as distribution chains, competition and consumer
preferences, but there is considerable potential here. Attendance at one of the many
European beauty care industry trade fairs would be a good way to start.
2.3 Diversification
Diversification is a high risk strategy and none of the options seems appropriate for you.
A move into a completely new market with new products would not build on any of your
strengths and would expose you to established competition. A vertical move up or
down the value system has more to recommend it, since you would be able to build on
your current market experience, but there would be significant disadvantages to such a
move.
A move upstream into manufacturing would put you in competition with your current
suppliers. You would not be operating on the same scale as them and therefore you
would expect your costs to be higher. It is possible that you could find and exploit a
manufacturing niche, perhaps producing a small number of similar lines that you
currently have difficulty in sourcing, but this does not seem to offer much prospect for
achieving your aim of continued substantial growth. If you contemplate manufacturing,
you should certainly think in terms of off-shore production, perhaps by entering into
outsourcing agreements. This would significantly reduce the capital requirement.
A move downstream into retailing would be even more difficult. You have no
experience of retail operations, so your bank would be unlikely to provide the capital to
acquire a chain of outlets; this means that you would have to build the new business by
organic growth, which would necessarily be a slow process. Such a move would require
you to learn all the skills involved in retailing and to source a much larger range of
products.
3 Methods of growth
3.1 Acquisition
I have already mentioned the relatively slowness of organic growth. More rapid growth
can often be achieved by the acquisition of an appropriate existing business. This might
be an attractive option for expansion within your existing markets and as an alternative
to the product development route mentioned above. Acquisition could also be a route to
rapid implementation of the international expansion and manufacturing niche strategies.
3.2 Joint venture/strategic alliance
A joint venture or strategic alliance might be an alternative route to expansion. The
difference between the two concepts is that the former involves the creation of a new,
jointly owned business entity, while the latter is based on the shared use of an asset, thus
spreading its costs and creating scale economies from the increased rate of use. Either of
these approaches could be a relatively low risk route to international expansion, for
example. A joint venture might be arranged with an existing customer or supplier, while
a form of strategic alliance might be created by the use of a foreign commercial agent.
The drawback of these vehicles from your point of view would be that you would have to
share control, which might not be an attractive prospect.
4 Conclusions
Either a cost focus or a differentiation focus could be a route to further market penetration,
though growth by these means would probably be slow.
There do not seem to be good prospects for expansion based on product development.
You may wish to look more closely at the two possibilities for market development I have
described: further manufacturing for own brand retailers and a foreign venture. Acquisition or
joint venture might be worth further examination as means to the latter end.
The only diversification strategy that seems worthy of further examination seems to be the
development of a manufacturing niche. Acquisition could also be a means of implementing
this idea.
(c) The question emphasises 'the context of the case study' scenario. This is a pretty clear indication
that your answer should not be confined to a discussion of theory!
Significant increases in inventories and debt have taken place as part of Kate and John's pursuit of
growth. The consequent increase in fixed costs makes the business much less resilient. Another
obvious point to make is that Kate's management style, while highly suitable to a small business, is
likely to become less appropriate as the business expands.
Much research has been done on why successful businesses decline and fail: for example, Altman's
Z score offers a rule of thumb for predicting failure from key financial ratios.
We have already noted that Kate and John's drive for expansion has led them to very significant
increases in borrowing and in the level of inventories. The consequent rise in operational gearing
means that they will be poorly placed if their business turns out to be less recession-proof than they
believe it to be. In any case, the profitability of the business appears to be declining, which will
make servicing debt more difficult. A high level of gearing and overtrading are two management
mistakes that are made regularly: there seems to be some danger that Kate and John are on course
to fall into these errors. They must pay close attention to cash flows and reduce inventories as far as
possible, implementing the product line review already discussed.
It was mentioned earlier that hedging foreign currency may become necessary if currency rates
become more volatile this will require specialist knowledge that John is unlikely to have. He
should consider the possibility of employing a specialist financial manager to deal with such
matters and the day-to-day financial issues that arise. The bank has already expressed some
reservations over the increase in debt by charging higher interest rates. Given that all of Body
Beautiful's supplies come from overseas, this rate may also be reflecting the firm's greater exposure
to currency movements as purchases increase to cope with demand. Currency stability is unlikely
to last it is important that John is seen to be addressing this issue through the employment of a
financial manager and the use of currency hedging techniques to reduce inevitable risks.
Kate and John's desire to promote the growth of the business seems to be their principal strategic
idea. Wisely, they have taken advice on possible future courses of action, but there must be some C
doubt about their ability to put them into action. They display the drive, market knowledge and H
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tactical agility of the typical entrepreneur; unfortunately, these qualities are rarely combined with
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the ability to plan and control the operations of the much larger business they aspire to. T
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The business has grown to the point at which they need good quality management support and
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advice, but they may not be temperamentally suited to working in this way. Several symptoms of
poor top management relate to a general situation of dominance by one powerful individual. They
need help and the business needs more structure and systems that will support its routine
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operations without hampering its agility and innovation.
Kate and John will also have to keep a close eye on the conditions in their chosen markets. They
have been very fortunate in that they have encountered little competition so far. They should not
count on this continuing indefinitely: one of the major international companies may consider it
worthwhile to attack the spa market, for example, perhaps by offering a wider range of products or
better prices. It would be easy for a large company to drive them out of business. Similarly, the
relationship with the health club chain for which they produce own-brand goods is unequal; the
chain may decide to cut the margins they allow in the same way that the UK supermarkets do to
their suppliers.
(d) The question emphasises Kate and John's success and it would make sense, therefore, to confine an
answer to those parts of the value chain that have been managed in a way that contributes to that
success. However, an over-strict interpretation of the question requirement is not always a good
idea. Do not be afraid to add a few sentences that might seem to be marginal to such an
interpretation.
Marketing and sales is an obvious place to start among the primary activities, as Kate is basically a
very successful saleswoman.
Primary activities
Kate is a very successful saleswoman and the marketing and sales activity of the company, resting
in her hands as it does, must be regarded as a major source of the company's success. She has
created good relationships with key customers, not least by her determination to provide excellent
service. She has also successfully established both the Body Beautiful brand, which offers enhanced
margins and a bulk, own-brand supply to a chain of health clubs, which gives volume sales and the
advantages of bulk purchasing.
We might consider operations and both inbound and outbound logistics together. Kate has
invested substantially in storage and packing facilities and John has managed the company's staff
so as to provide a high quality of service: we must presume that this includes accurate and prompt
deliveries. All three of these activities form an important basis for the company's success.
The final primary activity is service, in the sense of after-sales service. The company's products are
generally too simple to require very much of this, but no doubt prompt attention to returns, when
required, contributes to its overall reputation.
Secondary activities
Procurement is also an activity into which Kate has put considerable effort and from which the
company derives great advantage. Kate sources products entirely from outside the UK and has
overcome problems of foreign exchange, international trade regulation and national culture to do
so successfully, having negotiated a number of favourable prices.
Technology development at Body Beautiful has two aspects. The development of the product
range continues apace, possibly to the extent that some rationalisation is required, as discussed
earlier. This might be counted a mixed success for this reason. The continuing development of
systems and utilisation of resources (such as those in the warehouse) has allowed the company to
expand its operations smoothly and without constraint. However, there is some concern about the
level of debt and thus fixed costs that has developed. Overall, this activity continues to need careful
management if it is not to become an important weakness.
Human resource management is also an activity worthy of some attention. Staff turnover has
been low, which is a good sign, but staff numbers are expected to double over the next three years
and it is therefore unlikely that this will continue. John will have to pay careful attention to
recruitment and training and be prepared for a higher level of turnover as numbers increase. There
is also the problem of managerial capacity already discussed: the business needs increased
managerial support of a high calibre.
Firm infrastructure in terms of specialist services such as legal advice is, no doubt, bought in as
required. There is however, a growing need for more in-house capacity for such activities as
planning, financial control and, possibly, as the scale of operations increases, quality management.
5.2.1 General observations about the worked example

There are no definitive answers to case study questions. You can probably think of other issues that
could be discussed in the Body Beautiful Ltd case study above. You should concentrate on how various
analytical tools can be used to assess the business position and how potential strategies interact with
one another in the context of the case. You are not being tested on how many theories you can
memorise it is your ability to apply appropriate theories to particular situations and integrate them
with other aspects of the business that the examiner is interested in. It is also important to use the data
in the question to support the argument and advice being given. This might include quantitative
analysis of the data in order then to provide a richer qualitative explanation of what is happening in the
business.
You will notice in the case study above that frequent reference was made to financial management
issues this is very important. Given that Body Beautiful had already taken on additional debt and was
considerably exposed to currency rate risk, formal financial management procedures are necessary to
secure the firm's continued success in the future. It was mentioned that two of the most common
managerial mistakes were overgearing and overtrading this is often the case because managers focus
too much on business strategy and not enough on the financial implications.
Interactive question 3: WG plc [Difficulty level: Intermediate]

Introduction
WG plc was formed four years ago following the merger of two large pharmaceutical companies. Prior
to the merger the two companies had been competitors: they believed that by combining forces the
shareholders of each company would benefit from increased profits arising from the rationalisation of
manufacturing facilities, distribution networks, and concentration of resources towards more focused
research and development.
With operating outlets in Europe, Asia, the United States of America and Africa, WG plc regards itself as
a global company. It employs approximately 50,000 people worldwide and has developed a wide
portfolio of products. Its profits before tax last year increased by 20% and represented approximately
35% of revenue. The company declared that its earnings and dividends per share in the same period
increased by 15% over the previous financial year.
All manufacturers of pharmaceutical products claim that their pricing policies need to be set at a level to
achieve high profitability in order to attract funds from investors. They argue that this is necessary to
meet their high research and development commitments. In recent years, WG plc and other
pharmaceutical manufacturers have encountered public and governmental challenges to their high
levels of profitability.
WG plc encounters strong competition from other world-class pharmaceutical manufacturers but these
are few in number. High research and development costs present a major obstacle to potential
competitors tempted to enter the industry.
Mission and objectives
The directors of WG plc have defined their overall corporate mission as being to 'combat disease by
developing innovative medicines and services and providing them to healthcare organisations for the
treatment of patients worldwide'.
The directors have confirmed their main objective is to sustain profitability while achieving the
company's overall mission. They have also explained that WG plc aims to work towards eliminating
those diseases for which the company is engaged in providing treatments. Achievement of the
profitability objective is continually threatened by patents coming to the end of their lives. Patents give
the sole right to make, use and sell a new product for a limited period. C
H
Product development A
P
A large proportion of the company's turnover in recent years has been derived from one particular drug. T
The patent for this drug expires next year and it is expected that its sales at that time will represent no E
more than 10% of total revenue. Four years ago, the sales of this drug produced almost half the R
company's entire revenue.
A new product, Coffstop, has now completed its rigorous development phases and is being marketed to
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pharmaceutical stores throughout the world by WG plc. It is in competition with a similar drug, Peffstill,
produced and marketed by a direct competitor of WG plc. Medical research and opinion has concluded
that Coffstop is generally more effective than Peffstill in treating the condition for which they are
intended. Both drugs are available over the counter from pharmacies. The directors of WG plc are
optimistic that Coffstop will become very popular because of its improved effectiveness over other
market products.
The retail market price of Coffstop is 1.50 per bottle, compared with 10 per bottle of Peffstill.
However, the recommended dosage of Coffstop is six times more than that for Peffstill. The bought-in
costs per bottle to the retail pharmacist are 0.50 and 7.40 for Coffstop and Peffstill respectively. Initial
indications to the management of WG plc are that retail pharmacists tend to prefer to stock Peffstill on
the basis that it achieves 2.6 times the level of gross contribution per bottle compared with Coffstop.
It is estimated that the cost to the retailer of holding Coffstop is 0.40 per bottle and 0.80 for Peffstill.
The availability of shelf space is a limiting factor for most retailers. The shelf area occupied by each
bottle of Coffstop is 18 square centimetres and 60 square centimetres for each bottle of Peffstill. Early
indications show that the average weekly sales volume for retail outlets stocking both products are 120
bottles of Coffstop and 20 bottles of Peffstill.
Market development
WG plc has experienced slow growth in its mature markets of Western Europe, North America and
Japan. These markets contribute 80% of overall revenue but their governments have reduced
expenditure on pharmaceutical products in recent years. The company has encountered a rapid sales
increase in its expanding markets of Eastern Europe, South America, the Asia Pacific region, India, Africa
and the Middle East. The directors of the company hold the view that increasing population growth in
these markets is likely to provide substantial opportunities for the company over the next two decades.
Research and development
Almost 15% of WG plc's revenue last year was spent on research and development. WG plc has the
largest research and development organisation of all pharmaceutical companies worldwide.
Much research is sponsored by national governments and world health organisations. A major piece of
research which has recently been undertaken relates to new treatments for malaria as the disease is now
demonstrating some resistance to existing treatments. WG plc has established a 'donation programme'
for the new drug in virulent areas for the disease. This means that the company is donating batches of
the drug to the health organisations in these areas. The cost of this programme is offset by the sales of
the new drug in other areas of the world by making it available to people proposing to travel to the
regions where malaria is widespread.
Requirements
(a) Evaluate the nature and importance of the market threat which WG plc would face if it failed to
provide sufficient resources for product development.
(b) WG plc's main objective is to sustain profitability through developing innovative medicines and
services for treating patients worldwide. The company also aims to eliminate disease.
Discuss the nature of the five competitive forces (identified by Porter) which are exerted on WG plc
in satisfying both these objectives at the same time.
(c) (i) Demonstrate whether Coffstop can provide a higher contribution to the retailer than Peffstill by
using:
(1) Cost Volume Profit analysis, taking account of the gross contribution per limiting factor.
(2) Direct Product Profitability analysis after charging holding costs.
(ii) Explain how WG plc can market Coffstop to improve its competitive position.
(d) Discuss the practical issues which the directors of WG plc would need to consider if the company
entered a strategic alliance with a competitor for the joint development of future pharmaceutical
products.
Summary and Self-test C
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Summary
Self-test
1 Pamper Products Ltd
Pamper Products Ltd was purchased as part of a management buy-out in 1996 by two brothers,
Peter and David Sample. The company buys nail care and cosmetic products from a variety of
suppliers in order to supply chemists and other retailers. Peter Sample was the Sales Director of the
business before the buy-out and David was an accountant working in practice at the time.
David organised the finance by re-mortgaging both of their houses and borrowing further from the
bank. He has continued to deal with the financial and administrative areas of the company whereas
Peter is totally involved with suppliers and customers.
Peter was always an excellent salesman and his commitment to customer service is second to none.
He deals personally with all of the major customers and has an excellent relationship with them.
Peter has a similar commitment to his suppliers. He has tried to limit the number of suppliers, but
as the company has grown he has been forced to deal with a growing supplier base. Most of the
purchases are from either the Far East or Europe. Initial concentration on a few major suppliers has
ensured that Pamper Products has been able to have exclusive access to some products.
The company buys its products from a variety of manufacturers but markets them under its own
brand name; it is able to charge premium prices for these products as a result of having created a
trusted brand.
The company has gone from strength to strength in the years since the management buy-out with
revenue increasing on average by over 20% per annum. This has led to an increased number of
suppliers and an increase in staff from seven in 1996 to 22 currently. The company has also
expanded physically and has recently rented a new warehouse, investing in a state of the art
inventory control system and a new computer system.
The initial bank loan was paid off according to its terms by 2001 but recently a further loan has
had to be taken out in order to finance the expansion.
Peter is committed to even further expansion but David is concerned that the company's systems
and finances cannot keep up with the rate of sales growth and would prefer a period of
consolidation. As an accountant David is happy with the financial controls and performance
measures that he has built into the system, but is concerned that possibly other non-financial
measures might be just as important, particularly as the company continues to expand.
Requirements
(a) Explain to David the most common reasons why companies may fail and suggest ways in
which Pamper Products Ltd could avoid them.
(b) Using the balanced scorecard approach, suggest other non-financial performance indicators
that Pamper Products Ltd could use to monitor its overall performance as it continues to
expand.
2 Two Wheels
Two Wheels is a private UK company founded in 1932 which produces bicycles for the general
market. It is managed by Darius Young, the grandson of its founder. The shares are totally owned
by the family, with Darius and his wife controlling just under half of the shares, the rest being held
by other members of the family. When the company was founded, the bicycles were targeted
mainly at people who could not afford to buy motor vehicles then a relative luxury but who
needed transportation to get them to work or for local travel. Initially the company was a regional
producer focusing on markets in Central England but over the next 75 years Two Wheels
transformed itself into a national company. Two Wheels took advantage of changes in fashion and
periodically introduced new models focusing on different market segments. Its first diversification
was into making racing bicycles, which still account for 16% of its volume output. Most of these
bicycles are very expensive to produce. They are made of specialist light-weight metals and are
often custom-built for specific riders, most of the sales being made on a direct basis. Members of
amateur cycling clubs contact the company directly with their orders and this minimises
distribution costs, so making these machines more affordable to the customers. Two Wheels'
reputation has been enhanced by this highly profitable product. The company has seen no reason
to change its branding policy and these products are still sold under the 'Two Wheels' brand name. C
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During the 1980s the company responded to the demand for more sporty leisure machines. A
Mountain bikes had become the fashion and Two Wheels designed and produced some models P
which appealed to the cheaper end of the market. These products, although robust and stylish, T
E
were relatively cheap and were aimed at families with teenage children and who could not afford
R
to spend large sums of money on the more sophisticated models. The company is currently selling
nearly 30% of its output to this market segment. Most of the sales are through specialist bicycle
shops, although about 25% of these mountain bikes sales are made through a national retail chain
1
of bicycle and motor vehicle accessories stores. Apart from those sold via this retail network, under
the retail brand name, the mountain bikes were also sold under the Two Wheels brand. With the
advent of fitness clubs the company saw an opening for the provision of cycling machines for the
health club and gymnasium market. These machines were sold at a premium price but they still
accounted for only 4% of total volume sales of the company. The main product group for the
company was still its basic bicycle it is the entry model for most families who are buying bicycles
for teenagers and for those people who still use bicycles as a means of transportation as distinct
from seeing them as entertainment or fun machines. The product is standardised, with few
differentiating features, and as such can be produced relatively cheaply. About 80% of this
segment is sold through the same national retail chain mentioned above with reference to
mountain bike sales. These bicycles in fact are built for the retail chain and marketed under their
brand name. This appears to be advantageous to Two Wheels because it guarantees them a given
level of business without their being responsible for either distribution or promotion. This segment,
however, is now seeing increasing competition from cheaper overseas imports.
The company had historically made reasonable profits and most of these were re-invested in the
company's production facilities, increasing capacity substantially. However, throughout the late
1990s, Two Wheels has seen its market being eroded. Sales have fallen gradually, mainly because
the total United Kingdom market for bicycles has been in decline, but also because of increased
competition from foreign suppliers. The high value of sterling has encouraged imports.
Surprisingly, during this period Two Wheels actually increased its share of domestic output. This is
due to the fact that it has been prepared to accept lower margins so as to maintain sales and, in
addition, a few UK producers had decided to exit the market and move into other, more attractive
product lines.
By early in the year 20X8 the company has seen its profits continue to fall. It now has a debt to the
bank of 7 million, having been unable to pay for all recent, new capital expenditure out of
retained earnings. (Table One gives some financial information about the recent performance of
Two Wheels.)
There are now very few UK manufacturers of bicycles who concentrate solely on producing
bicycles. Most have a diversified portfolio and can count on other product groups to support the
bicycle sector when demand is poor. However, Two Wheels has continued to focus entirely on this
specialised product range. It is surviving basically because it has built up a strong reputation for
reliable products and because the Young family has, until recently, been content with a level of
profits which would be unacceptable to a public company that had external shareholders to
consider. However, it is now becoming apparent that unless some radical action is taken the
company cannot hope to survive. The bank will now only make loans if Two Wheels can find a
suitable strategy to provide it with a higher and more acceptable level of profit. If the company is
to retain its independence (and it is questionable whether any company will really want to acquire
it in its current position) it has to consider radical change. Its only experience is within the bicycle
industry and therefore it appears to be logical that it should stay in this field in some form or other.
Darius Young has examined ways to improve the profitability of the company. He is of the opinion
that if Two Wheels becomes more successful it could become a desirable acquisition for other
companies. However, currently the company will not attract bidders unless it is at a low price.
Darius has looked at the profile of his products and wonders whether any rationalisation could help
to improve performance. He has also decided to look at the potential for overseas marketing.
Having examined statistics on current world production and sales statistics he has identified that
the real growth areas for bicycles are in the Far East. China alone supports a bigger market for
bicycles than the whole of Europe and North America. India and Pakistan have also developed a
significant demand for bicycles. Darius decided to visit some of these markets and he has returned
full of enthusiasm for committing Two Wheels to operate in these Far Eastern markets or in India
and Pakistan. Whilst Darius considers that exporting from the UK might be a viable option, he has
become increasingly attracted to manufacturing in the Far East, particularly in China. He believes
that transportation costs could prove to be a disadvantage to exporting for Two Wheels. He
estimates that costs for shipping and insurance could add about 20% to the final selling price.
Furthermore, he is concerned about the discrepancy between labour costs in the United Kingdom
and in China. Wage rates, including social costs in China appear to be about 25% of those in the
UK and these costs account for approximately 30% of the total production costs.
Darius has summoned a meeting of all the shareholders to persuade them to agree to plan to
manufacture, or at least assemble, bicycles in China. The other shareholders are not quite so
enthusiastic. They feel that this strategy is too risky. The company has never been involved in
overseas business and now they are being asked to sanction a strategy which by-passes the
exporting stage and commits them to significant expenditure overseas. Darius is convinced that
the bank will lend them the necessary capital, given the attractiveness of these overseas markets.
The other shareholders are more in favour of a gradual process. They want to improve the position
within the United Kingdom market first rather than leap into the unknown. They also believe that
diversification into other non-bicycle products might be less risky than venturing overseas. They
know the UK market but overseas is an unknown area. Darius has decided that it is time he sought
some professional advice for the company. A management consultant, Molly Dunn, has been
retained. She is a qualified accountant who also has an MBA from a prestigious business school.
Table One: Information concerning Two Wheels' current sales and financial performance
Financial years to 31 March 20X6/20X7 20X7/20X8 20X8/20X9
(estimated)
Mountain bikes
Volume 27,000 24,000 22,000
Direct costs '000 3,780 3,600 3,410
Revenue '000 4,590 4,200 3,850
Standard bicycles
Volume 45,000 40,000 36,000
Direct costs '000 4,050 3,600 3,312
Revenue 4,500 3,800 3,412
Racing bicycles
Volume 14,400 12,800 13,200
Direct costs '000 7,560 7,360 7,986
Revenue 10,080 9,280 9,900
Exercise bicycles
Volume 3,600 3,500 3,450
Direct costs '000 1,062 1,137.5 1,155.75
Revenue '000 1,224 1,277.5 1,259.25
Indirect costs '000:
Distribution 282 290 362
Promotion 484 407 346
Administration and other 1,209 1,234 1,456
Interest on loan 560 560
Profit before tax '000 1,967 369 (166.5)
Requirements
Acting in the role of Molly Dunn:
(a) Write a report, evaluating the current strategies being pursued by Two Wheels for its different
market segments, using appropriate theoretical models to support your analysis.
(b) Identify and explain the key factors which should be taken into consideration before Two
Wheels decides on developing manufacturing/assembly facilities in China.
(c) Write briefing notes to the shareholders, explaining the advantages to the company of
concentrating solely on the production of bicycles and also the opportunities which may be
available by pursuing a strategy of diversification.
Answers to Self-test C
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1 Pamper Products Ltd E
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(a) There have been many attempts to find a methodology to predict corporate decline, or
companies at risk of decline. This interest in the subject means that the main reasons for
corporate decline are heavily documented. There are many reasons why companies fail and in 1
most cases it will be due to a combination of such reasons.
Sales and profitability
Declining profitability is a clear reason for the eventual failure of a company. A decline in
profits is not always accompanied by a decrease in sales volume, but this is often the case. As
sales fall, the same level of fixed costs must be paid from reduced revenue, inevitably reducing
profits. Also, if a company expects increases in sales volume that do not materialise, this will
also cut profits if the company has invested further, in staff, plant and inventories, for
example. An important implication of this for Pamper Products is that a close eye must be
kept on costs of all kinds. The need to seek out low cost suppliers may be of particular
relevance, considering the past policy of only dealing with a few of those available.
Gearing and liquidity
As a company's borrowing increases, so do the costs of servicing loans. This can significantly
increase the risk of the company and in extreme cases if the loans or debentures are not
serviced they could be called in and the company put into liquidation. The Sample brothers
have borrowed extensively, so they should take great care over this. Allied to this problem is
that of a decrease in liquidity. A company can still be profitable but if it cannot pay its debts as
they fall due then eventually it will fail. One particular problem here is where seemingly
growing companies fall foul of overtrading. This occurs when sales are increasing and
therefore, so are inventory-holding costs and payments to suppliers but these costs are not
being matched in cash terms by money received from customers. Pamper Products has
expanded rapidly and has avoided this problem so far, but the brothers must continue to take
care of their cashflow.
Suppliers and customers
A company can appear to be successful, but if it is over-reliant on a few suppliers or customers
then the failure of one of these parties can have a disastrous knock-on effect. If a principal
supplier fails, this will have a major effect on the ability of the company to supply its own
customers. The loss of a major customer means a significant fall in turnover and cashflow. This
calls for close management attention.
Management
So far we have considered largely financial reasons for company failure; however, Argenti
argues that many causes of corporate failure are due to poor management. For example, an
autocratic chief executive, a passive board of directors and a weak finance director is a
common scenario of corporate failure. Finally, there is always the issue of complacency. If a
company is seemingly successful, then senior management may become complacent about
performance, growth and innovation, which will eventually lead to a loss of market share and
declining revenues. The implications for Pamper Products are obvious.
(b) (The balanced scorecard is a useful and popular model, both in the exam and in the real
world. Make sure you have learned and understood the nature of the four perspectives and
expect to have to suggest relevant possible measures for each one.)
A balanced scorecard considers performance indicators for a business within four
perspectives:
The financial perspective
The customer perspective
The internal business perspective
The innovation and learning perspective
While these four categories may be regarded as widely applicable, it is important to
understand that different organisations will require different measures for each if the
approach is to be useful. For example, a woodworking business would almost certainly be
very concerned about the safe use of its machinery: this would hardly be a topic of concern
for most financial service businesses, however.
Product safety is likely to be an important concern for Pamper Products, dealing as it does in
cosmetics.
As David is quite happy with the financial performance measures we will concentrate on the
other three perspectives.
Customer perspective
Performance measures in this area should measure how satisfied the customers are with the
quality of product and level of service provided by the company. Possible performance
measures might include:
Sales returns levels
Percentage of customers who do not return for repeat business
Levels of customer complaints
Internal business perspective
This perspective is concerned with the efficiency of the company's internal systems. Possible
performance measures might include:
Percentage of products returned to suppliers
Percentage of sales of products exclusive to Pamper Products
Labour turnover levels
Total number of suppliers
Innovation and learning perspective
This perspective is concerned with how the business is developing and moving forward, both
in its products and in its methods. Possible performance measures might include:
Time taken to introduce a new product
Percentage of sales revenue generated by products introduced within the last year
Extent of management training undertaken
2 Two Wheels
(a) Report
To: Darius Young, Managing Director
From: Molly Dunn, Management Consultant
Date: x-x-xxxx
Subject: Evaluation of Two Wheels Company strategies
Introduction
This report is designed to consider the different strategies that Two Wheels is following in its
different markets and to evaluate each of these individual strategies given the information
provided for the last two years and the current year's estimated figures.
In overall terms Two Wheels has seen a decline in demand for its products, with demand
expected to fall by 17% from the period 20X6/X7 to 20X8/X9. Revenue is expected to fall by C
9.6% by 20X8/X9. Direct costs are an increasingly large proportion of sales revenue and are H
A
expected to reach 86% of revenue in the current year, a rise of over five percentage points
P
over the period. Together with a dramatic expected increase in indirect costs of 38% over the T
period this has resulted in Two Wheels' profit of 1,967,000 in 20X6/X7 being turned into an E
expected loss of 166,500 by 20X8/X9. This performance is unacceptable. R
Two Wheels has four distinct market sectors racing bicycles, mountain bikes, health clubs
and basic bicycles with distinctly different strategies being followed for each market;
1
therefore I will consider each market in turn.
Background
Two Wheels is a private, family-owned company which is now a national producer of bicycles.
Some of its products are sold under its own brand name whereas others are sold through a
national retail chain under its retail brand name. Over the last few years Two Wheels has seen
its market being eroded with increasing competition from cheaper overseas imports. The
overall UK market for bicycles is in decline and this has been made worse by the high value of
sterling encouraging imports from foreign suppliers. However, during this period Two Wheels
has been able to increase its share of domestic output by accepting lower profit margins in
order to maintain sales. Two Wheels concentrates its efforts solely on the bicycle market and
has a strong reputation for reliable products.
Each individual market that Two Wheels operates in will now be considered in turn in the light
of this background information.
Racing bicycles
Two Wheels has been making racing bicycles for many years and this area currently accounts
for approximately 16% of its volume output and almost 50% of its sales revenue. This is the
only sector of Two Wheels' business where the volume of sales is expected to increase this
year. This sector is by far the most profitable of Two Wheels' market areas, although
anticipated revenue has fallen by 2% over the period considered and direct costs of
production have increased by an expected 5.6%. However, this area still remains profitable
and although the bicycles are expensive to produce, some being custom-made, the
distribution costs in this sector are minimised by the policy of taking direct orders from
amateur cycling clubs. These racing bicycles are marketed under the Two Wheels brand name
and have enhanced its reputation.
Two Wheels appears to have followed a successful strategy of premium pricing in this market
and has differentiated the product by the policy of producing custom-made bicycles. Despite
the cost increases, the margins in this sector are still healthy with clear potential for volume
and revenue growth. Any potential for increasing UK market share in this area or diversifying
into sales of racing bicycles overseas should seriously be considered as this is clearly the most
successful part of the current business.
This area of the business could be described as a cash cow according to the BCG growth-
share matrix as Two Wheels' market share is relatively high and the market is growing slowly.
Mountain bikes
Two Wheels moved into this fashion area in the 1980s producing relatively cheap models and
currently this sector accounts for 30% of Two Wheels' output but only 23% of revenue. The
volume of sales is expected to decline by 19% over the period considered and revenue to
decline by 16%. However, direct costs of production have increased each year and are
anticipated to be 89% of revenue for mountain bikes in the current year. Despite increases in
costs and decreases in revenue this sector remains relatively profitable in relation to other
market sectors of the business.
About 75% of these mountain bike sales are made under the Two Wheels brand name
through specialist bicycle shops. The remaining sales are made through a national retail
chain of bicycle and motor vehicle accessories stores under the retailer's own brand name.
Two Wheels' pricing policy of charging relatively low prices for the mountain bikes is a
strategy of penetration pricing; however, in order for this to be successful, Two Wheels
needs to be able to compete on costs. The increases in direct costs will tend to invalidate this
policy as Two Wheels does not appear to have the production capacity to achieve the
economies of scale necessary to maintain profit margins as sales volumes decline and
cheaper foreign imports pose a threat.
As Two Wheels has been so successful in its premium pricing policy in the racing bike market,
and the majority of the mountain bikes are also marketed under the Two Wheels brand name,
the company should consider moving away from the low price market for mountain bikes.
If the mountain bikes produced are promoted as being of high quality based upon the well-
respected brand name of Two Wheels in the racing bike market, the company may be able to
attract customers prepared to pay a higher price due to the quality of the product.
This area of Two Wheels' business certainly appears to have potential but if changes in both
the stabilisation of costs and marketing and pricing policy are not made it would appear that
profits from this sector will continue to decline.
Exercise bicycles
The health club market for exercise bicycles plays only a small part in Two Wheels' business
currently with only 4% of total volume sales. As this is a niche market it is possible to have a
premium pricing policy; this sector has been consistently profitable over the period,
although margins have reduced to an expected 8% for the current year. Part of the reason for
the fall in profitability is, as with other areas of the business, the escalation of costs which in
the current year represent 92% of the sales value of the exercise bicycles.
This market sector is different from Two Wheels' other areas as it is a diversification into a
different line of business. The exercise bicycles will have some similarities to the other bicycles
manufactured but the market characteristics are very different. Health clubs are a completely
different type of customer from those for the other sectors. Sales volume is expected to show
a slight fall in the current year since Two Wheels do not produce a full range of exercise
equipment, which the market seems to prefer in its suppliers. Therefore, Two Wheels might
consider diversifying into production of other fitness equipment such as running machines
and cross trainers. This market appears to be potentially profitable but currently Two Wheels is
too small a player to take advantage of it in full.
Standard bicycles
The main product of the group, the standard bicycle, accounts for about 50% of the output
volume and is therefore still the core of the business. However, the margins in this area are
the main cause of Two Wheels' overall fall in profitability. Sales volume has decreased by 20%
over the past two years but sales revenue has fallen by even more, at 24%, as a result of
reducing price in an attempt to maintain sales levels in the face of increasing competition
from cheaper overseas imports. In the current year the margin has fallen to 2.9%, from 10%
two years ago. In 20X6/X7 the production cost per bicycle was 90 but this has increased to
92 per bicycle in the current year. In addition to this the selling price has reduced from 100
two years ago to just under 95 currently.
About 80% of these bicycles are supplied to a national retail chain supplying bicycles and
motor accessories and marketed under the chain's own brand name. As Two Wheels is heavily
dependent upon the retail chain it may be that the retailer is forcing prices down using its
buying power.
Two Wheels' strategy in this market appears to have been one of competing on both cost
and price. Unfortunately, it appears not to have worked. Prices are coming down and costs
are rising. This area of the business is now being subsidised by the other more profitable but
smaller markets.
There is no real brand association with the basic bicycles as the majority is sold under the
retailer's brand name. Therefore it might be difficult for Two Wheels to disassociate itself from
the retailer and sell directly, although it may be possible to build on the brand association
from the racing bicycle market. According to the BCG growth-share matrix the basic bicycle
market could be categorised as a dog as the UK market in this area does not appear to be
growing and Two Wheels appear to have a relatively low market share.
If Two Wheels is to improve profitability in this market it must decrease costs, probably move
away from dependence on the retailer and attempt to differentiate its product in some way. C
Withdrawal from this market could be considered although as it is such a significant element H
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of the business this may be a dangerous strategy and should only be considered when all
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other options have been examined. T
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Indirect costs
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A further worrying area of the business is in the escalating indirect costs. Over the two years
there has been a staggering increase of 38% in total indirect costs. Distribution costs are up
by 28% although this may be understandable given the nature of the direct sales of the racing 1
bicycles and exercise bicycles.
Administration costs have also increased by 20% over the last two years which, given the
decrease in sales volumes, appears unusual.
Promotion costs have, however, fallen and this must be rectified if Two Wheels is to
capitalise on its brand name and increase sales volumes.
Loan interest is unavoidable but worryingly high as in the current year interest cover is only
0.70 times, an unsustainable level in the long run.
Conclusion
Two Wheels currently has a wide range of strategies, a premium pricing policy for racing
bicycles and exercise bicycles, and an attempt to be a cost leader at the lower end of the
market with its basic and mountain bikes. Production costs must be brought under control
before any rationalisation of strategies can be considered.
It would appear that Two Wheels' strengths lie in its strong reputation and brand association
in the racing bicycle market. If this can be extended to the mountain bike market and a
premium pricing policy introduced here with market differentiation based upon the quality
of the product, then this could produce significant improvements in the mountain bike
market.
A further potentially successful market is that of the health club equipment if the production
range can be extended. The basic bicycle market could be improved with more control of
direct costs but as the UK market is not expanding and the strategy has been one of cost
leader, which has not succeeded, then it may be necessary to consider withdrawal from this
market.
It would appear that the future of ABC lies with the quality products as Two Wheels does not
appear to have the production capacity to achieve the cost economies necessary for a
successful cost leader strategy at the lower end of the market.
(b) (To some extent our answer is unstructured, addressing salient points in no particular order. If
you prefer a more structured approach, you could use the PESTEL and Porter's Five Forces
concepts to produce something like an environmental analysis. You would have to cover the
same ground, but you may find this approach more fruitful if you are wondering just how to
get started.)
When considering any potential investment many factors must be taken into account but
when considering such a major change in strategy as the managing director is proposing then
there must be a wide ranging review of the key factors.
Operations
Let us first consider the operational aspects of the development of a manufacturing or
assembly facility in China. The proposal is based upon the large demand for bicycles
perceived in the Far East, the cheaper labour which would reduce production costs and the
reduction in transportation costs.
As far as the demand for bicycles is concerned, the view of the market appears to be that of
the managing director and there is no evidence that any market research activities have
been carried out. What type of bicycles is in demand in China and can Two Wheels produce
bicycles that satisfy this demand? If the bicycles required are not the same as those currently
manufactured by Two Wheels there may be significant costs involved in re-design and
changes to the manufacturing processes.
The labour cost aspect must be put into perspective. Labour costs only account for 30% of
the total production cost therefore the cheaper labour would only lead to a maximum
decrease in production costs of 22.5%. The labour issue should be considered further how
does the productivity of bicycle manufacturing employees in China compare to that in the
UK?
If productivity is significantly lower in China then this could wipe out any cost benefit.
The transportation costs of bicycles from the UK to China are obviously significant.
However, if the proposed facility is set up in China instead there are still likely to be significant
transportation costs since China covers a vast area and demand is likely to be spread widely.
This internal transportation cost should not be ignored.
Two Wheels must consider other operational aspects of setting up a manufacturing facility in
China. Can the correct components be purchased at a competitive price and be delivered on
time? What type and amount of marketing expenses will there be? Two Wheels must also
question its ability to run such an operation as it has no experience in even trading with
other countries, let alone setting up a full scale operation in one, particularly one as distant
and unknown as China.
Finance
Two Wheels must also consider financial aspects. The company has very low profit levels
currently and a large debt outstanding. How does it propose to raise the finance necessary
for such a major investment? Would the finance be raised in this country or in China? Are
there opportunities for a UK company to raise major finance in China? Would a joint venture
with a Chinese company be a viable option?
Further financial problems will concern the remittance of funds back to the UK and any
foreign exchange risks that Two Wheels may face. Many countries restrict the amount of
their currency that can be taken out of the country and as Two Wheels is so short of funds it
will clearly require any profits to be remitted back to the UK. Two Wheels should also consider
the foreign exchange risks that are associated with any form of trade with foreign countries. If
the Chinese currency moves against sterling then Two Wheels could be subjected to large
foreign exchange losses.
Risk
Political risk is a further important area that should be considered. How stable is the Chinese
government? What is their attitude to foreign investors, are they encouraged or are there
sanctions which will make operations more difficult and expensive?
Analysis
Many of the key factors involved in this proposal can be addressed through a PESTEL analysis
(social, legal, economic, political and technological aspects). Analysis of social factors will help
to define the market, determine the type of bicycle required and clarify the potential customer
and method of marketing and sale. Legal factors will include dealing with suppliers, contracts
for setting up a factory and employment issues. Economic factors will help to define the
demand structure, inflation rates, interest rates and availability of finance. Political issues will
be of great importance in a country such as China which has large state control. From the
technological viewpoint, particularly if there is a demand for Two Wheels' more high-tech
products, such as the racing bicycle, does the technology exist in China or must it be
exported?
(c) Briefing notes on advantages of concentration on bicycle production or diversification
Advantages of concentrating on bicycle production
Two Wheels has been in the bicycle manufacturing business for many decades and
therefore has the skills and competences necessary to operate in this area. These skills
might not necessarily be easily transferred to other markets such as production of other
fitness equipment.
The fact that Two Wheels specialises in the production of bicycles, albeit of different
types, would argue that the company obtains some economies of scale from just this
type of production. As direct costs are increasing there is some doubt about these
economies of scale but diversification into another field may reduce margins even more.
It could be argued that Two Wheels should stick to its core activities and not be side-
tracked into other areas in which it has limited experience. This will also be of benefit in C
developing value chain relationships. H
A
By remaining within the bicycle industry the Two Wheels brand name can be cultivated. P
Its value in other sectors must be doubted. T
E
Advantages of diversification R
If the bicycle market is in decline or faced with significant competition from cheaper
foreign imports then there may be gains to be made in other markets. 1
Other markets, such as the health and fitness club market, may offer higher gains than
the bicycle market although the risks may also be greater because of factors such as
changes in technology.
If Two Wheels were to diversify, this would reduce the risk of becoming involved in an
individual market area that may decline and would give the company greater flexibility
to deal with changes in fashion and technology.
It is possible that Two Wheels could use its current distribution networks in order to
market a different range of products.
New products may have greater potential to provide technological or commercial
advantages to the company.
Conclusion
The theory behind diversification for large companies is that there is no need for a company
to do this simply to reduce the risk of just being in one industry as the shareholders are quite
capable of doing this on their own behalf by owning a portfolio of shares. However, for a
private family-owned company that is experiencing problems with profitability, a move into a
new area is enticing. For Two Wheels, given its core expertise, diversification should only be
considered if it is believed that there are no future gains to be made from its current markets
and that moves into non-core areas are likely to be successful.
Answer to Interactive question 1

(a) Here are some ideas. Barriers to entry are high. There are plenty of substitute products (coffee),
competitive rivalry is high because of the difficulty of stockpiling products. Customer bargaining
power is high, but supplier power is low: all it needs is capital, the right sort of land and labour.
(b) One possible strategy would be to 'get in touch with the consumer' directly. Rather than selling
tea at auction, which means that the product is not differentiated from those of all the other tea-
growers, this particular tea-grower could market directly to the consumer. One way of doing this
could be the use of a mail order system, offering specialist teas delivered directly to the consumer.
The service could be advertised in magazines initially those with a moderate distribution aimed at
the type of customer who is likely to purchase specialist teas (for example, magazines sent out to
premier credit card customers). The tea grower should not be too ambitious with this new project
too early, given the need to set up reliable ordering and distribution systems, but should also
maintain its practice of selling some of his tea at auction. This should guarantee a minimum
income whilst the new venture is being developed. In an industry with vast over-supply, tea
growers must increasingly focus on how to make their product more attractive to the market. An
excellent strategy for doing this is to appeal directly to the consumers themselves.

(a) LBG should gather as much information as possible about its competitors, as both new and
existing competitors are one of the main elements in its immediate task environment. A formal
process of information gathering and analysis provides the best route to thorough coverage
without unnecessary duplication, as such a process can be designed to address specific objectives.
Reliance on information gathered on an opportunistic basis is unwise, as there is no guarantee that
LBG will obtain the specific information it requires.
The fact that a formal approach to competitor analysis should make LBG more knowledgeable
about who its competitors are and what they are doing can only be advantageous. The philosophy
that 'knowledge is power' certainly applies here. In a maturing industry, it is essential that LBG
knows who and what pose potential threats to its current position it is only through this
knowledge that LBG will be able to take steps to counteract these threats. As the profitability of a
firm is influenced by the competitive environment, it is only through understanding this
environment that LBG can hope to continue its success.
The knowledge gained from conducting a formal competitive analysis will allow LBG to adjust its
strategy to meet the challenges posed by competitors' behaviour. If, for example, competitors are
attempting to reduce margins to attract customers, LBG would have to decide whether competing
on price is a strategy it would like to pursue, or whether it would prefer to maintain its reputation
for quality, premium products. Even if it decides to maintain its current strategy, it is important that
LBG knows what its competitors are doing in order to gauge the threats and potential
opportunities that may arise from their behaviour.
(b) The first stage in the competitor analysis process is the identification of who the main competitors
are. LBG should be careful here as it is operating in a specialised niche market. Although there are
many manufacturers of branded cosmetics, many of these will be aimed at the high street
customer. As LBG manufactures specifically for the theatre and movie industry, it should focus only
on those firms that produce similar products aimed at the same market.
Once LBG has established who its main competitors are, it should focus on competitors' goals, such
as financial goals, attitude to risk and whether managerial beliefs affect their companies' goals. Are
competitors more interested in quantity rather than quality? Are their managers more intent on
them being renowned for low price rather than premium products? The use of a model such as
Porter's five forces might be useful here. Different firms in the same industry will have different
strategies, therefore it is important to establish how sophisticated competitors' strategies are and
hence how much threat they are likely to pose.
If possible, LBG should try to establish the aims and objectives of its competitors. Many cosmetics
companies market to various sectors, such as the high street, catwalk, theatre and movie industries. C
What is important for LBG to establish is the relative importance of the movie and theatre industry H
A
markets to their competitors. Are they just a sideline, in which case the products may be subsidised
P
by the more profitable main product lines, or are they the main focus of the business? T
E
Establishing competitors' assumptions about the industry is essential as this will play a large part in
R
determining their future activity. For example, a competitor that strongly believed that the industry
was reaching over capacity might consider leaving the industry altogether. This is linked to the
relative importance of the industry to competitors' overall strategy. If movie and theatre cosmetics
1
are only a sideline, the competitor may be more inclined to 'walk away' and concentrate its
resources elsewhere. As such assumptions exist mainly in the heads of senior managers, it may be
difficult to obtain, and LBG may have to rely on opportunistic behaviour to gather details.
In a specialist industry such as the one that LBG operates in, competitive advantage depends
largely on the possession of unique competences and assets. Establishing the extent to which
competitors have these is the next stage in the investigation. In the movie and theatre cosmetics
industry, the use of new technologies to develop and bring new and improved products to market
is particularly important. The ability to work closely with companies responsible for new cinematic
techniques is also essential, to allow knowledge-building of how new techniques can affect the
effectiveness of the cosmetics.
Once LBG has gathered the information above, it should be able to begin the process of predicting
how competitors might behave in a range of possible future circumstances, including changes
brought about by LBG's own potential future strategies. What should be borne in mind is that
competitor analysis is not a 'once and for all' process it is a continuous activity that is essential to
the future prosperity of LBG.

In our answer to part (a) we have referred to product development in connection with the Ansoff
matrix. Part (b) calls for application of the five competitive forces, and the question even tells you it is
Porter's model in case you need a memory jogger! The numerical analysis in part (c) points you in the
direction of contribution per limiting factor. Our answer includes a reference to the importance of
inventory turnover in the analysis. You should have few difficulties in applying the marketing mix for
part (c)(ii). Part (d) requires a discussion of the practical issues surrounding strategic alliances. This does
not necessarily call for an assessment of the advantages and disadvantages of such alliances, although
an analysis along these lines may have been appropriate and would have earned marks if it clearly
addressed practical issues.
(a) Product development and market threat
(i) Growth. A successful business must develop its products and manufacturing methods on a
regular basis if it is to maintain market share. This calls for strategic decisions on the part of
WG plc. Its stated objectives include to develop innovative medicines and services, which it
can only do by investing in development.
(ii) Competition. Product development has the advantage that it forces competitors to innovate
and discourages newcomers with significant barriers to entry. If WG's existing products were
to fall in price and it did not have new products (such as Coffstop) to fall back on, its
profitability would suffer. The expiry of patents and the opening up of a product and its
market to competitors also highlights the danger of lack of innovation. Sales from previously
central products will fall. In the case of WG, a product which previously accounted for nearly
half its revenue is expected to contribute only 10% in future.
(iii) Innovation. Failure to invest in research and development in such an innovative and dynamic
sector is therefore of paramount importance. Nobody expects scientific or medical research
to stand still while there are still diseases that need cures, or where existing cures are being
resisted by new strains. A company that rests on its laurels, enjoys high profitability and seems
to give little back will at the very least suffer a grave image problem.
(iv) Shareholders in a pharmaceutical company should expect to see investment in research and
development, but will also want to see more immediate profitability. The decision about the
relative size of investment and payments for shareholders each year is a trade-off that the
directors will have to make, when balancing long and short-term performance issues.
WG does have significant production facilities, with much of its research being sponsored. The
investment in research into malaria treatments has paid off, in that the company is able to
donate supplies of the medicine to overseas areas. This will do a great deal to enhance WG's
reputation worldwide.
(v) Cash flows contributed by the products in WG's portfolio can be illustrated using the Boston
Consulting Group Growth Share Matrix. This model demonstrates that, depending upon a
product's individual life cycle, that product will go through stages of cash generating ability.
Staple products are known as 'cash cows' they have a high market share in a stable market,
and can provide the cash resources to invest in the development of 'stars', which are those
products which achieve a high market share in a high growth market. Coffstop may have the
potential to become a star, and WG must make sure that there are others in the pipeline.
For the reasons outlined above, investment is crucial in maintaining market share and the
appropriate resources must be allocated. The expense and the risks associated with
significant investment in research and development must, however, be taken into account. It
may take several years for the benefits of investment to be felt on sales and profits, so the
products chosen for development must be carefully selected.
(b) Conflicting objectives and the Five Forces
This part of the question was concerned with application of Porter's Five Forces model, so a straight
repetition of the model is not enough. You need to consider which of the forces are most
applicable to the company and their effect on objectives.
The twin aims of sustained profitability through development of innovative medicines, and the
elimination of disease, are contradictory when taken to the logical extreme. If all disease was
eradicated, then WG would have no market in the long term.
The overall corporate mission aims to reflect a short-term responsibility to shareholders, as well as
recognition of wider social responsibility. Investment in developing markets overseas, such as the
donation of the malaria treatment, will impact on profits. Public and government challenges to
high levels of profitability reflect the fact that WG is expected to contribute to furthering
knowledge, perhaps via collaboration with universities or research institutes. This will reduce WG's
profitability while new products and markets are developed, but it will be aware of the latest
developments and should be able to capitalise on them in the future.
Porter's model of the five competitive forces shows those factors which collectively determine the
potential of the industry as a whole. Some industries have bigger profit potential than others. The
pharmaceutical industry is one such profitable sector, because competition is relatively restricted
by the significant levels of research and development that are required.
Competitive forces and their applicability to WG's objectives
(i) Threat of new entrants. This is not a significant threat for WG. It is the product of a merger
and enjoys significant economies of scale that a competitor is unlikely to be able to match.
Manufacturing and research facilities operated by WG are amongst the largest in the industry
and its distribution network is global. A new entrant would have to build up a large market
share very quickly to be able to sustain its cost structure and hence profitability. World class
pharmaceutical manufacturers are few in number.
WG has built up a good reputation for its products and is likely to have strong customer
loyalty. Its brands may crowd out the opposition, and patent rights give it breathing space
to develop further products, as discussed above in part (a). Access to sources of raw materials
on favourable terms may include a long-term, low-price supply contract.
(ii) Bargaining power of customers. Customers usually want better quality products at the
lowest possible price. If they are successful in getting this, WG's profitability will be affected.
It has to concentrate its efforts on creating a strong brand image so that customers are not
tempted to shop around, especially when patent restrictions are lifted. The price awareness
of customers will vary. When product quality is important to the customer, as it is likely to be
in the market for medicines, the customer is likely to be less price sensitive and so WG will be
more profitable. C
H
Customer demand for long running profitable products may divert production resources from A
developing more innovative products, but if such long running products are 'cash cows' they P
may also be able to contribute towards development of disease-eradicating 'stars'. T
E
(iii) Bargaining power of suppliers. WG can access supplies on a global basis and is therefore R
unlikely to be controlled by an individual supplier. A supplier is unlikely to be able to demand
higher prices from WG. This depends on factors such as the technical specification of the
products being supplied, and how important a particular supplier's products are for WG. 1
Where there are just one or two dominant suppliers, they may be able to charge monopoly
prices.
The development of innovative products and working towards the eradication of disease does
depend very strongly upon an adequate supply of technical specialists and expertise.
Research scientists are likely to be able to exert some bargaining power over WG when
negotiating salaries. The few world-class companies will be competing for the best human
resources, which could be limited in supply.
(iv) Existing levels of competition. There are only a few players in WG's market. Competitor
activity usually means price competition, advertising battles, sales promotion campaigns,
new products, improved levels of service and provision of guarantees or warranties.
Competition can help an industry to expand by stimulating demand.
The level of competition found in the pharmaceutical industry is likely to be less intense than
that found in other sectors, and firms will try to avoid competing on price. Competition is
likely to be centred on innovation and research activities, as has already been discussed. This
keeps WG ahead of the competition and moves it further towards the eventual eradication of
disease.
(v) Substitute products. These are unlikely to come from another industry, but will arise when
patents run out and competitors can start making their own version of a successful product.
Again, the vital importance of research and development must be stressed.
(c) CVP and DPP analysis
(i) The calculations in this part of the question are very simple, but do not confuse CVP and DPP.
(1) Retail pharmacists prefer Peffstill because they calculate that it achieves a 2.60
contribution compared to 1.00 for Coffstop. This analysis ignored the fact that Peffstill
comes in a bigger bottle and so takes up more shelf space. Cost volume profit analysis
demonstrates the contribution achievable with regard to the limiting factor (retailers'
shelf space) as follows.
Peffstill Coffstop

Selling price 10.00 1.50
Cost per bottle for retailer 7.40 0.50
Contribution per bottle 2.60 1.00
Sq cms shelf space per bottle 60 18
Contribution per sq cm in pence 4.33 5.56
Coffstop generates the most contribution per unit of limiting factor for the retailer.
A retailer who stocks both products should give as much space to Coffstop as possible.
Coffstop also sells more per week on average.
(2) Applying direct product profitability to weekly sales, thereby taking all costs into
account:
Peffstill Coffstop

Contribution per bottle as above 2.60 1.00
Holding costs 0.80 0.40
Net contribution per bottle 1.80 0.60
Contribution % of sales price 18% 40%
Shelf area required per week 60 sq cm 20 18 sq cm 120 bottles
bottles
= 1,200 sq cm 2,160 sq cm
The total weekly contribution 36.00 72.00
Per unit of shelf area 3.00p 3.33p
This analysis gives the same result for the retailer as cost volume profit analysis, indicating
that Coffstop should still be the preferred product of the retailers. The shelf area required
per week is the minimum that should be allocated to each product by reference to
average sales.
It should be noted that inventory turnover is also a relevant consideration WG plc
may offer to replenish the retailer's shelves twice a week, thereby halving the amount of
space needed to support the same sales volume. This will increase the amount of
contribution per scarce resource.
(ii) The marketing strategy of Coffstop can be planned with reference to the marketing mix.
Product
Medical research and opinion has shown that Coffstop is the more effective product, and
therefore brings a better 'package of benefits' for the customer. WG plc has a strong
reputation with a wide portfolio of products, which Coffstop should be linked with in the
customer's perception.
Price
Coffstop is cheaper per bottle, which will encourage customers to purchase it, if only on a trial
basis. The customer must have six times as much dosage of Coffstop as Peffstill, making the
comparable prices 9 and 10 respectively. Therefore, on price Coffstop has an advantage.
Peffstill may respond by dropping its price, or promoting the convenience of having to buy
only one bottle, but customers have come to expect discounts for buying in bulk. The fact
that Coffstop is cheaper as well as being a better product than Peffstill would appear to give it
a significant advantage.
Place
Retailers may decide to stock Coffstop instead of Peffstill, or at least reduce their stocks of
Peffstill while Coffstop is introduced to the customers.
Both drugs are available over the counter from pharmacies and so it is possible to start selling
Coffstop through supermarkets, who sell cough medicines (assuming that Coffstop is a cough
medicine the scenario is not specific) and often have their own in-house pharmacies. This
will enable WG to reach an even larger market.
Promotion
The promotion campaign should highlight price and product benefits. Television advertising
for cough and cold medicines is common, often on a seasonal basis, so this may be an
appropriate product launch medium. Radio advertising, coupons, and free trial sizes are all
possible promotional activities. Giving medicines away to the general public may be frowned
upon, especially if Coffstop should be carefully administered, but free trial packs could be a
suitable promotional tool when introducing the product to doctors.
Literature and posters detailing Coffstop's benefits could be distributed to doctors' surgeries
and pharmacies. Making the packaging attractive while containing the expected safety
features (child-proof caps, for example) will be a task for WG's marketing or design
department.
(d) Strategic alliances
C
(i) Efficiency. WG is the product of a merger, which has enabled it to achieve economies of H
scale. Without going so far as another merger or takeover, a strategic alliance may offer A
benefits to WG, for example in the value chain. WG's expertise in production and research P
may be supplemented by the other's marketing and distribution facility. Complementary T
E
competences can be exploited to mutual advantage.
R
(ii) Knowledge. Alliances can also be a learning exercise for each partner. An alliance with a
university would provide a good example, with WG taking on trainees or work experience
placements from the science faculties. New technology offers many uncertainties as well as 1
opportunities, so the funding of expensive research via an alliance can spread the risks.
(iii) Goal congruence. Practical considerations include potential conflicts of interest between the
parties. Disagreements may arise over profit shares, resources invested, management issues
(including project management and resource management), products to be developed and
marketing strategy. The alliance must be entered into on a contractual basis so that each
party is clear about its rights and responsibilities.
(iv) Reputation. Regulatory bodies may be concerned that a strategic alliance between dominant
market players could be anti-competitive, and the venture may be subject to investigation
before it is allowed to go ahead. The parties to the alliance must make sure that they have
fully researched the implications of their venture for the industry to be able to present their
case favourably to the regulator.
(v) Partnership. Resource investment includes consideration of share of expenses and tangibles
such as capital contribution, but also intangibles such as expertise. Joint ownership of patents
for products that are developed by an alliance could be fertile ground for arguments about
fair share of returns, unless the agreement is carefully and thoroughly worded. Such alliances
may therefore involve significant legal bills.
(vi) People. Management issues also involve staff considerations. Staff loyalty may be tested, and
confidentiality of individual business processes may be threatened. It may take a while for
trust to be built up, but the benefits of such an alliance are likely to make the practical
considerations a hurdle worth clearing.
CHAPTER 2
Business risk management
Introduction
Topic List
1 A review of risk management issues
2 Enterprise risk management
3 Risk management and control systems
4 The risk management process
5 Establishing the context
6 Risk identification
7 Risk assessment
8 Risk profiling
9 Risk quantification and consolidation
10 Risk responses
11 Implementation of plans
12 Risk monitoring and control
71
Introduction
Demonstrate a detailed understanding and application of risk assessment issues
Demonstrate a detailed understanding and application of the various steps involved in

constructing a risk management plan, including establishing context, identifying risk and the
assessment and quantification of risk
Demonstrate a detailed understanding of the limitations of risk management
Demonstrate a detailed understanding of enterprise risk management, its framework and its
benefits
1 A review of risk management issues
Section overview
Risk, and internal management's attitude towards it, has a considerable bearing on the way in
which different organisations conduct their business that is, their business strategy.
The risk of an organisation, whether genuine or perceived, has a direct effect on a firm's cost of
capital, the rates of interest it pays on its loans, and therefore the types of projects it can pursue.
This section reviews the risk management issues that were covered in the Business Strategy paper
at the Professional stage.
C
H
1.1 Risk and uncertainty A
P
Risk and uncertainty must always be taken into account in strategic planning. Many areas of risk and T
uncertainty are exogenous that is, outside the control of the organisation. E
R
1.1.1 Risk
Risk is sometimes used to describe situations where outcomes are not known, but their probabilities can 2
be estimated. (This is the underlying principle behind insurance.)
1.1.2 Uncertainty
Uncertainty is present when the outcome cannot be predicted or assigned probabilities. For example,
many insurance companies exclude 'war damage, riots and civil commotion' from their insurance cover.
1.2 Risk and managers

It is worth noting that shareholders and managers have different approaches to risk.
Shareholders can spread risk over a number of investments.
Managers' careers tend to be bound up with the success or failure of one particular company, so
managers are therefore likely to be more risk averse than shareholders might be.
1.3 Risk appetite

Because risk management is bound up with strategy, how organisations deal with risk will not only be
determined by events and the information available about events, but also management perceptions
or appetite to take risk. These factors will also influence risk culture, the values and practices that
influence how an organisation deals with risk in its day-to-day operations.
1.3.1 Personal views

Surveys suggest that managers acknowledge the emotional satisfaction from successful risk-taking,
although this is unlikely to be the most important influence on appetite.
1.3.2 Response to shareholder demand

Shareholders demand a level of return that is consistent with taking a certain level of risk. Managers will
respond to these expectations by viewing risk-taking as a key part of decision-making.
1.3.3 Organisational influences

Organisational influences may be important, and these are not necessarily just a response to shareholder
concerns. Organisational attitudes may be influenced by significant losses in the past, changes in
regulation and best practice, or even changing views of the benefits risk management can bring.
Business risk management 73

1.3.4 National influences
There is some evidence that national culture influences attitudes towards risk and uncertainty. Surveys
suggest that attitudes to risk vary nationally according to how much people are shielded from the
consequences of adverse events.
1.3.5 Cultural influences

Adams argued that there are four viewpoints that are key determinants in how risks are viewed.
Viewpoints Features
Fatalists Think they have no control over their own lives and hence risk management is
pointless.
Hierarchists Most likely to exist in a bureaucratic organisation, with formal structures and
procedures. Will emphasise risk reduction through formal risk management
procedures.
Individualists Seek to control their environment rather than let their environment control them.
Often found in small, single-person dominated organisations with less formal
structures, and hence risk management too will be informal, if indeed it is considered
at all.
Egalitarians Loyal to groups but have little respect for procedures. Often found in charities and
public sector, non-profit making activities, prefer sharing risks as widely as possible,
or transfer of risks to those best able to bear them.
1.4 Risk aversion and risk toleration

Aversion and seeking are two different attitudes towards risk.
Aversion focuses on the risk level. An organisation should not undertake an activity if it results in
higher risk, unless the higher level of return that compensates for the risk is acceptable.
Seeking focuses on the return level. An activity should be undertaken if it results in higher returns,
even if the resulting risk level is also higher.
1.5 Conformance and performance

The International Federation of Accountants (IFAC) has highlighted two aspects of risk management
which can be seen as linking in with risk aversion and risk seeking.
(a) Conformance focuses on controlling pure (only downside) strategic risks. It highlights compliance
with laws and regulations, best practice governance codes, fiduciary responsibilities, accountability
and the provision of assurance to stakeholders in general. It also includes ensuring the effectiveness
of the risk analysis, management and reporting processes and that the organisation is working
effectively and efficiently to achieve its goals.
(b) Performance focuses on taking advantage of opportunities to increase overall returns within a
business. It includes policies and procedures that focus on alignment of opportunities and risks,
strategy, value creation and resource utilisation, and guides an organisation's decision-making.
IFAC guidance states that risk management should seek to reconcile performance and conformance
the two enhance each other. Case studies and surveys commissioned by IFAC have shown that many
people believe that organisations focus too much on compliance, and not enough on strategy and
building a business. IFAC's 2004 report Enterprise Governance; Getting the balance right showed that
though compliance is necessary to avoid failure, it cannot ensure success.
Interactive question 1: Nature and extent of risks [Difficulty level: Intermediate]
In the context of a major confectionery and non-alcoholic beverage company identify the nature and
potential extent of six risks that the company might face. (These risks should be specific to the industry
in question.)
1.6 Sources of risk

Sources of risk are dealt with in detail in Chapter 4 Investment appraisal, in the context of international
investment for example, political and cultural risks, and translation, transaction and economic C
exposure. Chapter 7 Financial engineering covers risks that arise due to changes in interest rates and H
foreign exchange rates, and steps that can be taken to reduce the risks. A
P
T
1.6.1 Sources of risk and uncertainty E
R
Risk Comment
Physical Earthquakes, fire, flooding, equipment breakdown. In the long term, 2

climatic changes: global warming, drought (relevant to water firms).
Economic Assumptions about the economic environment may be incorrect. Not

even the government forecasts are correct.
Business Lowering of entry barriers (eg new technology); changes in

customer/supplier industries leading to changed relative power; new
competitors and factors internal to the firm (eg culture);
management misunderstanding of core competences; volatile cash
flows; uncertain returns; changed investor perceptions increasing the
required rate of return.
Product life cycle Different risks exist at different stages of the life cycle.
Political Nationalisation, sanctions, civil war, political instability all of these

can have an impact on the business.
Financial Can be affected by changes in interest rates, economic climate,

gearing, bad debt risk, liquidity, insolvency.
Case example: GlaxoSmithKline disclosure of key risks

In its 2012 annual report, GlaxoSmithKline (GSK) one of the world's largest pharmaceutical companies
identified a number of key risks that may have a significant impact on business performance and
ultimately the value of shareholders' investment in the company.
'There are risks and uncertainties relevant to the Group's business, financial condition and results of
operations that may affect the Group's performance and ability to achieve its objectives. The factors
below are among those that the Group believes could cause its actual results to differ materially from
expected and historical results:
Risk that R & D will not deliver commercially successful new products.
Risks of failing to secure and protect intellectual property rights, including failure to obtain effective
intellectual property protection and expiry of intellectual property rights protection.

Risk to patient or consumer as a result of the failure by GSK, its contractors or suppliers to comply
with good manufacturing practice regulations in commercial manufacturing or through inadequate
governance of quality through product development.
Risk of interruption of product supply.
Risk that the Group may fail to secure adequate pricing/reimbursement for its products or existing
regimes of pricing laws and regulations become more unfavourable.
Risks arising from non-compliance with laws and regulations affecting the Group.
Risk of exposure to various external political and economic conditions, as well as natural disasters,
that may impact the Group's performance and ability to achieve its objectives.
Risks from alliances and acquisitions, including risk of assuming significant debt, becoming subject
to unknown or contingent liabilities, failing to realise expected benefits and problems with
integration.
Risk associated with financial reporting and disclosure and changes to financial reporting standards,
including having to account for changes in market valuation of certain financial instruments before
gains/losses are realised and volatility from deferred tax on inter-company inventory.
Risk that as the Group's business models change over time, the Group's existing tax policies and
operating models will no longer be appropriate, or that significant losses arise from treasury
investments.
Risk of failing to create a corporate environment opposed to corruption or failing to instil business
practices that prevent corruption and comply with anti-corruption legislation.
Risk of substantial adverse outcomes of litigation and government investigations. Key areas of
concern include product liability, anti-trust and sales and marketing litigation.
Risk of ineffectively managing environment, health, safety and sustainability objectives and
requirements.
Risk from Group's sales of products to a small number of wholesalers (large exposure to credit
risks).
Risk of exposing business critical or sensitive data due to inadequate data governance or
information systems security.
Later in this chapter we shall examine the ways in which GlaxoSmithKline manages these risks.
1.7 Business risk and financial risk

1.7.1 Business risk
Business risk, as the name suggests, is the risk associated with the day-to-day operations of a particular
company. It relates to the variability of operating cash flows, the company's exposure to markets,
competitors, exchange rates and so on. It is part of the company's overall systematic (or undiversifiable)
risk and can be divided into:
Strategic risk
Operational risk
Hazard risk
Case example: Clinton Cards
Strategic risks are risks that relate to the fundamental decisions that the directors take about the future
of the organisation. These can include adopting the wrong strategy at the wrong time or failing to
adopt the right strategy quickly enough.
In May 2012 Clinton Cards, the high street chain specialising in greeting cards, was forced to go into
administration. Although aggressive tactics by its principal supplier, American Greetings, precipitated its
failure, it was also a consequence of the increasing pressure that Clinton had come under from
supermarkets and on-line retailers, such as Funky Pigeon and Moonpig, that sell personalised on-line
greetings cards.
At one stage Clinton owned 1,145 shops and controlled 25% of the greetings card market. However it
rapidly declined from a pre-tax profit of 24.1m in 2009 to a loss of 10.6m in 2011. Clinton failed to
adapt quickly enough to the demand for e-cards, relying for too long on the belief that most people
preferred sending and receiving real cards in the post. By the time it launched its own e-card business, it
was up against firmly established rivals such as Moonpig. Clinton also relied on a large high street
presence, reinforcing it by buying up high street rival, Birthdays. Its logic was that cards were a
secondary purchase and it therefore had to be where shoppers went. Again however it failed to realise
the implications of increased online shopping early enough and kept expanding for too long. The result
was a 80m a year rental bill.
Nevertheless there still appeared to be some life in the model Clinton followed. Ironically a subsidiary of
C
American Greetings acquired the brand, assets and about half the stores that were still open in June H
2012. A
P
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1.7.2 Financial risk R
Financial risk can be seen from different points of view:

2
The company as a whole. If a company borrows excessively, it may have insufficient funds to
meet interest and capital repayments, which may eventually force it into liquidation.
Lenders. If a company to whom money has been lent goes into liquidation, the lenders may not
be paid in full. Companies considered to be a risky investment will be charged higher rates of
interest to compensate lenders for the possibility of default.
Ordinary shareholders. This group is at the bottom of the list for payment in the event of a
company winding up. The lower the profits, and the higher the level of gearing, the greater the
risk that is faced by ordinary shareholders.
1.7.3 Relationship between business and financial risk

Business risk is borne by both the firm's equity holders and providers of debt, as it is the risk associated
with investing in the firm in whatever capacity. The only way that either party can get rid of the
business risk is to withdraw its investment in the firm.
Financial risk, on the other hand, is borne entirely by equity holders. This is due to the fact that payment
to debt holders (ie interest) takes precedence over dividends to shareholders. The more debt there is in
the firm's capital structure, the greater the financial risk to equity holders as the increased interest
burden coming out of earnings reduces the likelihood that there will be sufficient funds remaining from
which to pay a dividend. Debt holders do not bear financial risk, as they know there is a legal obligation
on the firm to meet their interest commitments.
Case example: Thomas Cook

A key risk highlighted in Thomas Cook's 2011 annual report was a reduction in demand for products
and services due to the downturn in the global economy. Thomas Cook combated this risk by using a
flexible and asset-light business model. Its features included aircraft operating leases with staggered
maturity profiles, minimisation of committed hotel capacity, being able to make changes in capacity late
in the booking season and tight cost discipline.
1.8 Continuous v event risk

Continuous risk as the name suggests is risk that companies face all the time, simply by virtue of being
in business. Multinationals, for example, face the continuous risk of foreign currencies moving in the
wrong direction and the political risks of operating in different countries. These risks must be
continuously monitored as part of the company's general risk management policy.

Event risk is the risk of suffering excessive financial losses due to severe and sudden shocks arising from,
for example, human error, natural disasters or stock market crashes. Event risks are difficult to predict
but once these events have happened there will be inevitable consequences, such as liquidity problems.
Event risk is often characterised by contagion that is, one event can precipitate other events whose
effects spread across markets and end up affecting everyone. Companies can prepare for event risk by
carrying out regular stress testing, which involves generating credible worst-case scenarios that show
how particular events could affect all relevant markets. It is essential for companies to have crisis
management processes in place, covering such crucial areas as communication and leadership.
Case example: Texas fertiliser plant disaster

An explosion and fire at a Texas fertiliser plant killed 15 people and injured at least 160 in what
appeared to be the worst US industrial disaster since the 2010 Upper Big Branch mine accident in West
Virginia.
A fire tore through the facility, sparking an explosion that destroyed dozens of homes in the 2,700-
person town of West, 80 miles south of Dallas and 20 miles north of Waco, late on Wednesday.
West Fertilizer is an anhydrous ammonia facility, a spokesman for the Texas Department of Public Safety
said. The gas is used to make nitrogen fertiliser, which is applied by farmers directly to the soil to boost
crop yields.
The plant, owned by Adair Grain which is also based in the town of West, was fined $2,300 by the
Environmental Protection Agency (EPA) in 2006 for failing to have a risk management plan that met
federal standards, records show.
According to the EPA website a risk management plan "includes an executive summary, registration
information, off-site consequence analysis, five-year accident history, prevention program and
emergency response program."
In a statement about the incident, President Barack Obama said: "A tight-knit community has been
shaken, and good, hard-working people have lost their lives."
Source: FT.com, April 18, 2013
Case example: The global credit crunch

A credit crunch is a crisis caused by banks being too nervous to lend money to customers or to each
other. When they do lend, they will charge higher rates of interest to cover their risk.
One of the first obvious high-profile casualties of the recent global credit crisis was New Century
Financial the second largest sub-prime lender in the United States which filed for Chapter 11
bankruptcy in early 2007. By August 2007, credit turmoil had hit financial markets across the world.
In September 2007 in the UK, Northern Rock applied to the Bank of England for emergency funding
after struggling to raise cash. This led to Northern Rock savers rushing to empty their accounts as shares
in the bank plummeted. In February 2008 the UK Chancellor of the Exchequer, Alistair Darling,
announced that Northern Rock was to be nationalised.
Years of lax lending on the part of the financial institutions inflated a huge debt bubble as people
borrowed cheap money and ploughed it into property. Lenders were quite free with their funds
particularly in the US where billions of dollars of 'Ninja' mortgages (no income, no job or assets) were
sold to people with weak credit ratings (sub-prime borrowers). The idea was that if these sub-prime
borrowers had trouble with repayments, rising house prices would allow them to remortgage their
property. This was a good idea when US Central Bank interest rates were low but such a situation
could not last. In June 2004, following an interest rate low of 1%, rates in the US started to climb and
house prices fell in response. Borrowers began to default on mortgage payments and the seeds of a
global financial crisis were sown.
The global crisis stemmed from the way in which debt was sold on to investors. The US banking sector
packaged sub-prime home loans into mortgage-backed securities known as collateralised debt
obligations (CDOs). These were sold on to hedge funds and investment banks that saw them as a
good way of generating high returns. However when borrowers started to default on their loans, the
value of these investments plummeted, leading to huge losses by banks on a global scale.
In the UK, many banks had invested large sums of money in sub-prime backed investments and have
had to write off billions of pounds in losses. On 22 April 2008, the day after the Bank of England
unveiled a 50 billion bailout scheme to aid banks and ease the mortgage market, Royal Bank of
Scotland (RBS) admitted that loan losses hit 1.25 billion in just six weeks. In August 2008, RBS
reported a pre-tax loss of 691 million (after writing down 5.9 billion on investments hit by the credit
crunch) one of the biggest losses in UK corporate history. At the beginning of 2009, RBS announced
that it expected to suffer a loss of up to 28 billion as a result of the credit crunch. On 3 March 2008, it
was reported that HSBC was writing off sub-prime loans at the rate of $51 million per day.
A number of critics went back to basics and highlighted lending by banks to customers who could not
supply sufficient assurance that they could repay debt. To quote Paul Moore, former Head of Group
C
Regulatory Risk at HBOS: H
A
'There must have been a very high risk if you lend money to people who have no jobs, no provable
P
income and no assets. If you lend that money to buy an asset which is worth the same or even less than T
the amount of the loan and secure that loan on the value of that asset purchased, and then assume that E
asset will always continue to rise in value, you must be pretty much close to delusional.' R
Some critics have focused on the doubtful quality of the CDOs and other investments. These products
appear to have been imperfectly understood by many in the financial sector. However they created
2
positions in the trading books of banks that were hugely vulnerable to shifts in confidence and liquidity.
Others have focused on the increasing complexity in the financial sector caused by the variety of the
securities sold. The 2009 Turner review highlighted a complex chain of relationships between multiple
institutions. However the results were that 'most of the risks (were still left) somewhere on the balance
sheets of banks but in a much more complex and less transparent fashion.' Turner also highlighted the
growth of the relative size of the financial sector, accompanied by very high growth in the debt and
leverage of financial institutions, which increased the impact of financial sector instability on the real
economy.
Other experts highlighted the role of governance. The 2009 Walker report commented that 'why
different banks operating in the same geography, in the same financial and market environment and
under the same regulatory arrangements generated such massively different outcomes can only be fully
explained in terms of differences in the way they were run.'
In June 2010 the Independent Commission on Banking in the UK (the Vickers Commission, chaired by
economist Sir John Vickers) was set up by the incoming Coalition government. It produced its final
report in September 2011. The report recommended that UK banks' domestic retail operations
(operations concerned with customer deposits, business lending and the transmission of money) should
be ring-fenced from their wholesale and investment operations. Retail banking activities should be
carried out by separate subsidiaries within banking groups, with the ring-fenced part of the bank having
its own board and being legally and operationally separate from the parent bank. Ring-fenced banks
should have a capital cushion of up to 20%.
Non-retail parts of banking groups should be allowed to fail. The report anticipated that this would
mean that their cost of capital went up. However the lack of guaranteed government support for
investment activities should mean that banks were less likely to take excessive risks in this area.
Banks were given until 2019 to implement these requirements fully, a period felt by some
commentators to be very lengthy. The time period was set to coincide with the international capital
requirements changes being introduced by the Basel regulators.
1.9 Managing risk in business strategy and financial strategy

Traditionally, management teams tend to be risk-averse that is, they prefer less risk and are prepared
to take steps to reduce any potential risks arising from either being in business in general or from
specific projects that the company undertakes. The objective of risk management is ultimately to have
procedures in place that will reduce these risks to a level that is acceptable to the company and its
shareholders. However, setting up and maintaining these procedures takes time, money and human
resources, all of which are limited within any organisation.

Case example: Tesco
Tesco has the following approach to interest rate and foreign currency risk management.
'Interest rate risk management Our objective is to limit the impact to our profit and loss from rising
interest rates. Forward rate agreements, interest rate swaps, caps and floors may be used to achieve the
desired mix of fixed and floating rate debt.
'Our policy is to fix interest rates for the year on a minimum of 40% of actual and projected debt
interest costs of the Group excluding Tesco Bank. At the year-end the percentage of interest-bearing
debt at fixed rates was 75% (2012 90%). The remaining balance of our debt is in floating rate form.
'Foreign currency risk management Our principal objective is to reduce the effect of exchange rate
volatility on operating margins. Transactional currency exposuresare managed, typically using
forward purchases or sales of foreign currencies and currency options...we only hedge a proportion of
the investment in our international subsidiaries as well as ensuring that each subsidiary is appropriately
hedged in respect of its non-functional currency assets'
Source: Tesco Annual Report and Financial Statements, 2013
2 Enterprise risk management
Section overview
Enterprise risk management provides a coherent framework for organisations to deal with risk,
based on such components as internal environment, objective setting and event identification.
The framework is designed to identify potential events that may affect the entity and manage risks
to be within its risk appetite.
2.1 Nature of enterprise risk management
Definition
Enterprise risk management is a process, effected by an entity's board of directors, management and
other personnel, applied in strategy setting and across the enterprise, designed to identify potential
events that may affect the entity and manage risks to be within its risk appetite, to provide reasonable
assurance regarding the achievement of entity objectives. COSO
The Committee of Sponsoring Organisations of the Treadway Commission (COSO) goes on to expand
its definition. It states that enterprise risk management has the following characteristics.
(a) It is a process, a means to an end, which should ideally be intertwined with existing operations
and exist for fundamental business reasons.
(b) It is operated by people at every level of the organisation and is not just paperwork. It provides a
mechanism helping people to understand risk, their responsibilities and levels of authority.
(c) It is applied in strategy setting, with management considering the risks in alternative strategies.
(d) It is applied across the enterprise. This means it takes into account activities at all levels of the
organisation from enterprise-level activities such as strategic planning and resource allocation, to
business unit activities and business processes. It includes taking an entity level portfolio view of
risk. Each unit manager assesses the risk for his unit. Senior management ultimately consider these
unit risks and also interrelated risks. Ultimately, they will assess whether the overall risk portfolio is
consistent with the organisation's risk appetite.
(e) It is designed to identify events potentially affecting the entity and manage risk within its risk
appetite, the amount of risk it is prepared to accept in pursuit of value. The risk appetite should be
aligned with the desired return from a strategy.
(f) It provides reasonable assurance to an entity's management and board. Assurance can at best be
reasonable since risk relates to the uncertain future.
(g) It is geared to the achievement of objectives in a number of categories, including supporting the
organisation's mission, making effective and efficient use of the organisation's resources, ensuring
reporting is reliable, and complying with applicable laws and regulations.
Because these characteristics are broadly defined, they can be applied across different types of
organisations, industries and sectors. Whatever the organisation, the framework focuses on
achievement of objectives.
C
An approach based on objectives contrasts with a procedural approach based on rules, codes or H
procedures. A procedural approach aims to eliminate or control risk by requiring conformity with the A
rules. However, a procedural approach cannot eliminate the possibility of risks arising because of poor P
management decisions, human error, fraud or unforeseen circumstances arising. T
E
R
2.2 Framework of enterprise risk management

The COSO Framework consists of eight interrelated components. 2
Objective setting
Event identification
Risk assessment
Risk response
Internal environment or control environment
Control activities or procedures
Information and communication
Monitoring
Case example: Enterprise risk management

Different commentators have developed guidance on enterprise risk management in different ways.
Ernst and Young identified six components of risk management:
Risk strategy
Risk management processes
Appropriate culture and capability
Risk management functions
Enabling technologies
Governance
Ernst and Young suggests that risk management should focus on what shareholders consider to be vital
for the business. Companies should establish what shareholders think affects company value, link risks to
value drivers, determine shareholders' preferred treatment of risks and communicate what the company
is doing.

2.3 Benefits of enterprise risk management
COSO highlights a number of advantages of adopting the process of enterprise risk management.
Alignment of risk appetite and The Framework demonstrates to managers the need to
strategy consider risk toleration. They then set objectives aligned
with business strategy and develop mechanisms to manage
the accompanying risks and to ensure risk management
becomes part of the culture of the organisation, embedded
into all its processes and activities.
Link growth, risk and return Risk is part of value creation, and organisations will seek a
given level of return for the level of risk tolerated.
Choose best risk response Enterprise risk management helps the organisation select
whether to reduce, eliminate or transfer risk.
Minimise surprises and losses By identifying potential loss-inducing events, the
organisation can reduce the occurrence of unexpected
problems.
Identify and manage risks across As indicated above, the Framework means that managers
the organisation can understand and aggregate connected risks. It also
means that risk management is seen as everyone's
responsibility, experience and practice is shared across the
business and a common set of tools and techniques is used.
Provide responses to multiple For example, risks associated with purchasing, over- and
risks under-supply, prices and dubious supply sources might be
reduced by an inventory control system that is integrated
with suppliers.
Seize opportunities By considering events as well as risks, managers can identify
opportunities as well as losses.
Rationalise capital Enterprise risk management allows management to allocate
capital better and make a sounder assessment of capital
needs.
2.4 Risk architecture

In its 1999 report Enhancing Shareholder Wealth by Better Managing Business Risk the International
Federation of Accountants argued for the development of a risk architecture within which risk
management processes could be developed. The architecture involves designing and implementing
organisational structures, systems and processes to manage risk. This is a slightly different
framework to that of enterprise risk management.
IFAC argued that developing a risk architecture is not just a response to risk but marks an organisational
shift, changing the way the organisation:
Organises itself
Assigns accountability
Builds risk management as a core competency
Implements continuous, real-time risk management
Best practice, IFAC argued, is to develop a highly integrated approach to risk management, using a
common language, shared tools and techniques and periodic assessments of the risk profile for the
entire organisation. Integration is particularly important when most units have many risks in common,
and when there is significant interdependency between units. It is vital when managers are trying to
achieve a shared corporate vision.
The risk architecture developed by IFAC has eight components:
Acceptance of a risk management framework
Commitment from executives
Establishment of a risk response strategy
Assignment of responsibility for risk management process
Resourcing
Communication and training
Reinforcing risk cultures through human resources mechanisms
Monitoring of the risk management process
IFAC identified four components of risk management:
Structure to facilitate the identification and communication of risk
Resources sufficient to support implementation
Culture reinforcing decision-making processes
Tools and techniques developed to enable organisation-wide management of risk
C
H
2.5 The Turnbull report A
P
The Turnbull report (published 1999, revised 2005) aims to provide guidance on risk management and T
control systems to supplement the broad outlines set out in the Combined Code (now the UK E
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Corporate Governance Code). Turnbull emphasises the importance of the evolution of a system of
internal control to take account of new and emerging risks, control failures, market expectations or
changes in the company's circumstances or business objectives. Evolution requires regular and
systematic assessment of the risks facing the business. 2
2.6 Risk resourcing

Whatever the division of responsibilities for risk management, the organisation needs to think carefully
about how risk management is resourced; sufficient resources will be required to implement and
monitor risk management (including the resources required to obtain the necessary information).
Consideration will be given not only to the expenditure required, but also the human resources in
terms of skills and experience.
Case example: Intercontinental Hotel Group (IHG)

IHG's risk report describes the elements of its approach to enterprise risk management:
Policies and standards formal documentation of the approach, controls and actions for IHG
employees when dealing with specific risks. These set out accountability for risks, relevant roles and
responsibilities and actions that are measurable or auditable.
Ways of working practical aspects of risk management such as tools, templates, systems, forums
and behaviours, which help management bring the policies and standards to life.
Training and communication face-to-face and online learning programmes to provide
appropriate skills and knowledge and regular communication to raise awareness.
Operate and control ongoing operational activities and control measures to comply with
policies and standards and to manage risk.
Risk financing consideration of the financial impact of risks and ensuring that arrangements are
in place usually insurance coverage or budgetary funds.
Monitor and report the collection and analysis of management information to evaluate the
effectiveness of the risk profile, policies and standards, ways of working, training and
communications and risk financing activities.

3 Risk management and control systems
Section overview
This section discusses the underlying features of risk and control systems.
Consideration of risk issues should be an integral part of board agendas.
The board's risk committee and the risk management function are also key players in managing
risk.
There are various methods that can be used to promote awareness of risk and control issues within
a company.
The Turnbull report stresses the importance of embedding risk management and control systems
within business processes.
3.1 Board responsibilities

If effective risk management is to be embedded within a company, the board must oversee its
establishment. The board should consider on a regular basis:
The nature and extent of the risks facing the company
The extent and categories of acceptable risks
The likelihood of the risks materialising
The company's ability to reduce the incidence and impact of risks that do materialise
The costs of operating particular controls versus their benefits
The Walker report in 2009 highlighted that the monitoring role of the board in financial sector
institutions was particularly important because of the speed and scale of change in this sector:
'The whole board needs to be attentive to developments in the risk space to a degree far exceeding that
in non-financial business.'
Ownership of the risk management and internal control system is a vital part of the chief executive's
overall responsibility for the company. The chief executive must consider in particular the risk and
control environment, focusing amongst other things on how his or her example promotes a good
culture. The chief executive should also monitor other directors and senior staff, particularly those whose
actions can put the company at significant risk.
As well as explicit responsibilities, the board's role in 'setting the tone' and demonstrating clearly that
they respect the need for effective control systems is a very important part of risk management. This
includes respecting the need for separation of duties between managers carrying out executive duties,
and non-executive directors and staff responsible for monitoring them.
3.1.1 Review of board's role

Following on from the revisions to UK corporate guidance in 2010, the Financial Reporting Council
undertook a review of how boards were approaching their responsibilities, with a view perhaps to
revising the Turnbull guidance originally published in 1999. The consultation found that boards' focus
on risk had changed significantly over the last decade and the approaches and techniques that they
used were developing rapidly.
The main points arising from the consultation included the following:
Boards should aim for better risk taking, but this did not necessarily mean less risk taking as risk
taking is essential to entrepreneurship.
Different board committees are appropriate for different industries. The decision on appropriate
committee structure should be left to individual boards rather than making a risk committee
compulsory for everyone. A risk committee is appropriate for companies in the financial sector and
separate committees are commonly used by companies in the pharmaceutical and extractive
industries, which are exposed to significant safety, environmental or regulatory risks. Examples in
these industries include compliance committees and corporate responsibility committees.
Responsibility for monitoring internal controls and risk management could be delegated to board
committees, but the whole board should retain strategic responsibility for risk decision-taking.
Boards need to understand how risk exposure might change as a result of changes in strategy and
the operating environment.
Boards need to focus on individual risks capable of undermining the strategy or long-term viability
of the company or damaging its reputation. Reputation risk requires greater attention, partly
because failures can be publicised widely and quickly in the global information environment. Boards
need to have robust crisis management plans.
Boards should not just focus on net or residual risk, but need to understand exposure to the
combination of risks faced, before risk management policies are implemented.
It could be difficult to decide how much information about risks boards need, and in particular
when a particular risk should be brought to the board's attention. C
H
Organisations need transparency and clear lines of reporting and accountability. A
P
Investors are increasingly seeking more meaningful reporting on risk, for example an integrated T
discussion of business model, strategy, key risks and mitigation. Investors also want to know how E
R
companies' exposure to risk is changing.
Case example: HBOS 2
The issue of separation of duties was highlighted in February 2009 by the testimony of Paul Moore,
former head of the group regulatory risk at HBOS, to the UK House of Commons' Treasury Select
Committee. Moore commented:
'There has been a completely inadequate separation and balance of powers between the executive
and all those accountable for overseeing their actions and reining them in ie internal control functions
such as finance, risk, compliance and internal audit, non-executive Chairmen and Directors, external
auditors, the FSA, shareholders and politicians.
There is no doubt that you can have the best governance processes in the world but if they are carried
out in a culture of greed, unethical behaviour and indisposition to challenge they will fail.'
3.2 Risk committee

Boards also need to consider whether there should be a separate board committee, with responsibility for
monitoring and supervising risk identification and management. If the board doesn't have a separate
committee, under the UK Corporate Governance Code the audit committee will be responsible for risk
management.
Consideration of risk certainly falls within the remit of the audit committee. However there are a number
of arguments in favour of having a separate risk committee.
(a) A risk management committee can be staffed by executive directors, whereas an audit committee
under corporate governance best practice should be staffed by non-executive directors. However if
there are doubts about the competence and good faith of executive management, it will be more
appropriate for the risk committee to be staffed by non-executive directors.
(b) As a key role of the audit committee will be to liaise with the external auditors, much of their time
could be focused on financial risks.
(c) A risk committee can take the lead in driving changes in practice, whereas an audit committee will
have a purely monitoring role, checking that a satisfactory risk management policy exists.
Morris in An Accountant's Guide to Risk Management suggests that written terms of reference might
include the following:
Approving the organisation's risk management strategy and risk management policy.
Reviewing reports on key risks prepared by business operating units, management and the board.
Monitoring overall exposure to risk and ensuring it remains within limits set by the board.

Assessing the effectiveness of the organisation's risk management systems.
Providing early warning to the board on emerging risk issues and significant changes in the
company's exposure to risks.
In conjunction with the audit committee, reviewing the company's statement on internal control
with reference to risk management, prior to endorsement by the board.
Note that the focus is on supervision and monitoring rather than the committee having responsibility for
implementation of policies.
Having a separate risk committee can aid the board in its responsibility for ensuring that adequate risk
management systems are in place. The application of risk management policies will then be the
responsibility of operational managers, and perhaps specialist risk management personnel.
Case example: Intercontinental Hotel Group (IHG)

The board of IHG has of course, ultimate responsibility for the group's strategy, risk management and
internal control and reviewing their effectiveness. The audit committee carries out an annual review of
the risk management system. In addition, the company's Risk Working Group, which is chaired by the
Company Secretary and comprises the Global Heads of Strategy, Risk Management and Internal Audit,
takes an active role in overseeing the most significant risks to IHG. Risks identified in the regions and
corporate functions are consolidated, refined and calibrated against a strategic view of risks by the Risk
Working Group. Major risks are discussed to gain agreement on the risk descriptions, ownership and
actions, before final presentation to the audit committee and Board. The Risk Working Group monitors
changes to the major risks and the progress of actions on a quarterly basis, to ensure these risks are
appropriately managed and emerging risks are identified.
3.2.1 Risk committees in the financial sector

The Walker report recommended that FTSE-100 bank or life insurance companies should establish a risk
committee. Reasons for this recommendation included the need to avoid over-burdening the audit
committee, and to draw a distinction between the largely backward looking focus of the audit
committee, and the need for forward-looking focus of determining risk appetite and from this
monitoring appropriate limits on exposures and concentrations. The committee should have a majority
of non-executive directors. Any executive risk committee should be overseen by the board risk
committee.
Walker recommended that the committee should concentrate on the fundamental prudential risks for
the institution: leverage, liquidity risk, interest rate and currency risk, credit/counterparty risks and other
market risks. It should advise the board on current risk exposures and future risk strategy, and the
establishment of a supportive risk culture.
The committee should regularly review and approve the measures and methodology used to assess risk.
A variety of measures should be used. The risk committee should also advise the remuneration
committee on risk weightings to be applied to performance objectives incorporated within the incentive
structure for executive directors.
3.3 Risk management personnel

3.3.1 Risk specialists
Most individuals have little time for looking after their personal safety and security, still less for searching
the market for the most suitable insurances. They frequently employ agents to help manage some of
their risks.
A specialist advising on management of personal risks can work only as well as the client allows. A good
specialist will ask for information and for co-operation with the expert surveys that enable him to
provide a proper service. He will ensure that the client understands what safety measures are required
and he will see that they are put into practice.
3.3.2 Risk manager
The risk manager will need technical skills in credit, market, and operational risk. Leadership and
persuasive skills are likely to be necessary to overcome resistance from those who believe that risk
management is an attempt to stifle initiative.
Lam (Enterprise Risk Management) includes a detailed description of this role, and the COSO framework
also has a list of responsibilities. Combining these sources we can say that the risk manager is typically
responsible for:
(a) Providing the overall leadership, vision and direction for enterprise risk management.
(b) Establishing an integrated risk management framework for all aspects of risk across the
organisation, integrating enterprise risk management with other business planning and
management activities and framing authority and accountability for enterprise risk management in C
business units. H
A
(c) Promoting an enterprise risk management competence throughout the entity, including P
facilitating development of technical enterprise risk management expertise, helping managers align T
E
risk responses with the entity's risk tolerances and developing appropriate controls.
R
(d) Developing risk management policies, including the quantification of management's risk appetite
through specific risk limits, defining roles and responsibilities, ensuring compliance with codes,
regulations and statutes and participating in setting goals for implementation. 2
(e) Establishing a common risk management language that includes common measures around
likelihood and impact, and common risk categories. Developing the analytical systems and data
management capabilities to support the risk management programme.
(f) Implementing a set of risk indicators and reports including losses and incidents, key risk
exposures, and early warning indicators. Facilitating managers' development of reporting
protocols, including quantitative and qualitative thresholds, and monitoring the reporting process.
(g) Dealing with insurance companies: an important task because of increased premium costs,
restrictions in the cover available (will the risks be excluded from cover) and the need for
negotiations with insurance companies if claims arise. If insurers require it demonstrating that the
organisation is taking steps actively to manage its risks. Arranging financing schemes such as self-
insurance or captive insurance.
(h) Allocating economic capital to business activities based on risk, and optimising the company's
risk portfolio through business activities and risk transfer strategies.
(i) Reporting to the chief executive on progress and recommending action as needed.
Communicating the company's risk profile to key stakeholders such as the board of directors,
regulators, stock analysts, rating agencies and business partners.
The risk manager's contribution will be judged by how much he increases the value of the organisation.
The specialist knowledge a risk manager has should allow the risk manager to assess long-term risk and
hazard outcomes and therefore decide what resources should be allocated to combating risk.
Clearly certain strategic risks are likely to have the biggest impact on corporate value. Therefore a risk
manager's role may include management of these strategic risks. These may include those having a
fundamental effect on future operations such as mergers and acquisitions or risks that have the potential
to cause large adverse impacts such as currency hedging and major investments. In financial institutions
the Walker report highlighted the assessment of whether product launches or the pricing of risk in a
particular transaction was consistent with the risk tolerance determined by the risk committee.
The Walker report stressed the need for provisions enhancing the independence of the chief risk officer,
for example rights of access to the chairman of the risk committee and removal from office to require
the agreement of the whole board.
Walker highlighted the need for effective reporting. The risk committee's report should be a separate
report in the annual accounts and include details of risk exposures and risk appetite for banking and
trading exposures, and the effectiveness of the risk management process. Some detail should be given
of the stress-testing of risk.

Case example: HBOS
The role of the risk manager in banks was highlighted in February 2009 by the evidence given to the UK
House of Commons' Treasury Select Committee enquiry into the banking system by Paul Moore, the ex
head of Group Regulatory Risk at HBOS. Moore had allegedly been sacked by Sir James Crosby, Chief
Executive Officer at HBOS. As a result of Moore making his allegations, Sir James resigned as deputy
chairman of London city watchdog, the Financial Services Authority.
Moore stated that in his role he 'felt a bit like being a man in a rowing boat trying to slow down an oil
tanker'. He said that he had told the board that its sales culture was out of balance with its systems and
controls. The bank was growing too fast, did not accept challenges to policy, and was a serious risk to
financial stability and consumer protection. The reason why Moore was ignored and others were afraid
to speak up was, he alleged, that the balance of powers was weighted towards executive directors, not
just in HBOS but in other banks as well.
'I believe that, had there been highly competent risk and compliance managers in all the banks, carrying
rigorous oversight, properly protected and supported by a truly independent non-executive, the
external auditor and the FSA, they would have felt comfortable and protected to challenge the practices
of the executive without fear for their own positions. If this had been the case, I am also confident that
we would not have got into the current crisis.'
Moore was replaced by a Group Risk Director who had never previously been a risk manager. The new
head had been a sales manager and was allegedly appointed by the Chief Executive Officer without
other board members having much, if any, say in the appointment.
During the time that Paul Moore was head of Group Regulatory Risk, the Financial Services Authority
had raised its own concerns about practices at HBOS and had kept a watching brief over the bank. In
December 2004 the Authority noted that although the group 'had made good progress in addressing
the risks highlighted in February 2004, the group risk functions still needed to enhance their ability to
influence the business'. In June 2006 the Authority stated that whilst the group had improved its
framework, it still had concerns: 'The growth strategy of the group posed risks to the whole group and
these risks must be managed and mitigated.'
At the end of the week in which Paul Moore's evidence was published, Lloyds, which had taken HBOS
over, issued a profit warning in relation to HBOS for 2008 for losses of over 10 billion.
3.3.3 Risk management function

Larger companies may have a bigger risk management function whose responsibilities are wider than a
single risk manager or risk specialist. The Institute of Risk Management's Risk Management standard lists
the main responsibilities of the risk management function:
Setting policy and strategy for risk management
Primary champion of risk management at a strategic and operational level
Building a risk aware culture within the organisation including appropriate education
Establishing internal risk policy and structures for business units
Designing and reviewing processes for risk management
Coordinating the various functional activities which advise on risk management issues within an
organisation
Developing risk response processes, including contingency and business continuity programmes
Preparing reports on risks for the board and stakeholders
3.4 Procedures for embedding risk

Employees cannot be expected to avoid risks if they are not aware that they exist in the first place.
Embedding a risk management frame of mind into an organisation's culture requires top-down
communications on what the risk philosophy is and what is expected of the organisation's employees.
Case example: Internal communications programme
Here is an example of an internal communications programme slightly adapted from an example in the
COSO Framework.
Internal communications programme
Management discusses risks and associated risk responses in regular briefings with employees.
Management regularly communicates entity-wide risks in employee communications such as
newsletters, an intranet.
Enterprise risk management policies, standards, and procedures are made readily available to
employees along with clear statements requiring compliance.
Management requires employees to consult with others across the organisation as appropriate C
when new events are identified. H
A
Induction sessions for new employees include information and literature on the company's risk P
management philosophy and enterprise risk management programme. T
E
Existing employees are required to take workshops and/or refresher courses on the organisation's R
enterprise risk management initiatives.
The risk management philosophy is reinforced in regular and ongoing internal communication
2
programmes and through specific communication programmes to reinforce tenets of the
company's culture.
3.4.1 Human resource procedures

The COSO framework also recommends certain organisational measures for spreading ownership of risk
management.
(a) Enterprise risk management should be an explicit or implicit part of everyone's job description.
(b) Personnel should understand the need to resist pressure from superiors to participate in improper
activities, and channels outside normal reporting lines should be available to permit reporting such
circumstances.
(c) Managers should provide appropriate incentives. This may entail setting performance targets and
tying results to performance pay.
3.4.2 Training
Aside from practical matters like showing employees which buttons to press or how to find out the
information they need, training should include explanation of why things should be done in the way
that the trainer recommends. If employees are asked to carry out a new type of check but are not told
why there is every chance that they won't bother to do it, because they don't understand its relevance.
It just seems to mean more work for them and to slow up the process for everyone.
3.4.3 Risk policy statement

Organisations ought to have a statement of risk policy and strategy that is distributed to all managers
and staff.
3.4.4 Risk register

Organisations should have formal methods of collecting together information on risk and response. A
risk register lists and prioritises the main risks an organisation faces, and is used as the basis for decision-
making on how to deal with risks. The register also details who is responsible for dealing with risks and
the actions taken. The register should show the risk levels before and after control action is taken, to
facilitate a cost-benefit analysis of controls.

3.5 Control systems
The Turnbull report emphasises the importance of control systems in effectively managing risks. The
report provides a helpful summary of the main purposes of an internal control system.
Turnbull comments that internal control consists of 'the policies, processes, tasks, behaviours and other
aspects of a company that taken together:
(a) Facilitate its effective and efficient operation by enabling it to respond appropriately to significant
business, operational, financial, compliance and other risks to achieving the company's objectives.
This includes the safeguarding of assets from inappropriate use or from loss and fraud and ensuring
that liabilities are identified and managed.
(b) Help ensure the quality of internal and external reporting. This requires the maintenance of proper
records and processes that generate a flow of timely, relevant and reliable information from within
and without the organisation.
(c) Help ensure compliance with applicable laws and regulations, and also with internal policies with
respect to the conduct of business.
The Turnbull report also summarises the key characteristics of the internal control systems. They should:
Be embedded in the operations of the company and form part of its culture.
Be capable of responding quickly to evolving risks within the business.
Include procedures for reporting immediately to management significant control failings and
weaknesses together with control action being taken.
The system should include control activities, information and communication processes and processes
for monitoring the continued effectiveness of the system of internal control.
The Turnbull report goes on to say that a sound system of internal control reduces but does not
eliminate the possibilities of losses arising from poorly-judged decisions, human error, deliberate
circumvention of controls, management override of controls and unforeseeable circumstances. Systems
will provide reasonable (not absolute) assurance that the company will not be hindered in achieving its
business objectives and in the orderly and legitimate conduct of its business, but won't provide certain
protection against all possible problems.
4 The risk management process
Section overview
This section introduces a commonly used framework for assessing and managing risk.
The individual steps in the process will be discussed in detail in following sections.
Another commonly used framework for assessing and managing risk involves the following processes.
Establishing the context
Risk identification
Risk assessment
Risk profiling
Risk quantification
Risk responses
Implementation of plans
We will consider these processes in the next few sections. In real life, none of these processes are easy
what is considered to be a risk by some might not be seen as such by others which can lead to disputes
over which risks should be given priority. Quantification of an item that is essentially subjective is never
going to be straightforward in itself, putting a value on different risks is a subjective process.
5 Establishing the context
Section overview
This is the first stage in the risk management process.
This step includes establishing both the internal and external contexts, the risk criteria and the
structure for risk analysis.
By performing this step, you are laying the foundations on which the entire risk management
process is based.
Before any risk can actually be identified, you have to establish the context within which risk will be C
assessed that is, you have to determine the domain within which assessment will take place. For H
example, management may only be interested in identifying financial risks, which means that those A
P
responsible for gathering information will concentrate on that area of risk only.
T
E
5.1 Establish the internal context R
Risk is essentially the chance that an event will occur that will prevent the company from meeting its
objectives. Therefore, in order to understand the risks, you must first identify the objectives. By doing
so you will ensure that decisions taken to reduce risk still support the overall goals of the organisation 2
which encourages long-term and strategic thinking.
Case example: Owner managed restaurant

A small restaurant employs a full-time chef, an apprentice chef and two waiters. Business is slow and
cash flow becoming a problem, therefore the owner decides he will have to let the apprentice chef and
one of the waiters go.
Four months later, the restaurant wins a five-year contract to supply lunches to a local firm and business
in general picks up with the opening of a new office block in close proximity to the restaurant's
premises. The restaurant owner had been preparing for the new contract, having tendered for it several
months before paying off the apprentice chef and the waiter, and was aware of the imminent opening
of the office block.
The owner then had problems of a different kind. The chef could not cope with both the contracted
lunches and the general improvement in business, nor could the waiter deal with a full restaurant on his
own. The apprentice chef had already found alternative employment, as had the previous waiter. The
owner was forced to take on a less experienced apprentice who then had to be trained by the already
overworked chef and another waiter who was unfamiliar with the general operations of the restaurant.
In context, the restaurant owner should have tried to find alternative means of dealing with what he
must have known to be a temporary cash flow problem, rather than getting rid of staff in whose
training time and money had already been invested.
When trying to establish the internal context, business owners should also consider such issues as:
Internal culture. Are staff likely to be resistant to change?
Existing business capabilities, such as people, equipment and processes
5.2 Establish the external context

The external context is the overall environment in which the business operates, including an
understanding of the perceptions that clients or customers have of the business. This could take the
form of a SWOT analysis. It should also cover such issues as external regulations that the business must
comply with.

5.3 Establish the risk management context
In order to correctly identify risks associated with a project, you must first define the project's limits,
objectives and scope.
Case example: Accountancy body

Due to expansion of staff and necessary documentation, the student support and education
departments of a professional accountancy body are moving into larger office premises. Before the
move takes place, the head of administration who is taking charge of the move undertakes a risk
assessment of the relocation.
The risk management context includes:
The main objective: to move staff, furniture, equipment and documentation to the new premises
with a minimum of disruption to student services and production of examination papers.
Ensure the security and confidentiality of the examination papers held at the current premises
which will be transferred in locked safes to the new location.
An overall timeframe (including planning, liaison with telephone companies, etc) of three months.
A budget of 25,000 for use of external relocation support.
This risk management context provides sufficient information with which the head of administration can
assess the risks associated with the relocation, particularly those that impact on the primary objective of
minimising disruption to student services and production of examination papers.
5.4 Develop risk criteria

This step allows the business to identify unacceptable levels of risk, or, looking at it another way, to
define acceptable levels of risk for a specific project. These risk levels can be more closely defined as the
process progresses.
In the case study above, for example, it would be completely unacceptable for the confidentiality and
security of the examination papers to be compromised, therefore this documentation must be kept in
locked safes and transported using professional safe movers.
5.5 Define the structure for risk analysis

The final stage in the establishment of context is to define the structure for risk analysis. This involves
isolating the risk categories that need to be managed, which can then be assessed individually. This will
allow for greater depth and accuracy when identifying important risks.
6 Risk identification
Section overview
Before being able to establish risk management processes, you must identify the risks that your
organisation actually faces.
Some risks may be familiar to the organisation; others may not.
This step is a continuous process; as the business environment changes, so do the risks faced by
organisations operating in that environment.
No-one can manage a risk without first being aware that it exists. Some knowledge of perils, what items
they can affect and how, is helpful to improve awareness of whether familiar risks (potential sources
and causes of loss) are present, and the extent to which they could harm a particular person or
organisation. The risk manager should also keep an eye open for unfamiliar risks which may be present.
Actively identifying the risks before they crystallise makes it easier to think of methods that can be used
to manage them.
Risk identification is a continuous process, so that new risks and changes affecting existing risks may be
identified quickly and dealt with appropriately, before they can cause unacceptable losses.
6.1 Risk conditions

Means of identifying conditions leading to risks (potential sources of loss) include:
(a) Physical inspection, which will show up risks such as poor housekeeping (for example, rubbish left
on floors, for people to slip on and to sustain fires).
(b) Enquiries, from which the frequency and extent of product quality controls and checks on new
employees' references, for example, can be ascertained. C
H
(c) Checking a copy of every letter and memo issued in the organisation for early indications of major A
changes and new projects. P
T
(d) Brainstorming with representatives of different departments. E
R
(e) Checklists ensuring risk areas are not missed.
(f) Benchmarking against other sections within the organisation or external experiences.
2
6.2 Event identification

A key aspect of risk identification, emphasised by the Committee of Sponsoring Organisations of the
Treadway Commission's report Enterprise Risk Management Framework, is identification of events that
could impact upon implementation of strategy or achievement of objectives.
Events analysis includes identification of:
(a) External events such as economic changes, political developments or technological advances.
(b) Internal events such as equipment problems, human error or difficulties with products.
(c) Leading event indicators. By monitoring data correlated to events, organisations identify the
existence of conditions that could give rise to an event, for example customers who have balances
outstanding beyond a certain length of time being very likely to default on those balances.
(d) Trends and root causes. Once these have been identified, management may find that assessment
and treatment of causes is a more effective solution than acting on individual events once they
occur.
(e) Escalation triggers, certain events happening or levels being reached that require immediate
action.
(f) Event interdependencies, identifying how one event can trigger another and how events can
occur concurrently. For example, a decision to defer investment in an improved distribution system
might mean that downtime increases and operating costs go up.
Once events have been identified, they can be classified horizontally across the whole organisation and
vertically within operating units. By doing this management can gain a better understanding of the
interrelationships between events, gaining enhanced information as a basis for risk assessment.
7 Risk assessment
Section overview
The fundamental difficulty in assessing risk is determining how often this particular risk may occur.
Statistical information is not available on all manner of past incidents.
The financial benefits of risk management are dependent on how and the frequency with which
risk assessment is performed.

It is not always simple to forecast the financial effect of a possible disaster, as it is not until after a loss
that extra expenses, inconveniences and loss of time can be recognised. Even then it can be difficult to
identify all of them.
Organisations will probably keep more detailed records of their activities and the unit costs involved, but
it is unlikely that any organisation can predict the full cost of every loss that might befall it with
certainty.
8 Risk profiling
Section overview
It is important for organisations to group risks according to their likelihood and potential impact.
This process is very useful when setting priorities for putting risk mitigation processes in place.
This stage involves using the results of a risk assessment to group risks into risk families. One way of
doing this is a likelihood/consequences matrix.
Consequences
Low High
Loss of suppliers Loss of senior or specialist
staff
Low Loss of sales to competitor
Loss of sales due to
Likelihood
macroeconomic factors
Loss of lower-level staff Loss of key customers
Failure of computer systems
High
This profile can then be used to set priorities for risk mitigation.
9 Risk quantification and consolidation
Section overview
The quantification of risk is necessary to estimate how much the organisation stands to lose in the
event of a particular risk occurring.
For physical assets, quantification is often fairly straightforward; however exposure of financial and
intangible assets is more difficult to put a monetary figure on.
The individual risks that have been identified in different parts of the business must be
consolidated (ie aggregated) to establish the risk at the corporate level.
Risks that require more analysis can be quantified, where possible results or losses and probabilities are
calculated and distributions or confidence limits added on. From this exercise is derived the following
key data.
Average or expected result or loss
Frequency of losses
Chances of losses
Largest predictable loss
to which the organisation could be exposed by a particular risk. The risk manager must also be able to
estimate the effects of each possible cause of loss, as some of the effects that he needs to consider may
not be insured against.
The likely frequency of losses from any particular cause can be predicted with some degree of
confidence, from studying available records. This confidence margin can be improved by including the
likely effects of changed circumstances in the calculation, once they are identified and quantified. Risk
managers must therefore be aware of the possibility of the increase of an existing risk, or the
introduction of a new risk, affecting the probability and/or possible frequency of losses from another
cause.
Often quantification of losses will not involve statistical techniques, but a simple single estimate of what
would be lost if adverse events or circumstances occur. For example, if an accountancy firm had a client
that generated a fixed fee each year, the loss would be the contribution (fees lost less labour and other
C
variable costs saved). H
A
Ultimately the risk manager will need to know the frequency and magnitude of losses that could place
P
the organisation in serious difficulty. T
E
R
9.1 Exposure of physical assets
Exposures with physical assets may include:
2
Total value of the assets, for example the value of items stolen from a safe.
Costs of repair, if for example an accident occurs.
Change of value of an asset, for example property depreciating in value because of a new airport
development nearby.
Decrease in revenues, for example loss of rent through a rental property being unlettable for a
period.
Costs of unused capacity, costs incurred by spare capacity that is taken as a precaution but does
not end up being used.
9.2 Exposure of financial assets

Whilst the risk of trading shares and most forms of debt might be that their values fall to zero, this is not
necessarily true of futures (where losses could be unlimited) and options (whose losses are limited to the
option premium). In addition anyone who is exposed to loss as a result of price rises is in theory
exposed to the risk of infinite loss, since prices could rise indefinitely.
Case example: Banking crisis

The 2009 Turner report highlighted faulty measurement techniques as a reason why many financial
institutions underestimated their risk position. The required capital for their trading activities was
excessively light. Turner also highlighted the rapid growth of off balance sheet vehicles that were highly
leveraged but were not included in standard risk measures. However the crisis demonstrated the
economic risks of these vehicles, with liquidity commitments and reputational concerns requiring banks
to take the assets back onto their balance sheets, increasing measured leverage significantly.
Turner also saw the complexity of the techniques as itself being a problem. 'The very complexity of the
mathematics used to measure and manage risk made it increasingly difficult for top management and
boards to assess and exercise judgements over risks being taken. Mathematical sophistication ended up
not containing risk, but providing false assurance that other prima facie indicators of increasing risk (eg
rapid credit extension and balance sheet growth) could be safely ignored.'

9.3 Exposure of human assets
9.3.1 Death or serious injury
The most severe risk to employees is the risk of death or serious injury. The loss to the employee's family,
for which the organisation may be liable, could be the future value of their expected income stream,
mitigated by any benefits available but enhanced by other losses that arise as a result of death, for
example loss of any available tax allowance. Alternatively it could be measured by the expenditure
required to fulfil the needs of the deceased's dependent family. For less serious injuries, the costs of
medical care may be the relevant figure.
9.3.2 Key persons

Certain individuals may make a significant contribution to the office because of their knowledge, skills or
business contacts. One measure of this loss will be the present value of the individual's contribution
(attributable earnings less remuneration). Indirect costs may include the effect on other staff of the loss
of the key person (decreased productivity or indeed the costs of their own departure).
9.3.3 Business discontinuation losses

If a director, partner or senior employee dies or departs, there may be costs of having to cope with the
disruption, including even the costs of dissolution if local law requires termination of a partnership on
the departure of a single partner.
9.4 Risk consolidation

Risk that has been analysed or quantified at the division or subsidiary level needs to be aggregated at
the corporate level and grouped into categories. This aggregation will be required as part of the overall
review of risk that the board needs to undertake. The process of risk categorisation also enables the risks
categorised together to be managed by the use of common control systems.
10 Risk responses
Section overview
Although organisations operating in the same industry may face similar risks, the ways in which
they respond to these risks can differ significantly.
Risk responses depend on such factors as the potential impact of the risk on the organisation and
management's attitude towards risk.
The four main responses to risk are: avoidance, reduction, transfer and acceptance.
Once risks have been identified, assessed and quantified, decisions must be taken as to how to respond
to these risks. Methods of dealing with risk include avoidance, reduction, retention and transfer.
Risk response can be linked into the likelihood/consequences matrix and also the organisation's appetite
for risk-taking.
Consequences
Low High
Accept or absorb Transfer

Risks are not significant. Insure risk or implement contingency
Low Keep under review, but costs plans. Reduction of severity of risk will
of dealing with risks unlikely minimise insurance premiums.
to be worth the benefits.
Likelihood
Reduce or manage Avoid or control

Take some action, eg self- Take immediate action to reduce
High insurance to deal with severity and frequency of losses, eg
frequency of losses. insurance, charging higher prices to C
H
customers or ultimately abandoning A
activities. P
T
E
10.1 Avoidance of risk R
Organisations will often consider whether risk can be avoided and if so whether avoidance is desirable
that is, will the possible savings from losses avoided be greater than the advantages that can be gained
by not taking any measures and running the risk? 2
An extreme form of avoiding business risk is terminating operations altogether for example, operations
in politically volatile countries where the risks of loss (including loss of life) are considered to be too
great or the costs of security too high.
Case example: Toyota

Toyota responded to concerns over the safety of its cars by recalling millions of models worldwide
during 2009 and 2010. Sales of a number of models were suspended in the USA. Although Toyota's
actions aimed to resolve the risks to health and safety, it may have been less effective in mitigating the
risks to its reputation. Commentators highlighted an initial reluctance to admit the problem and poor
communication of what it intended to do to regain control of the situation. The impact threatened car
sales and share price, with investors reluctant to hold Toyota shares because of the level of uncertainties
involved.
10.2 Reduction of risk

Often risks can be avoided in part, or reduced, but not avoided altogether. This is true of many business
risks, where the risks of launching a new product can be reduced by market research, advertising and so
on.
Other risk reduction measures include contingency planning and loss control.
Case example: Pearson

Pearson highlights the risks to its intellectual property and proprietary rights as potential major
constraints on its ability to grow. Pearson seeks to mitigate these risks through general vigilance, co-
operation with other publishers and trade associations, advances in technology and taking legal action.
The group has developed data rights management standards and monitoring programs, and has
established a piracy task force to identify weaknesses and remediate breaches. Pearson also monitors in
each market developments in copyright and intellectual property law.
10.2.1 Contingency planning

Contingency planning involves identifying the post-loss needs of the business, drawing up plans in
advance and reviewing them regularly to take account of changes in the business. The process has
three basic constituents.

Information How, for example, do you turn off the sprinklers once the
fire is extinguished? All the information that will need to
be available during and after the event should be gathered
in advance.
Responsibilities The plan should lay down what is to be done by whom.
Practice Unless the plan has been tested there is no guarantee that
it will work. A full-scale test may not always be possible;
simulations, however, should be as realistic as possible and
should be taken seriously by all involved.
Case example: London emergency services

Before and since the London bombings in 2005, the London emergency services have held regular
simulation exercises of how they would react in an emergency situation. Usually held at weekends,
these simulation exercises often take place in tube stations, using hundreds of 'extras' to play the parts
of injured members of the public. Such exercises are vital to test the way in which, and how quickly,
the emergency services will deal with terrorist attacks.
10.2.2 Loss control

Control of losses also requires careful advance planning. There are two main aspects to good loss
control: the physical and the psychological.
There are many physical devices that can be installed to minimise losses when harmful events
actually occur. Sprinklers, fire extinguishers, escape stairways, burglar alarms and machine guards
are obvious examples. It is not enough however to install such devices. They will need to be
inspected and maintained regularly.
The key psychological factors are awareness and commitment. Every person in the business should
be made aware that losses are possible and that they can be controlled.
10.3 Accepting risks

Risk acceptance or retention is where the organisation bears the risk itself, and if an unfavourable
outcome occurs, it will suffer the full loss. Risk retention is inevitable to some extent. However good
the organisation's risk identification and assessment processes are, there will always be some unexpected
risk. Other reasons for risk retention are that the risk is considered to be insignificant or the cost of
avoiding the risk is considered to be too great compared with the potential loss that could be incurred.
The decision of whether to retain or transfer risks depends firstly on whether there is anyone to transfer
a risk to. The answer is more likely to be 'no' for an individual than for an organisation, because:
Individuals have more small risks than do organisations and the administrative costs of transferring
and carrying them can make the exercise impractical for the insurer; and
The individual has smaller resources to find a carrier.
In the last resort, organisations usually have customers to pass their risks or losses to, up to a point, and
individuals do not.
10.4 Transfer of risk

Alternatively, risks can be transferred to other internal departments or externally to suppliers,
customers or insurers. Risk transfer can even be to the State.
Decisions to transfer risk should not be made without careful checking to ensure that as many
influencing factors as possible have been included in the assessment. A decision not to rectify the
design of a product, because rectification could be as expensive as paying any claims from disgruntled
customers, is in fact a decision to transfer the risk to the customers without their knowledge: it may not
take into account the possibility of courts awarding exemplary damages to someone injured by the
product, to discourage people from taking similar decisions in the future.
Internal risk transfer can also cause problems if it is away from departments with more 'clout' (for
example, sales) and towards departments, such as finance, that may be presumed to downplay risks
excessively.
10.4.1 Hold harmless agreements

A hold harmless agreement is an agreement between two or more parties defining an obligation to
make good the liability, loss or damage incurred.
10.4.2 Limitation of liability

Some contracts, in which one party accepts strict liability up to a set limit, or liability which is wider than
the law would normally impose, follow very ancient customs. Examples are contracts for carriage of
passengers or goods by air or sea.
C
H
10.4.3 Legal and other restrictions on transferring risks A
P
The first restriction is that a supplier or customer may refuse to enter a contract unless your organisation
T
agrees to take a particular risk. This depends on the trading relationship between the firms concerned, E
and not a little on economics: how many suppliers could supply the item or service in question, for R
example, and how great is your need for the item?
10.4.4 Risk sharing 2
Risks can be partly held and partly transferred to someone else. An example is an insurance policy,
where the insurer pays any losses incurred by the policyholder above a certain amount.
Risk-sharing arrangements can be very significant in business strategy. For example, in a joint venture
arrangement, each participant's risk can be limited to what it is prepared to bear.
Interactive question 2: VSYS [Difficulty level: Intermediate]

VSYS Inc manufactures a range of computer products from its single factory located in a medium-sized
town in central USA. About 20% of the working population are employed at VSYS, and the company
has a reputation for being a good employer with specific focus on maintaining and enhancing benefits
for its employees.
Although the company is profitable, the recent management accounts show falling margins with the
possibility of a loss being made next year; the first in the 25 year history of the company. The main
reasons for the falling profits have been identified as increasing competition from manufacturers in the
Far East, and ongoing quality control issues with several key manufacturers. A recent feasibility study
shows that moving production to a Far Eastern country would enable VSYS to take advantage of lower
labour costs and proximity to suppliers of high quality components. The administration and marketing
functions would remain at their current location.
Movement of production systems to the Far East is seen as a particular problem for VSYS. Specific areas
of concern include:
(a) Obtaining and maintaining supplies from new suppliers
(b) Setting up production lines with new workforce and new machinery
(c) Maintaining sufficient inventory of materials to meet demand when the delivery times are
uncertain
(d) Implementing any necessary revisions to the management accounting systems
However, the Board is confident that the move will be successful and looks forward to a positive
response from workers and shareholders.
Requirement
Assess the risks associated with the decision to outsource to the Far East, and briefly recommend ways in
which these risks can be controlled.

10.5 Risk pooling and diversification
Risk pooling and diversification involves using portfolio theory to manage risks. You may remember that
portfolio theory is an important part of an organisation's financial strategy, but its principles can be
applied to non-financial risks as well.
Risk pooling or diversification involves creating a portfolio of different risks based on a number of events,
which, if some turn out well others will turn out badly, and the average outcome will be neutral. What
an organisation has to do is to avoid having all its risks positively correlated which means that
everything will turn out extremely well or extremely badly.
One means of diversification may be geographical diversification across countries at different stages of
the trade cycle.
In addition, although diversification may sound good in theory, the company may have insufficient
expertise in the product or geographical markets into which it diversifies and it may be vulnerable to
competition from other companies that focus on a specific market or product type.
Interactive question 3: Budget airline [Difficulty level: Intermediate]

A budget airline that offers low cost short-haul flights is considering the provision of flights to a country
with a volatile political environment, where public spending on such facilities as airports is often
withdrawn without warning. There is also a history of foreign planes being grounded for no apparent
reason and being forbidden to leave the country for several days. Market research has shown that
despite these problems there is considerable demand for low cost flights to this country.
Requirement
Identify potential risk strategies that could be adopted by the airline's management.
11 Implementation of plans
Section overview
Once risks have been identified, assessed and quantified, and the approaches to risk have been
decided, the task of putting the plans into action begins.
Implementation should be treated as a separate project with clear objectives and success criteria.
Implementation of the risk management process helps to clarify what ongoing actions should be taken
beyond the planning stage to ensure that the process is implemented in a manner that is beneficial to
the management team. The implementation process helps to ensure that you get the best risk
protection for the amount invested in the risk and other management processes.
The implementation process focuses on the process itself rather than the risks of a particular project.
This step should be ongoing, focusing on the performance of the risk management process and the way
in which it is integrated with other processes relevant to the project in question.
Organisations need to treat the implementation stage as a separate project with clear objectives and
success criteria, clear planning, proper resourcing and effective monitoring and control.
Case example: Tesco Principal risks

In the Corporate governance section of its 2013 Annual Report and Financial Statements, Tesco provides
a summary of the principal risks it faces, and for each risk it identifies key controls and mitigating factors.
The principal risks identified are:
Business strategy risk if the Group follows the wrong direction, or if strategic direction is not
effectively communicated or implemented, the business may suffer.

Financial strategy risk risks relate to an incorrect or unclear financial strategy and the failure to
achieve financial plans.
Competition and consolidation risk failure to compete on areas including price, product range,
quality and service in increasing UK and overseas retail markets could impact on the Group's market
share and adversely affect its financial results.
The consolidation of competitors, key geographical areas or markets through mergers or trade
agreements could also adversely affect Tesco's market share.
Reputational risk Failure to protect the Group's reputation and brand in the face of ethical, legal and
moral challenges could lead to a loss of trust and confidence, a decline in customer base, and could
therefore affect the Group's ability to recruit and retain good staff.
Performance risk in the business Risk that business units underperform against plan and against
C
competitors, and that business fails to meet the stated strategy. H
A
Property risk Continuing acquisition and development of property sites carries inherent risk; targets to
P
deliver new space may not be achieved; challenges may arise in relation to finding suitable sites, T
obtaining planning or other consents, and compliance with design and construction standards in E
different countries. R
Economic risks In each country where it operates, Tesco is affected by the underlying economic
environment and the fiscal measures which apply to the retail sector.
2
Political and regulatory risks In each country in which it operates, Tesco could be affected by legal
and regulatory changes, increased scrutiny by competition authorities, and political developments
relevant to domestic trade and the retail sector.
Product safety Failures to ensure product safety could damage customer trust and confidence,
affecting Tesco's customer base and therefore financial results.
IT systems and infrastructure Any significant failure in the IT processes of Tesco's retail operations
would impact its ability to trade. Failure to invest appropriately in IT could increase its vulnerability to
attack, constrain the growth of the business, and fail to safeguard personnel, supplier or customer data.
People Failure to attract, retain, develop and motivate the best people, with the right capabilities at all
levels could limit the Group's ability to succeed.
Group Treasury Failure to ensure the availability of funds to meet the needs of the business, or to
manage interest or exchange rate fluctuations could limit the Group's ability to trade profitably.
Tesco's financial risks are separately identified as: funding and liquidity, interest rate risk, foreign
currency risk, and credit risk.
Tesco Bank the impact on the Group of financial risks taken by Tesco Bank.
Pensions The Group's IAS 19 deficit could increase if there is a fall in corporate bond yields which is
not offset by an increase in the pension scheme's assets. There are also risks of legal and regulatory
changes introducing more burdensome requirements.
Fraud, compliance and internal controls As the business develops new platforms and grows both in
size and geographical scope, the potential for fraud and dishonest activity by our suppliers, customers
and employees increases.
Business continuity and crisis management A major incident, or activism, could have an impact on
staff and customer safety, or the Group's ability to trade.
Source: Tesco Annual Report and Financial Statements, 2013

12 Risk monitoring and control
Section overview
The risk management process is an on-going one risks must be continually monitored to
determine any change in profile which may lead to procedures to control these risks being altered.
This step can be thought of as an audit of the overall risk management process, where expected
and actual results are compared and recommendations made for any remedial action to be taken.
Just because risk management procedures are in place does not mean that companies are immune
from the effects of risk such procedures may reduce the impacts of risk but will not eliminate
them completely.
It is important to know when sufficient risk management procedures are in place, otherwise the
process would never be completed.
12.1 Monitoring of risk management plans

All risk management plans must be monitored to ensure that they are achieving the desired results and
that changes to the project's risk profile are reflected.
To assess the effectiveness of risk management plans, you need to establish standards and benchmarks
against which results should be measured. Standards can come from such sources as industry
regulations or the industry leader.
Once the standards and benchmarks have been established, the risk management plan can be
measured continually against them over time to allow actual performance to be compared with
expected performance which in turn can be used to adjust below-standard results.
In order to determine when adjustments to performance should take place, you should establish a
threshold (or 'trigger point') which represents a sufficient change in risk exposure to warrant another risk
analysis being carried out. Risk management is a continuous process and those responsible for handling
risk should be prepared to treat it as such.
As with any process, evaluation of risk management plans is essential to ensure they are performing to
expectations. Managers and stakeholders in the risk management process should consider such areas
as:
How successful was the plan and were the benefits and costs at the predicted level?
In the light of the above, are any changes needed to improve the plan?
Would the plan have benefited from the availability of additional information?
You can think of risk monitoring as being similar to an audit of the risk management process. Various
tests will be carried out to determine whether individual controls are working properly and
recommendations made in the light of results. However, unlike auditing, risk management monitoring
does not take place only on an annual basis. Risk monitoring is a continuous process.
12.2 Board monitoring of control systems

As well as monitoring specific plans, the board needs to have procedures in place for reviewing the
effectiveness of systems taken as a whole. Turnbull suggests that boards should regularly receive and
review reports and information on internal control, concentrating on:
What the risks are and strategies for identifying, evaluating and managing them.
The effectiveness of the management and internal control systems in the management of risk, in
particular how risks are monitored and how any weaknesses have been dealt with.
Whether actions are being taken to reduce the risks found.
Whether the results indicate that internal control should be monitored more extensively.

In addition, when directors are considering annually the disclosures they are required to make about
internal controls, the Turnbull report states they should conduct an annual review of internal control.
This should be wider-ranging than the regular review; in particular it should cover:
The changes since the last assessment in risks faced, and the company's ability to respond to
changes in its business environment.
The scope and quality of management's monitoring of risk and internal control, and of the work of
internal audit, or consideration of the need for an internal audit function if the company does not
have one.
The extent and frequency of reports to the board.
Significant controls, failings and weaknesses which have or might have material impacts upon the
accounts. C
H
The effectiveness of the public reporting processes. A
P
T
Case example: Basel Committee E
R
Since 1974 the Basel Committee on Banking Supervision has made important recommendations
affecting risk management and internal controls operated by banks.
The Basel II accords were particularly important in establishing risk management and capital adequacy 2
requirements.
The Committee highlighted the need for boards to treat the analysis of a bank's current and future
capital requirements in relation to its strategic objectives as a vital element of the strategic planning
process. Control systems should relate risk to the bank's required capital levels. The board or senior
management should understand and approve control systems such as credit rating systems. Banks
should use methods such as value at risk models that capture general market risks and specific risk
exposures of portfolios.
The Committee stressed the importance of banks having an operational risk management function that
develops strategies, codifies policies and procedures for the whole organisation and designs and
implements assessment methodology and risk reporting systems. It is particularly important for banks to
establish and maintain adequate systems and controls sufficient to give management and supervisors
the confidence that their valuation estimates are prudent and reliable.
Banks' risk assessment systems (including the internal validation processes) must be subject to regular review
by external auditors and/or supervisors. The regular review of the overall risk management process should
cover:
The adequacy of the documentation of the risk management system and process
The organisation of the risk control unit
The integration of counterparty credit risk measures into daily risk management
The approval process for counterparty credit risk models
The validation of any significant change in the risk measurement process
The scope of counterparty credit risks captured by the risk measurement model
The integrity of the management information system
The accuracy and completeness of position data
The verification of the consistency, timeliness and reliability of data sources used to run internal
models, including the independence of such data sources
The accuracy and appropriateness of volatility and correlation assumptions
The accuracy of valuation and risk transformation calculations
The verification of the model's accuracy through frequent testing and review of results

The most recent guidance, Basel III, published in December 2010 and updated in June 2011, focused on
capital and liquidity standards. Basel III established higher minimum capital levels and tightened the
rules on the definition of capital. In particular it focused on raising capital requirements for trading and
complex securitisation processes, which have been a major source of losses. It also introduced measures
to strengthen the capital requirements for counterparty credit exposures, arising from banks' derivatives,
repo and securities' financing activities. The capital requirements were supplemented by a leverage ratio
requirement, aiming to limit the risk of destabilising deleveraging processes and introducing additional
safeguards against model risk and measurement error.
The Committee also introduced for the first time global liquidity standards, noting that the difficulties
experienced by banks were sometimes due to lapses in the basic principles of liquidity risk management.
The liquidity standards have two objectives, firstly ensuring that banks have enough liquidity to survive
an 'acute stress scenario' lasting one month. The second objective is concerned with the longer-time
horizon, creating incentives for banks to use more stable sources of funding.
Other requirements aim to limit the shocks caused to financial systems by the impact of cycles. These
include promoting disclosure of expected losses, conserving capital above the minimum requirements
and adjustment of the capital buffer range when there are signs that credit has grown to excessive
levels.
Basel III has been seen as building on the risk management requirements of Basel II, in particular
promoting an enterprise risk management approach.
The US Federal Reserve announced in December 2011 that it would implement virtually all of the Basel
III rules.
Further details about the reports of the Basel Committee are on the website of the Bank for International
Settlements: www.bis.org/list/bcbs/index.htm
12.3 Reporting on risk management

The Turnbull Report laid down minimum expected guidelines for disclosure on risk management and
corporate governance. The Report was intended to encourage best practices, and stated that publicly
traded companies should report on the risks they faced and outline the risks.
The Turnbull Report requires the following disclosures.
The governing body of the company (generally the board of directors) should acknowledge
responsibility for internal control systems.
An ongoing system should be in place for identifying, evaluating and managing significant risks.
An annual process should be in place for reviewing the effectiveness of the internal control systems.
There should be a process to deal with the internal control aspects of any significant problems
disclosed in the annual report and accounts.
Case example: GlaxoSmithKline risk management

We have already discussed the key risks facing GlaxoSmithKline (GSK) according to its 2012 annual
report. The report goes into detail about how risks are being managed.
Risk Mitigation
R and D not delivering Reorganisation of R and D department into smaller units, to

commercial new products encourage entrepreneurialism and accountability. Collaboration
with partners in academia, biotechnology companies and other
pharmaceutical companies and consultation with payers and
patients.
Failure to protect intellectual Use of a global patents group to oversee processes and monitor
property rights new developments in patent law, in particular litigation processes
to ensure successful enforcement and defence of patents.

Risk Mitigation
Product quality failures causing Adoption of Quality Management System throughout supply
risk to the patient or consumer chain and lifecycle of products. Oversight by a Chief Product
Quality Officer and Quality Council that examines emerging risks,
shares experience and cascades what has been learnt over the
group. Assignment of quality staff to each business unit.
Interruption of product supply Assessment of standing of suppliers, safety stocks and backup
supply arrangements and, if possible, avoidance of dependence
on a single supplier.
Inability to obtain adequate Demonstration, particularly to governments of value of medicines.
prices Exploration of different pricing models for innovative products. C
H
Restructuring of business to take advantage of growth A
opportunities. P
T
Non-compliance with laws and Continuously changing internal control framework to take into E
regulations account changes in commercial model, marketplace, guidance R
and regulations. Oversight by a chief regulatory officer and
regulatory governance board. Involvement of Medical
Governance Ethical Committee to ensure application of principles 2
of good medical science, integrity and ethics. Global code of
practice for marketing and promotional activities. Policies ensuring
adherence to economic sanctions and export control laws.
Exposure to political and Diversification mitigates exposure to local risks. Assignment of a
economic risks and natural cross-business team to manage European economic risks, which
disasters has developed response plans to different European economic
events. Reduction of exposure in key countries, including
exercising caution in counterparty exposures and proactively
managing liquidity positions.
Alliances and acquisitions Due diligence procedures, review of major transactions by
difficulties management boards and management of integration by
Corporate Strategy group, with integration team being appointed
for each acquisition.
Financial reporting risks Testing of design and operating effectiveness of key management
controls, working with advisers to ensure Group up-to-date with
latest developments. Procedures for review and sign-off across
group and by senior management.
Tax and treasury losses Monitoring of current debates to anticipate changes in tax law,
use of compliance policies and procedures and engagement of
advisers to review application. Use of simplified intellectual
property ownership model to give greater certainty in application
of transfer pricing.
GSK's treasury department does not act as a profit centre, to
reduce risks. Treasury risk is managed by a detailed set of
management policies that is reviewed and approved annually by
board.
Failure to comply with anti- Global anti-bribery programme that includes global policy,
corruption legislation ongoing training and requirements relating to due diligence,
contracting and oversight. Stronger controls over interactions
with government officials and business development transactions.
Dedicated team drives implementation of programme, supported
by extended team of functional experts.

Risk Mitigation
Adverse outcome of litigation Focus on patient safety in drug development. Medical governance
and government investigations system involving Global Safety Board and Chief Medical Officer
responsible, amongst other things, for safeguarding human
subjects in tests. Dispute management procedures aiming to
resolve disputes early.
Non-compliance with health, Emphasis on culture where employees feel valued, along with
safety and environment procedures to minimise hazards. Reduction of water and energy
requirements consumption and hazardous waste, and reporting in corporate
responsibility report.
Credit risk from large customers Monitoring of financial information and credit ratings, and review
of credit limits.
IT security breaches Assessment of changes in risk environment, review of policies and
controls and routine training of employees.
However the systems and controls that GSK had in place failed to prevent a police investigation into
corrupt activities by some of its Chinese executives.
12.4 Limitations of risk management plans

As with all business processes, regardless of their quality, risk management plans have their limitations.
They are only as good as the information that is used to construct them in the first place remember
the old adage 'rubbish in rubbish out'? If risks are not assessed properly, then a great deal of time and
resources could be wasted in dealing with the risk of losses that in fact are highly unlikely to occur
time and resources that could have been more gainfully employed elsewhere. While it is possible for
unlikely events to occur, if a risk is highly unlikely to happen then it may be better to simply accept the
risk and deal with any losses if and when they arise. Some organisations over-estimate what such
processes should be able to achieve to the extent that work is suspended until the risk management
process is considered to be complete.
At the other extreme, there are organisations who believe themselves to be immune from losses
resulting from business risk simply because they have risk management processes in place.
Complacency is one of the worst enemies of successful businesses. As mentioned above, risk
management processes must be continually monitored for any weaknesses just like the business
environment itself, they are not static instruments.
Such is the focus on risk and its consequences in today's business that there is a danger of management
spending so long thinking about the negative aspects of projects that they forget about the positive
aspects. Just as the human body loses its ability to fight infection if it is locked in a sterile environment
for a long period of time, so do businesses lose their resilience for dealing with risk if they become
obsessed with trying to avoid it. Make sure you control risk but do not let risk control you.
Interactive question 4: LP [Difficulty level: Intermediate]

LP manufactures and supplies a wide range of different clothing to retail customers from 150 stores
located in three different countries in the Eurozone.
In order to increase sales, a new internet site is being developed which will sell LP's entire range of
clothes using 3D revolving dummies to display the clothes on screen. The site will use some new
compression software to download the large media files to purchasers' PCs so that the clothes can be
viewed. This move is partly in response to environmental scanning which indicated a new competitor,
PVO, will be opening an unknown number of stores in the next six months.
As a cost cutting move, the directors are considering delaying LP's new range of clothes by one year.
Sales are currently in excess of expectations and the directors are unwilling to move away from
potentially profitable lines.

Requirement
Explain the business risks affecting LP and briefly describe how these risks can be managed.
Case example: BP
The impact of the oil spill in the Gulf of Mexico on BP was a significant news story in much of 2010. On
3 August 2010 the US government stated that the oil spill in the Gulf of Mexico was officially the
biggest leak ever, with an estimated 4.9 million barrels of oil leaked before the well was capped in July
2010. The consequences of the spill included the departure of BP's chief executive, Tony Hayward. BP
created a compensation fund of $20bn and had paid out a further $8bn in the clean-up campaign by C
the end of 2010. H
A
The results of BP's own internal investigation were published in September 2010. It blamed a 'sequence P
of failures involving a number of different parties', that is BP and two other companies working on the T
well, although both of the other companies criticised this report. Problems highlighted by the BP report E
included 'a complex and interlinked series of mechanical failures, human judgements, engineering R
design, operational implementation and team interfaces.'
Critics have pointed to other operational problems BP has had, from the explosion at its Texas City
2
refinery to the temporary shut-down at Prudhoe Bay. CNN news quoted an employee who had worked
at both locations as saying that no-one should be surprised by the 2010 disaster: 'The mantra was 'Can
we cut costs by 10%.' Transocean, one of the other companies criticised in BP's September 2010 report,
also blamed BP for cost-cutting. Transocean was quoted by Associated Press as commenting: 'In both its
design and construction BP made a series of cost-saving decisions that increased risk in some cases
severely.'
The US Commission that reported on BP in January 2011 found that BP did not have adequate controls
in place, and that its failures were systemic and likely to recur. The report apportioned blame between
the various companies involved, although it emphasised BP had overall responsibility. The report
highlighted failures of management of decision-making processes, lack of communication and training
and failure to integrate the cultures and procedures of the different companies involved in the drilling.
The report drew attention to the failure of BP's engineering team to conduct a formal, disciplined
analysis of the risk factors on the prospects for a successful cement job and also the failure to address
risks created by late changes to well design and procedures. The report highlighted the flawed design
for the cement used to seal the bottom of the well, that the test of the seal was judged successful
despite identifying problems, and the workers' failure to recognise the first signs of the impending blow-
out. The commission found that decisions were taken to choose less costly alternative procedures. These
were not subject to strict scrutiny that required rigorous analysis and proof that they were as safe as the
more expensive regular procedures.
The report also blamed inadequate government oversight and regulation, with the agency responsible
lacking staff who were able to provide effective oversight. Many aspects of control over drilling
operations were left to the oil industry to decide. There were no industry requirements for the test that
was misinterpreted, nor for testing the cement that was essential for well stability. When BP contacted
the agency to ask for a permit to set the plug so deep in the well, the agency made the same mistake as
BP, focusing on the engineering review of the well design and paying far less attention to the decisions
regarding procedures during the drilling of the well.
On the basis of what BP has published however, its risk management approach did not appear to differ
greatly from other oil companies, and from many other large organisations across the globe. For
example BP had sophisticated risk assessment processes in place. In 2007 it completed 50 major
accident risk assessments. The assessments identified high-level risks that, if they occurred, would have a
major effect on people and the environment. BP's monitoring procedures included the work carried out
by the safety, ethics and environment assurance committee. The committee's work encompassed all
non-financial risks.
BP's systems also received external backing. Accreditations BP held included ISO 14001 at major
operating sites, reporting to GRI A+ standard and assurance by Ernst and Young to AA100AS principles
of inclusivity, materiality and responsiveness.

It's possible that BP relied on generally accepted risk management practices which had become less
effective over time.
In February 2012 BP announced a 14% rise in dividends, after profits for 2011 of $23.9bn, compared
with a $4.9bn loss in 2010. In July 2012, however, BP set aside an additional $847m provision to pay for
the 2010 disaster, raising the potential cost to $38bn. Second quarter figures for 2012 showed a 35%
fall in underlying profits. The $38bn included $14bn in costs to restore over 4,000 miles of shoreline
and $8.8bn in compensation payments, although it had been reduced by $4bn following settlements
with partners in the venture. BP also still faced 'significant uncertainty' as it had not yet reached a
settlement with the US Department of Justice. The company had however resumed drilling in the Gulf
of Mexico.
In April 2012, former BP engineer, Kurt Mix, was arrested on charges of intentionally destroying text
messages between himself and a supervisor, containing details about how attempts to cap the leaking
well were going.

Summary
C
H
A
P
T
E
R

Self-test
1 ANG
ANG is a road haulage contractor. The company specialises in collection and delivery of large or
heavy items such as railway locomotives and sections of bridges from the manufacturer to the
customer. The company owns 49 road vehicles of different sizes to enable transportation of the
different goods.
ANG's risk management policy is based on taking out insurance. As well as the standard employer
and third party liability classes of insurance, ANG also insures against damage to road infrastructure
such as bridges and tunnels from its own vehicles or as a result of goods being carried becoming
unstable and falling off ANG's lorries.
ANG's terms and conditions of carriage note that radioactive goods will not be transported under
any circumstances. Explosives are carried, but only where the owner accepts liability on their own
insurance.
Contingency planning is limited; the board of ANG believes that if any risks do occur, then ANG
has sufficient vehicles to continue operations.
The Board of ANG is also considering a new venture for the same day delivery of goods where the
distance to travel is more than its existing fleet of road vehicles could travel in one day. This
venture involves the purchase of surplus 'Hercules' transport 'planes from the army. The board has
recently decided to make the purchase of the 'planes because they are being offered at a
substantial discount. Marketing activities will commence next month.
Requirements
(a) Explain the elements of a risk management framework in an organisation.
(b) Explain the risk management strategies available to an organisation.
(c) Evaluate the risk management strategy of ANG, explaining any amendments that you think
are necessary.
2 HOOD
HOOD sells a wide range of coats, anoraks, waterproof trousers and similar outdoor clothing from
its 56 stores located in one country. The company is profitable, although the gross profit in some
stores has declined recently for no apparent reason.
Each store uses EPOS to maintain control of inventory and provides the facility to use EFTPOS for
payments. However, about 55% of all transactions are still made in cash. Details of sales made
and inventories below re-order levels are transferred to head office on a daily basis where
management reports are also prepared.
Inventory is ordered centrally from head office, details of requirements being obtained from the
daily management information provided by each store. Orders are sent to suppliers in the post,
with stock arriving at each store approximately 10 days after the re-order level is reached.
Recent newspaper reports indicate that one of the chemicals used to waterproof garments releases
toxic fumes after prolonged exposure to sunlight. The board of HOOD is investigating the claim,
but is currently treating it with some degree of scepticism. The product range has generally sold
well, although there has been little innovation in terms of garment design in the last four years.
Requirements
(a) Identify the different risks facing HOOD, placing the risks into suitable categories.
(b) Discuss the potential effect of each risk on the organisation, describing how the impact of that
risk may be minimised.
3 LinesRUs
The LinesRUs Company is responsible for maintaining the railway infrastructure for the rail network
in a large European country. Main areas of responsibility for the company include:
Ensuring that the railway tracks are safe
Signalling equipment is installed correctly and works properly
Maintenance of overhead power lines for electric trains

Income is fixed each year dependent on the number of train services being operated and is paid via
a central rail authority. The company is granted a sole franchise each year to provide services on
the rail network.
Work is scheduled in accordance with the amount of income, and to provide LinesRUs with an
acceptable operating profit. Any additional work over and above standard maintenance (eg due to
foreseen factors such as bridges being damaged by road vehicles and unforeseen factors such as
car drivers falling asleep and driving their cars onto railway tracks) is negotiated separately and
additional income obtained to repair the infrastructure in these situations.
A lot of maintenance work is relatively simple (eg tightening nuts and bolts holding railway tracks
together) but is extremely important as an error may result in a train leaving the rails and crashing.
The board of LinesRUs is aware of many of these risks and attempts to include them in a risk
management policy.
C
However, recently a train was derailed causing the death of 27 passengers. Initial investigations H
A
show that faulty maintenance was the cause of the derailment. One of the unforeseen
P
consequences of the crash has been a fall in the numbers of people using trains with a subsequent T
fall in income for train operators. LinesRUs are being sued by the train operators for loss of income, E
and the national press are suggesting LinesRUs must be incompetent and are calling for a re- R
evaluation of the method of providing maintenance on the rail network.
Requirements
2
(a) Advise the directors of LinesRUs of the main stages of a structured risk analysis approach that
will be appropriate to the company's needs.
(b) Using the Transfer Avoid Reduce Accept framework, construct four possible strategies for
managing the risk that rail crashes could occur. Your answer should describe each strategy
and explain how each might be applied in the case.

1 ANG
(a) Risk management structure
The organisation needs a structure to facilitate and communicate information about risks.
A system such as an intranet or groupware product would be suitable as it connects all the
individuals in an organisation, allowing access to shared databases where information about
risks can be stored.
Resources
Sufficient resources are required to support effective risk management. This means that the
board of an organisation must allocate an appropriate budget for risk management, and
then the budget should be spent on appropriate areas. The appointment of a risk
management officer will help to ensure budgeted amounts are spent appropriately.
Risk culture
The culture of the organisation should be developed as far as possible to ensure employees
are aware of risk and to act to avoid risks where possible. Having a risk avoidance culture
will help to ensure that management decisions taken focus on and avoid important risks.
Tools and techniques
Appropriate tools and techniques are available in the organisation to enable the efficient and
consistent management of risks across an organisation. Tools and techniques available
may include obtaining appropriate insurance against risks and having a clear risk
management policy in place.
(b) Avoidance
In this situation, the organisation attempts to determine whether the possible losses avoided
from not undertaking a risky activity are greater than the advantages that can be gained
from carrying out the activity. If the losses avoided appear to outweigh the benefits of
carrying out the activity, then the activity may not take place. In an extreme situation, entire
sections of the business may be closed down if the risk or loss is considered to be too great.
Reduction
Risks are avoided in part but not reduced to zero. For example, the risk of launching a new
product can be reduced by obtaining market research on possible demand for the product
prior to manufacture and launch.
Risk reduction will also involve contingency planning to ensure that if a risk does crystallise,
then the damage from that risk is minimised. For example, most companies will have a
contingency plan against their computer systems failing. Files will be backed-up regularly, and
alternative processing locations will be available if one centre becomes unavailable eg due to
fire or flood.
Acceptance
Risk retention is where the organisation bears the risk itself. This means that if the
unfavourable outcome occurs, then the organisation will suffer the full loss of that event.
Risk retention normally occurs in two situations. First, where some risk occurs which the
organisation's risk management policy did not detect. Second, where risk was classified as
insignificant or the cost of the risk was deemed to be too great compared to the
likelihood of that risk occurring.
Risk retention may also involve self-insurance. This means that funds are placed into some
fund against risks actually occurring.

Transfer
The last risk management strategy is to transfer the risk to a third party. The most
commonly used risk transfer policy is take out insurance against a risk occurring. However,
risks may also be transferred to other third parties, often without the knowledge of that
party. For example, there may be a minimal risk of errors occurring in some software. The
cost of carrying out additional testing may be more than any compensation that may be
payable if the error occurs and the customer makes a successful complaint. In this situation,
risk has been transferred to the customer without the customer's knowledge.
(c) Transfer
The overall risk management strategy of ANG appears to be one of risk transfer. This is the
policy adopted by most businesses and is wholly appropriate given the likelihood of many
risks occurring is low, but if they do occur then significant expenditure would be C
involved. For example, if a load did fall off one of ANG's lorries, then the damage caused H
A
could be considerable, not only to the load itself, but also to other vehicles, people and even
P
the roads being used. ANG would not be able to operate legally without this insurance, T
and so it is essential to obtain it. E
R
Insurance
Whether ANG needs to insure against damage to roads, bridges and so on, is unclear. The
government of the country is normally responsible for maintaining the transport 2
infrastructure. ANG could probably withdraw this insurance and effectively transfer the risk
to the government. Some cost savings would accrue from this move.
Self-insurance
It appears that ANG effectively self-insures against loss of vehicles in respect of being able to
provide a replacement vehicle at short notice. This may be acceptable in the case of individual
losses. However, it may be inappropriate in situations where, for example, a significant
number of ANG's vehicles are destroyed in a fire or flood. Where haulage contracts are
signed for time critical delivery of goods, then some reciprocal agreement with another
haulage company may be appropriate.
Avoidance
The decision by ANG to avoid risk completely in the transfer of hazardous materials seems
sensible. There has been some bad publicity about the transfer of radioactive goods by road,
and the potential for claims, particularly if an accident occurred in an area of high population
density, could be excessive and the damage to ANG's reputation would be considerable. In
the case of explosives, ANG would need to ensure that the contract for carriage clearly stated
that the owner of the goods was responsible for insurance. ANG may also want to obtain a
copy of the insurance contract to confirm this.
Risk acceptance
There appears to be some risk in purchasing the transport 'planes prior to any market
appraisal of the new venture. Normally the risk of a new venture would be reduced by
carrying out market research prior to significant expenditure being incurred. The board
would normally be advised to check whether there was a demand for this service prior to
expenditure being committed.
Published accounts, internal accounts and budgets are a fertile source of information.
The more carefully costs are allocated to each department, the easier it should be to calculate
additional costs which would be incurred in a given emergency, which budgets will be
affected and how quickly necessary funds can be made available.
Detailed plans of site and buildings will show potential bottlenecks in fire escape routes,
obstructions which might make difficulties for fire engines and problems of access which
could occur for both the site and its neighbours from fire, explosion, or escaping gas.
Physical inspection of buildings and machines (and perhaps of personnel, in the medical
sense, and of their working practices) should take place on a regular basis.

2 HOOD
Risk can be defined as the possibility that events or results will turn out differently from what is
expected.
(a) The risks facing the HOOD Company are outlined below.
Operational risks
These are risks relating to the business's day-to-day operations.
(i) Accounting irregularities
The unexplained fall in gross profit in some stores may be indicative of fraud or other
accounting irregularities. Low gross profit in itself may be caused by incorrect
inventory values or loss of sale income. Incorrect stock levels in turn can be caused by
incorrect inventory counting or actual stealing of inventory by employees. Similarly,
loss of sales income could result from accounting errors or employees fraudulently
removing cash from the business rather than recording it as a sale.
(ii) Systems
Technical risks relate to the technology being used by the company to run its business.
(1) Backup
Transferring data to head office at the end of each day will be inadequate for
backup purposes. Failure of computer systems during the day will still result in loss
of that day's transaction data.
(2) Delays in inventory ordering
Although stock information is collected using the EPOS system, re-ordering of
inventory takes a significant amount of time. Transferring data to head office for
central purchasing may result in some discounts on purchase. However, the average
10 days before inventory is received at the store could result in the company
running out of inventory.
Non-business risks
These are risks that arise for reasons beyond the normal operations of the company or the
business environment within which it operates.
(i) Production
The possibility of sunlight making some of HOOD Company's products potentially
dangerous may give rise to loss of sales, also stock recall.
(ii) Event
HOOD may be vulnerable to losses in a warehouse fire.
Business risks
External risks relate to the business; they are essentially uncontrollable by the company.
(i) Macro-economic risk
The company is dependent on one market sector and vulnerable to competition in that
sector.
(ii) Product demand
The most important social change is probably a change in fashion. HOOD has not
changed its product designs for four years indicating some lack of investment in this
area. Given that fashions tend to change more frequently than every four years, HOOD
may experience falling sales as customers seek new designs for their outdoor clothing.
HOOD may also be vulnerable to seasonal variations in demand.

(iii) Corporate reputation
Risks in this category relate to the overall perception of HOOD in the marketplace as a
supplier of (hopefully) good quality clothing. However, this reputation could be
damaged by problems with the manufacturing process and a consequent high level of
returns.
Profiling
By identifying and profiling the effects of the risks, HOOD can assess what the consequences
might be, and hence what steps (if any) are desirable to mitigate or avoid the consequences.
(b) The potential effects of the risks on HOOD and methods of overcoming those risks are
explained below.
Operational risks C
H
(i) Accounting irregularities A
P
The potential effect on HOOD is loss of income either from inventory not being T
available for sale or cash not being recorded. The overall amount is unlikely to be E
significant as employees would be concerned about being caught stealing. R
The risk can be minimised by introducing additional controls including the necessity of
producing a receipt for each sale and the agreement of cash received to the till roll
2
by the shop manager. Loss of inventory may be identified by more frequent inventory
checks in the stores or closed-circuit television.
(ii) Systems
(1) Backup
The potential effect on HOOD is relatively minor; details of one shop's sales could
be lost for part of one day. However, the cash from sales would still be available,
limiting the actual loss.
Additional procedures could be implemented to back up transactions as they
occur, using online links to head office. The relative cost of providing these links
compared to the likelihood of error occurring will help HOOD decide whether to
implement this solution.
(2) Delays in inventory ordering
The potential effect on HOOD is immediate loss of sales as customers cannot
purchase the garments that they require. In the longer term, if stock outs become
more frequent, customers may not visit the store because they believe goods will
not be available.
The risk can be minimised by letting the stores order goods directly from the
manufacturer, using an extension of the EPOS system. Costs incurred relate to the
provision of internet access for the shops and possible increase in cost of goods
supplied. However, this may be acceptable compared to overall loss of reputation.
Non-business risks
(i) Production
The effect on HOOD is the possibility of having to reimburse customers and the loss of
income from the product until the problems are resolved.
The risk can be minimised by HOOD taking the claim seriously and investigating its
validity, rather than ignoring it. For the future, guarantees should be obtained from
suppliers to confirm that products are safe and insurance taken out against possible
claims from customers for damage or distress.

(ii) Event
The main effects of a warehouse fire will be a loss of inventory and the incurring of
costs to replace it. There will also be a loss of sales as the inventory is not there to fulfil
customer demand, and perhaps also a loss of subsequent sales as customers continue to
shop elsewhere.
Potential losses of sales could be avoided by holding contingency inventory elsewhere,
and losses from the fire could be reduced by insurance.
External risks
(i) Macro-economic risk
The potential effect on HOOD largely depends on HOOD's ability to provide an
appropriate selection of clothes. It is unlikely that demand for coats etc will fall to zero,
so some sales will be expected. However, an increase in competition may result in falling
sales, and without some diversification, this will automatically affect the overall sales of
HOOD.
HOOD can minimise the risk in two ways: by diversifying into other areas. Given that
the company sells outdoor clothes, then commencing sales of other outdoor goods such
as camping equipment may be one way of diversifying risk. It can also look to reduce
operational gearing, fixed cost as a proportion of turnover.
(ii) Product demand
Again the risk of loss of demand and business to competitors may undermine HOOD's
ability to continue in business.
This risk can be minimised by having a broad strategy to maintain and develop the
brand of HOOD. Not updating the product range would appear to be a mistake in this
context as the brand may be devalued as products may not meet changing tastes of
customers. The board must therefore allocate appropriate investment funds to updating
the products and introduce new products to maintain the company's image.
(iii) Corporate reputation
As well as immediate losses of contribution from products that have been returned,
HOOD faces the consequence of loss of future sales from customers who believe their
products no longer offer quality. Other clothing retailers have found this to be very
serious; a reputation for quality, once lost, undoubtedly cannot easily be regained.
The potential effect of a drop in overall corporate reputation will be falling sales for
HOOD, resulting eventually in a going concern problem.
HOOD can guard against this loss of reputation by enhanced quality control
procedures, and introducing processes such as total quality management.
3 LinesRUs
(a) Risk identification
Risks cannot be managed without first realising that they exist. Managers need to maintain a
list of known or familiar risks and the extent to which they can harm the organisation or
people within it. Managers also need to be aware that unfamiliar risks may exist and maintain
vigilance in case these risks occur. Risk identification is an ongoing process so that new risks
and changes affecting existing risks may be identified quickly and dealt with appropriately
before they result in unacceptable losses.
LinesRUs appear to have identified some risks in their risk management policy. However,
other risks do occur and managers within LinesRUs must be able to identify and respond to
those risks quickly.
Risk assessment
It may be difficult to forecast the financial effects of a risk until after a disaster has occurred.
Areas such as extra expenses, inconvenience and loss of time can then be recognised, even
if they were not thought of in initial risk analysis. In a severe situation, damage to the
company's reputation could result in LinesRUs becoming bankrupt.

In this situation, there has been a loss of confidence in the company, the extent of which may
not have been foreseen. This has resulted in additional expense in terms of lost passengers
legal advice will be needed to determine whether LinesRUs is liable and whether the
company's insurance meets this liability. It is also uncertain what the additional time and
cost of repairing the track will be and whether LinesRUs can claim additional income for this
work.
Sources of information to ensure that the risk can be minimised may include obtaining
regular reports from train operators on the state of the rail infrastructure and monitoring
news feeds such as Reuters for early indication of potential disasters. LinesRUs should file
appropriate reports of physical inspection of track as evidence of maintenance work carried
out.
Risk profiling
C
This stage involves using the results of risk assessment to group risks into families. A H
A
consequence matrix is one method of doing this.
P
T
Likelihood Consequences E
R
Low High
High Loss of lower level staff Loss of senior staff
2
Low Loss of suppliers Major rail disaster affecting reputation of
company
Major rail disaster not the
company's fault Loss of computer data on maintenance work
Loss of franchise
The analysis will be incomplete for LinesRUs because not all risks can be identified.
Risk quantification
Risks that require more detailed analysis can be quantified, and, where possible, results and
probabilities calculated. The result of calculations will show average or expected result or loss,
frequency of losses, chances of losses and largest predictable loss to which LinesRUs could be
exposed by a particular risk.
Unfortunately, many of the risks facing LinesRUs are significant. So while quantification can
be enhanced by past events such as drivers falling asleep, they appear to be one-off situations
meaning that the actual event may not occur again. However, the adverse effects of the risk in
terms of costs necessary to repair the rail infrastructure will be helpful, enabling LinesRUs to
ensure that appropriate insurance is available effectively guarding against loss by transferring
the risk.
Risk consolidation
Risks analysed at the divisional or subsidiary level need to be aggregated at the corporate
level. This aggregation will be required as part of the overall review of risk that the board
needs to undertake. Systems should identify changes in risks as soon as they occur,
enabling management to monitor risks regularly and undertake annual reviews of the way
that organisation deals with risk.
There is no information on the organisational structure of LinesRUs. Given the risky nature of
the company's business, LinesRUs is likely to be an independent legal entity to ensure that no
other companies are adversely affected should LinesRUs go out of business.
(b) Risk responses

Transfer
The risk is transferred to a third party. As noted above, this may not be possible if insurers are
not willing to accept the risk. Alternative methods of risk transfer may have to be considered
including asking the state for some form of insurance.

Avoidance
LinesRUs may consider whether the risk can be avoided. However, given that maintenance
work must continue and that errors are always possible, then the risk may crystallise.
Avoidance is not possible.
The only method of avoidance would appear to be termination of operations. This again
may not be appropriate given this would close LinesRUs's business.
Reduction
The risk can be reduced by taking appropriate measures. In the case of LinesRUs these will
include regular training for maintenance staff. Management should use other methods such
as newsletters to raise awareness of the importance of work being carried out and the
potential consequences of error. There should be maintenance and enforcement of
appropriate disciplinary procedures where breaches of work practices have been identified.
LinesRUs may also consider loss control options. These may include hiring of lawyers to
defend LinesRUs and release of publicity material on the work of LinesRUs showing extent of
maintenance normally carried out.
Acceptance
This is where the organisation retains the risk and if an unfavourable outcome occurs it will
suffer the full loss. In the case of the rail crash, LinesRUs may have to retain the risk if suitable
insurance cannot be found. Given the uncertainties regarding the costs resulting from the
unfavourable outcome, insurers may be unwilling to insure for this type of event.


Note: This is not an exhaustive list you may have thought of different examples that are equally
relevant.
Seasonality of business most purchases are likely to be associated with seasons. Easter and
Christmas are major seasons for the confectionery business, but there may be dips at other times of
the year. C
H
Impulse buying a large proportion of confectionery purchases are made on impulse. If economic A
changes reduced the amount of impulse buying due to consumers having less money to spend P
this could have a major effect on profits. T
E
Supply of raw materials sugar is a major raw material used in the manufacture of confectionery R
and non-alcoholic beverages. There may be a risk of relying too heavily on one major source of
supply of sugar and other raw materials necessary for the continued production of products.
2
Competition the confectionery and non-alcoholic beverages markets are highly competitive. If
there is a particular product that contributes a large proportion of sales revenue, there is a
considerable risk that a rival company will bring out a similar product and take some of the market
share. The extent of this risk will depend very much on the power of the brand.
Role of food in public health with lots of publicity about levels of obesity, children's eating
habits, heart disease and diabetes, there is a significant threat to the confectionery and fizzy drinks
markets. There is potential for governments to restrict advertising of certain products and to
impose additional taxes on confectionery and fizzy drinks, which could make marketing more
difficult. This could have a significant downward effect on sales and profits. Consumer tastes may
change for health-related reasons. If the company is unable to respond, this will also result in
declining sales or margins.
Product recalls and incorrect labelling of merchandise the confectionery industry is
particularly susceptible to the risk of product recalls and incorrect labelling. The necessary publicity
given to the potential consequences of nut allergies, for example, has led to much stricter
regulation of labelling information. There have been instances of products being recalled due to
failure to include warnings of nut content on labels. It is not just the product recall itself that is
expensive the potentially damaging effect on the company's reputation could have an even
greater impact. Although product recalls are infrequent, their considerable impact is such that very
tight internal controls are necessary to prevent their occurrence.

Possible non-compliance with laws USA
The possible reduction in the workforce in the USA will mean that many employees will be entitled to
some redundancy pay. There is the possibility of breach of employment law in processing and payment
of pay. Internal audit will need to review any redundancy calculations on a test basis to ensure that
employment law has been complied with.
Possible non-compliance with laws Far East
Establishing a factory in the Far East will mean that VSYS will have to comply with the laws and
regulations of a foreign country. The directors must ensure that the law in the country is understood,
possibly by hiring local solicitors.
Overall risks from new systems
Setting up a new factory in the Far East will also mean establishing new management and financial
accounting systems in that country. Risks inherent in establishing those systems may be minimised by
exporting the systems currently being used in the USA. However, it is unlikely that no modifications will

be necessary, as new systems will be necessary to meet the specific situation in the new location. New
systems always provide a risk of failure or incorrect reporting due to lack of adequate testing or
implementation problems. Internal audit will need to review the systems in detail to try to minimise the
errors that occur.
Communication risks Far East to USA
Establishing a new production location will mean that regular management and other reports will be
sent between two geographically diverse locations. This new communication system will run risks such
as communications being lost or intercepted en route. The board will need to ensure that appropriate
encryption systems are introduced across the communication system to minimise these risks.
Board control
Geographical distance from the USA to the Far East may limit the board's ability to maintain appropriate
control of the new production location. The risk is that the new factory may manufacture the computer
components correctly, but fail to meet its own constraints regarding mix of components produced or
timescales for production. To maintain adequate control, a director may have to be appointed to be in
residence at the new factory to ensure both locations are attempting to meet the objectives of VSYS.

Risk avoidance
The airline could abandon plans to offer services to this country.
Risk reduction
Invite the host government to be a partner in the venture.
Seek written assurances from the host government that the airport to be used will be fully
maintained to international safety standards and that planes will not be prevented from taking
off without good and communicated reasons.
Have contingency plans in place to adequately deal with any operational problems while in
the country for example, contacts with local coach company to ensure transport to hotels if
passengers have to spend another night in the country before the plane can take off; deals
with local hotels to provide any necessary accommodation.
If the new service is likely to boost the country's economy due to, for example, an increase in
visitors, it may be worth trying to lobby the country's government for a change in policy.
Risk transfer
Have adequate insurance in place to cover the cost of any planes being grounded.
Consider setting up an alliance with an airline located in the country in question, with the
service being offered in that airline's name but with a codeshare arrangement.
Risk retention
Accept the possibility that airports may not be properly maintained or planes may be
grounded, and the accompanying costs.

Business risks
These are risks that a company's performance could be better or worse than expected.
(a) The new business venture to sell clothes on the internet using 3D models to display the
clothes.
There is the risk that demand will be far short of that anticipated or that costs of developing the
internet site will significantly exceed budget.
LP should have assessed the 3D project for feasibility. Budgets should have been established and
actual expenditure regularly compared with budgets. If actual expenditure is unavoidably
significantly in excess of budget, the board should consider whether the project should continue.
Thorough testing procedures should have been built into the plan, and these should ensure that C
the site is capable of coping with anticipated demand. Once the site is operational, LP should H
A
monitor the level of sales generated by obtaining customer feedback through the site, and P
comparing sales generated with the costs of keeping the site updated. T
E
(b) Product obsolescence R
The decision to lengthen the time of sale for each product may appear to decrease development
costs. However, the board of LP must also take into account demand for the goods. The fashion
industry tends to issue new clothes and designs every few months, and certainly in temperate 2
climates, fashions will change according to the season. There is a risk that not amending the style
of products sold will reduce sales far in excess of the reduction in expenditure. The overall going
concern of the company may also be adversely affected if customers perceive the clothes to be 'out
of date' and change to other suppliers.
LP should monitor the performance of products in detail, and look for evidence of falling sales
and other evidence that its products are viewed as old-fashioned, for example adverse customer or
press comment. The board should also consider whether work on developing new products should
continue to some extent, so that new lines can be launched quickly if demand falls.
(c) New competition
The new company PVO appears to be aggressively attacking LP's market place. While the overall
effect of the new competitor is difficult to determine, having a new range of clothes available is
likely to attract customers with little if any brand loyalty to LP.
LP should make sure that competitor activity is carefully monitored and responses are made to
known or predicted competitor activity, for an example an advertising campaign to counter new
products being launched by the competitor. LP's board should also review very regularly the
performance of products which are most vulnerable to competitor activity and decide whether to
invest more in these or concentrate on other less vulnerable products.

CHAPTER 3
Cost analysis and control
Introduction
Topic List
1 Overview of cost accounting techniques
2 Limitations of traditional management accounting techniques
3 Cost reduction
4 The supply chain
5 Business process re-engineering
6 Outsourcing
123
Introduction
Demonstrate a detailed knowledge and understanding of the cost accounting techniques

studied at the Professional stage
Demonstrate and apply knowledge of multi-product break even analysis through
calculations and interpretation of results
Demonstrate a detailed understanding of the issues surrounding cost reduction
Demonstrate a detailed understanding of techniques that may be used in a strategy to

reduce costs, including the supply chain, business process re-engineering and
outsourcing
Demonstrate a detailed understanding of the linkages between costs, quality, marketing
and strategy

1 Overview of cost accounting techniques
Section overview
This section reviews some of the costing techniques that were covered in the Management
Information paper at the Professional stage, including cost classification, costing systems, activity
based costing (ABC) and break even analysis.
Cost classification is the separation of various costs into different categories, such as fixed, variable
and semi-variable. Costs can be classified for various reasons, including inventory valuation,
planning and decision-making, and control.
Costing systems include direct, marginal and absorption costing for calculating unit costs.
ABC is a specific costing system for allocating overheads according to the activities that cause (or
drive) the costs.
Break even analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships
between costs, volume and profit at various levels of activity.
The main difference between multi- and single-product break even analysis is that the former
relies on the product mix that is, the ratio in which different products are sold.
Unlike single product analysis, there is no single break even point for multiple products the
answer will change depending on the assumed product mix.
C
H
1.1 Cost classification A
P
Probably the best way to revise cost classification is to revisit the table you were introduced to in your
T
Management Information studies. E
R
Cost analysis and control 125

Financial information
Management accounting
Financial accounting
Internal management
Aggregate information
for external reporting information for planning,
control and decision-making
Classification for planning Classification for control

Cost objects
and decision-making System of responsibility
Requires knowledge of accounting segregates controllable
Cost units cost behaviour patterns costs and uncontrollable costs
Basic control unit
for costing purposes
Fixed cost Variable cost Semi-variable cost

Classification for inventory Not affected by Changes in line Partly affected by
valuation and profit measurement
changes in activity with level of activity changes in activity
Cost elements = materials,
labour and other expenses
Direct cost or Indirect cost or

prime cost Product cost Period cost
overhead
Allocated to value Deducted as
can be traced in cannot be traced
in full to cost of inventory until expenses in a
full to cost object
object being sold particular period
being costed
costed
Make sure you are familiar with all these classifications.
1.2 Costing systems

One of the purposes of the following costing systems is to calculate the cost of a unit of output which
can ultimately be used to set the selling price.
1.2.1 Absorption costing

With absorption costing, a unit of output is valued at full cost that is, the prime cost plus an absorbed
share of production overhead costs.
1.2.2 Marginal costing

Marginal costing is an alternative to absorption costing, where only variable costs are included in the
valuation of units. All fixed costs are treated as period costs and written off against sales revenue in the
period in which they are incurred.
The difference in unit valuations using the two methods lies in the treatment of the fixed costs.
The absorption cost of sales will include some fixed costs from a previous period (included in opening
inventory) whilst all fixed costs are written off as expenses in the year of incurrence with marginal
costing.

Interactive question 1: Absorption and marginal costing [Difficulty level: Easy]
Hamilton Ltd manufactures and sells a single product, the Feronda, which has a selling price of 150 per
unit and variable costs of 70 per unit. During the months of July and August, the following details are
available.
July August
Fixed production costs 110,000 110,000
Production 2,000 units 2,500 units
Sales 1,500 units 3,000 units
Hamilton Ltd normally expects to produce 2,200 units and fixed production costs were budgeted at
110,000, which are absorbed on a per unit basis. There were no opening inventories in July.
Requirements
(a) Determine the profit for both July and August using
(i) Absorption costing and
(ii) Marginal costing.
(b) Demonstrate why the profits under each method are different.
1.2.3 Activity Based Costing (ABC)

ABC is an alternative approach to absorption costing. Cost drivers that is, those activities that cause
C
costs in the first place are identified and overheads are assigned to products or services based on the H
number of the cost drivers generated by each. More than one cost might have the same cost driver, so A
costs associated with the same driver are gathered into cost pools and then allocated using the P
appropriate driver. The product costs resulting from ABC should be more accurate than those under T
E
absorption costing as overheads are allocated on a more objective basis. Try the question below to
R
make sure you remember the principles and procedures of ABC.
Interactive question 2: Activity Based Costing [Difficulty level: Easy] 3
Tammy plc currently makes and sells four products, cost and output details of which are below.
Product Alpha Bravo Echo Oscar
Output (units) 500 300 400 200
Cost per unit ():
Material 60 42 80 100
Labour 32 20 35 50
Activities:
Number of set ups 20 15 30 35
Number of times materials
handled 3 4 2 6
Number of orders 11 12 16 25
Number of spare parts 15 20 10 15
required
Total overhead costs ()

Set up costs 25,000
Material handling 69,000
Ordering costs 32,000
Engineering costs 45,000
171,000
Requirements
(a) Using the information in the question, what is the most suitable cost driver for each overhead cost?
(b) Calculate the total product cost for each of the four products, showing all workings.

1.3 Break even analysis
Break even analysis is the study of the inter-relationships between costs, volume and profit at various
levels of activity. The study of break even analysis requires understanding, application and
interpretation of various formulae which are summarised below.
You will notice from the chart that break even analysis is also used for decision making purposes where
there are limiting factors, such as make or buy decisions. Remember that the most important figure for
decision making is contribution if a product is making a contribution towards fixed costs then
production should continue, as overall profit will be reduced (or loss increased) if this contribution is
lost.
Breakeven analysis or
Cost-Volume-Profit (CVP)
analysis
Contribution =
Sales price Variable cost
Contribution ratio
Breakeven point (BEP) Limiting factor
Contribution
= No profit and no loss = analysis
Sales
Fixed costs Fixed costs Maximise the

BEP in units = BEP in =
Contribution per unit Contribution ratio contribution per
unit of limiting
factor
Margin of safety Make or buy

Budgeted sales BEP decision
= 100%
Budgeted sales
Break even chart

Depicts the profit or loss
over a range of activities
Contribution break even chart

Includes the variable cost line so
that contribution is highlighted
Interactive question 3: Break even analysis [Difficulty level: Easy]

Bonzo plc manufactures and sells roller skates. Current sales volume is 20,000 pairs of roller skates per
annum. Selling price and variable cost details per pair is shown below.

Selling price 55.00
Variable costs 25.00
Total fixed costs per annum are:

Marketing 75,000
Salaries 200,000
Other 150,000

Requirements
(a) How many pairs of roller skates have to be sold in one year for Bonzo plc to break even?
(b) What is the current margin of safety in terms of number of pairs of skates sold?
(c) Bonzo plc has decided to increase its marketing campaign, which means spending an extra
40,000 on marketing. Selling price of the roller skates will also increase to 65. If Bonzo plc
wishes to make a profit of 25,000, how much sales revenue must be generated from the sale of
roller skates?
1.4 Multi-product break even analysis

The key issue with multi-product break even problems is determining the mix in which the products are
sold and reducing it to the lowest common denominator. For example, if 500 units of Product X and
250 units of Product Y are sold, then the mix in which the two products are sold is 2:1. This mix is used
to define a standard batch which can be used to determine a break even point in terms of number of
batches. Once this has been determined, the number of batches can then be converted into the
number of units of each product that must be sold at the break even point.
Worked example: Multi-product break even analysis

Toodiloo Ltd manufactures and sells two types of microwave oven the Silver Star oven and the Gold
Senator combination oven and grill. The following information is available for the two models. C
Silver Star Gold Senator H
Sales volume in units 5,000 3,000 A
P
Per unit: T
Selling price 65.00 90.00 E
Variable costs 45.00 60.00 R
Direct fixed costs are 40,000 for the Silver Star and 30,000 for the Gold Senator. General fixed costs,
which can only be avoided if neither model is sold, are 63,000.
3
Requirement
Calculate how many units of each model would have to be sold for Toodiloo Ltd to cover all its fixed
costs.
Solution
As with all break even questions, the first thing to do is to establish the contribution per unit:
Silver Star Gold Senator

Selling price 65.00 90.00
Variable costs 45.00 60.00
Contribution per unit 20.00 30.00
The key to multi-product break even analysis is to look at the product mix. In this case we are told that
Toodiloo sells 5,000 units of the Silver Star and 3,000 units of the Gold Senator, giving a product mix
ratio of 5:3. A standard batch can therefore be assumed to comprise five Silver Star and three Gold
Senator, which will give a total contribution towards total fixed costs of 190 (5 20.00 + 3 30.00).

Using the total contribution per standard batch, we can calculate the number of batches that have to be
sold in order to break even:
Total fixed cos ts
Break even point in batches =
Contribution per batch
133,000
=
190
= 700 batches
How many units of each model will have to be sold in order to break even? Remember that in every
batch, five units of the Silver Star are sold and three units of the Gold Senator. Therefore, in order to
break even, Toodiloo will have to sell:
Silver Star: 5 700 = 3,500 units
Gold Senator: 3 700 = 2,100 units
Check:
Silver Star Gold Total
Senator

Contribution per unit 20.00 30.00
Total contribution 70,000 63,000 133,000
Fixed costs:
Direct 40,000 30,000 70,000
General 63,000
Total profit/(loss) NIL
Note: You will have probably noticed that this break even number of batches and units will only work if
the product mix remains at 5:3. As soon as the product mix changes you will have to calculate a new
break even point. As you might expect, an increase in the proportion of sales of products with a higher
contribution will normally reduce the break even point, while an increase in the proportion of sales of
products with a lower contribution will normally increase the break even point.
Interactive question 4: Multi-product break even analysis [Difficulty level: Easy]

Netcord Ltd produces and sells three different types of tennis racquet the McEnrova, the Grafassi and
the Federdal. The sales and costs forecast for the next period are as follows.
McEnrova Grafassi Federdal Total
Sales units 8,000 6,000 4,000

Sales revenue 320,000 360,000 400,000
Variable costs 176,000 228,000 280,000
Contribution 144,000 132,000 120,000 396,000
Total fixed costs 306,900
Net profit 89,100
Total fixed costs can only be avoided if all models are eliminated.
Requirement
How many units of each model must be sold in order for Netcord Ltd to break even and what is the
break even sales revenue?

2 Limitations of traditional management accounting
techniques
Section overview
It has been argued that traditional management accounting systems are inadequate for a
modern business environment that focuses on marketing, customer service, employee
involvement and total quality.
This section summarises the main problems with the traditional systems that you have covered in
earlier studies.
2.1 Short-term financial measures

Pressures to keep costs under control have emphasised the need for relevant and informative cost data
that is produced promptly. In addition these costs need to be compared with benefits, and this cannot
just be done on financial grounds. The qualitative benefits can be extremely important (for example
better product quality) and there may also be non-financial quantitative benefits. These may not
necessarily be easy to quantify (for example shorter set-up times, improved capacity utilisation).
However much of the output of traditional management accounting consists of short-term financial
performance measures such as costs, variances and so on. Many of these are produced too long after
the event and are too narrowly focused. A much wider view is now necessary.
C
H
2.2 Cost accounting methods A
P
Traditional cost accounting traces raw materials to various production stages via WIP, to the next stage T
and finally to finished goods, resulting in literally thousands of transaction entries. With just-in-time E
R
systems, production flows through the factory on a continual basis with near-zero inventories and very
low batch sizes and so such transaction entries become needlessly complicated and uninformative. Cost
accounting and recording systems must therefore be greatly simplified in the modern environment.
3
Backflush costing is one possible approach.
2.3 Performance measures

Traditional management accounting performance measures can produce the wrong type of responses.
In particular resulting in unnecessary cost increase.
Measurement Response Consequence of action
Purchase price variance Buy in greater bulk to reduce unit Excess inventories
price
Higher holding costs
Quality and reliability of
delivery times ignored
Labour efficiency variance Encourage greater output Possibly excess inventories of
the wrong products
Machine utilisation Encourage more running time Possibly excess inventories of
the wrong products
Cost of scrap Rework items to reduce scrap Production flow held up by re-
working
Scrap factor included in Supervisor aims to achieve actual No motivation to get it right
standard costs scrap = standard scrap first time

Measurement Response Consequence of action
Traditional absorption Produce more output to reduce Excess inventories, possibly of

costing unit costs and/or over recover unwanted products
overhead
Cost centre reporting Management focus is on cost Lack of attention to activities
centre activities, not overheads where cost reduction
possibilities might exist
2.4 Timing
The cost of a product is substantially determined when it is being designed, not when it is in
production. The materials that will be used, the machines and labour required, are largely determined at
the design stage. In the car industry it is estimated that 85% of all future product costs are determined
by the end of the testing stage. Management accountants, however, continue to direct their efforts to
the production stage.
2.5 Controllability
Only a small proportion of 'direct costs' are genuinely controllable in the short term. It has been argued
that controllable direct costs are about 10% of total costs, whereas controllable overhead costs
represent about 27%. It has been suggested that the reason why, in spite of this, accountants do not
devote nearly three times as much effort to analysing overhead costs as they devote to direct costs is
because overheads are more difficult to measure.
2.6 Customers
Many costs are driven by customers (delivery costs, discounts, after-sales service and so on), but
conventional cost accounting does not recognise this. Companies may be trading with certain
customers at a loss but not realise it because costs are not analysed in a way that would reveal it.
2.7 The solution

Whether all, or any, of the above criticisms are well founded is, of course, debatable. What is
indisputable, however, is that changes are taking place in management accounting and business
processes in order to meet the challenge of modern developments.
3 Cost reduction
Section overview
Cost reduction has become increasingly important in an increasingly competitive world. In order
to remain competitive, companies have had to keep prices low and the only other way to
influence the bottom line is to squeeze costs as far as possible.
There are numerous cost reduction programmes that a company can use and various ways in
which they can be implemented. It is a matter of what is most suitable for the company, given its
other objectives.
In order that cost reduction programmes are successful, companies should be keenly aware of the
effect that cost reduction has, not just on its reported financial results, but also on marketing,
strategy and quality.
Cost reduction should be viewed as an on-going exercise rather than being a panic reaction to a
profit crisis.

Case example: IKEA
The chief executive of the IKEA furniture chain famously travels economy class on all flights, whether
long or short haul, thus giving lower grades of director and manager no choice but to follow suit. On a
trip to the United States, the chief executive reportedly cut out a voucher for cut-price car hire in an in-
flight magazine and handed it to his management colleague who was travelling with him. The colleague
was expected to present the voucher to the car hire desk at their destination airport to obtain the
discount. This approach to cost reduction by the chief executive reinforces IKEA's market positioning
strategy as a low cost, no frills store.
In this section we will look at both cost reduction and cost control, and the lengths some companies will
go to in the quest to achieve them.
3.1 Introduction
st
Cost reduction has become the battle-cry of the 21 Century. As prices are slashed in a bid to remain
competitive, companies have to find other ways of boosting profits. The only other way to affect the
bottom line is to squeeze costs as far as possible and, hopefully, more effectively than competitors.
One of most quantifiable means of reducing costs is to tackle fixed costs. We talked about fixed costs
briefly in Section 1 and you will have dealt with them in detail in earlier studies. Fixed costs are those
costs that cannot be avoided regardless of activity levels if you can find a way of getting rid of some of
the sources of fixed costs permanently then you are on the way to a successful cost reduction
programme.
C
The best way to reduce costs is to develop a culture within the organisation whereby everyone thinks H
strategically about cost reduction. How do you reduce costs? Quite simply by avoiding them as much A
as possible. Of course that is easier said than done but if employees can be educated to actively seek P
ways to reduce costs then this will be a move in the right direction. T
E
R
3.2 Cost reduction techniques
As with all business decisions, there are right ways and wrong ways to approach cost reduction. The 3
right techniques will result in greater efficiency of company spending; the wrong ones could lead to
costs being cut that are in fact necessary for the maintenance of quality and company value. There is
often a fine line between necessary costs and unnecessary ones but taking a systematic approach to cost
reduction can help managers stay on the right side of that line.
Effective cost reduction techniques start with establishing what the programme is trying to achieve. If a
company does not know why it is cutting costs then it will have no idea where to cut costs. Companies
try to reduce costs for many reasons, such as to allow the price of a product or service to be cut without
affecting margins, to eliminate unnecessary spending and to create additional cash reserves. Ultimately
the aim is to maximise shareholders' wealth, therefore it is important that the correct costs are targeted
for reduction.
There are numerous ways in which companies can institute plans to reduce costs, including across the
board reductions, prioritised reductions and departmental reductions. Across the board reductions
could include the implementation of a new travel policy whereby all staff must travel economy class (as
we have seen is the case with IKEA) while prioritised reductions may include a strategy to reduce
pollution in order to avoid pollution tax.
Whatever techniques are used, if they are the right ones they can teach a company to be more
economical while maintaining its levels of service and quality. By forcing companies to regularly review
spending at all levels, cost reduction techniques allows companies to become more streamlined.
Sections 46 examine some techniques that are used in the modern business world to address such
issues as cost reduction and increased efficiency.

3.3 Which costs should be cut?
This depends on the type of business you are in, but the easiest way to cut costs is to focus firstly on
those expenses that are common to all companies. Gas and electricity, postage, stationery and
telephone charges are all obvious targets. The trick is to encourage all staff to participate, not demand it.
For example, notices posted next to light switches asking staff to 'switch off after use' are likely to be
more effective than a dictatorial memo demanding that staff should be more careful about using power.
If cutting the more obvious costs does not achieve the required effect, management will have to adopt a
more innovative approach, focusing on individual departments' spending. Whilst cutting such expenses
as telephone charges and stationery can be fairly straightforward, dealing with departmental costs is
more problematic. Not only do you have the issue that departments feel they are being victimised,
there is also the potential for seriously damaging the company's day to day operations and pursuit of
objectives. If staffing levels are cut, for example, it will be more difficult to maintain product or service
quality. Cutting inventory levels too far could result in the company being unable to fulfil delivery
promises. That is why management must understand how different costs affect profitability and the
extent to which each cost category can be reduced before the company's operations are adversely
affected.
Case example: Ryanair

Ryanair, a low cost airline based in Ireland, is well known for its cost cutting exercises. Keeping costs
down is part of Ryanair's overall strategy which means that when the company releases a statement of
further cost cutting schemes no-one is surprised. When asked in 2002 what was 'the gospel according
to Ryanair', the company's chief financial officer responded that it was to continually ask if Ryanair could
do what it was doing at a reduced cost.
At its first quarter results presentation in 2006, the company revealed that, while it had the lowest
revenue per passenger out of the eight airlines with which it compared itself, it also had the highest
operating margin (18%). Between 2000 and 2006, Ryanair managed to reduce its unit operating costs
by 40%.
Ryanair recognised that the cost category with greatest potential for reduction was flight operating
costs. In response to this Ryanair's cost cutting exercises have included charging passengers to check in
bags in an attempt to reduce baggage handling costs and encouraging passengers to make greater use
of web-based check-in. Ryanair has decided to remove check-in staff completely. The use of e-business
helped to eliminate approximately 12% of turnover costs, including travel agents' commission.
Overall Ryanair's cost reduction programme appears to have been successful over the last decade for the
company with its operating costs repeatedly increasing at a slower rate than its passenger revenues. In
2010 Ryanair announced a 319m profit and by 2012 annual profits had risen to 503m.
However Ryanair's reputation has come under significantly more pressure over the last few years.
Possibly the heaviest criticisms that Ryanair has faced were a result of the delays to flights caused by the
Icelandic volcanic ash in April 2010. Ryanair initially stated that refunds would be limited to the same
amount that passengers paid for their tickets. Lawyers and consumer groups questioned the legality of
this policy and Ryanair later backed down, saying it would refund all reasonable expenses to passengers.
(To be fair some other airlines also initially took a harsh stance towards passenger claims and later
retreated.)
Ryanair has also been criticised by the Office of Fair Trading for being 'puerile and childish' over its credit
card payment policy. Ryanair adds fees when customers use all but one type of credit card to pay
online. However because it offers a prepaid booking service with a Mastercard prepaid card (not the
most-used credit card) it is able to advertise cheap fares that don't include extra credit card charges.
More generally Ryanair's policy of charging for a large number of optional extras has come under
heavier criticism.
In March 2011 Ryanair was found to have breached European Union regulations that companies selling
goods online must offer customers the facility to complain via email. However Ryanair did not provide
email contact details, meaning that customer complaints had to be by letter, fax or by phoning
Ryanair's premium rate telephone number.
In February 2012 two UK newspaper ads for Ryanair were banned after complaints that they were sexist
and treated women as objects. The Advertising Standards Authority ruled that the women's appearance,

stance and gaze, together with the wording of the advert, linked female cabin crew with sexually
suggestive behaviour and thus breached the advertising practice code. This was not the first time that
Ryanair had fallen foul of the code in this area. A few years previously it had had to withdraw an advert
of a model dressed as a schoolgirl with the headline 'hottest back to school fares'.
Also in 2012 Ryanair attempted again to purchase its principal rival, Aer Lingus. A previous bid in 2006
had been disallowed by the European Commission. Ryanair already owned 30% of Aer Lingus and the
bid was prompted by the Irish government's plans to sell its 25% share in Aer Lingus. In June 2012
however Aer Lingus advised its shareholders to reject the bid, again on the grounds that it might not be
allowed by the competition authorities. After the bid was made, shares in Aer Lingus rose 15.4%, but
this was well short of the 38% premium that Ryanair offered, reflecting market doubts about the offer.
3.4 Implementing cost reduction programmes

As with choosing techniques, there is a right way and a wrong way to implement cost reduction
programmes. Cost reduction is inevitably a sensitive area and the wrong approach can alienate staff,
reduce motivation and have a detrimental effect on company harmony. A good cost reduction
programme is as much about damage limitation as cutting costs.
Effective cost reduction programmes should result from thorough management planning, a detailed
understanding of how company expenses can affect not just the bottom line but the overall quality of
the product or service and a vision of where the company is heading. Cost reduction is not about
reporting smaller numbers in the income statement it should be the culmination of extensive
planning, thought and participation by directors, management and employees. Directors should not
C
automatically assume that the most obvious cuts are the right ones. An innovative approach is often
H
more successful than the usual 'we have to cut costs by 10% across the board' requirement. A
P
Cost reduction programmes, as mentioned above, are ultimately implemented to improve profitability
T
without improving revenue figures. Any improvements in revenue will further enhance profits. E
Programmes should be integrated into the overall company strategy, not introduced on an ad hoc basis. R
Case example: Kraft and Cadbury 3

Kraft took over Cadbury in February 2010 and by July 2010 more than 100 senior Cadbury staff had left,
including Cadbury's Chairman, Chief Executive and Chief Finance Officer, also Cadbury's Marketing
Director and Chief Strategy Officer. A company spokesman commented that this amount of change was
not unusual when two companies merged. Critics pointed out that none of the top jobs subsequent to
the acquisition had gone to Cadbury staff.
Kraft also completed the controversial closure of Cadbury's Somerdale factory at Keynsham, which had
been planned before the acquisition, and moved production to Poland. In May 2010 Kraft announced it
intended to cut 379 million from operational costs. These savings would be generated by changes to
IT and back office operations, and process, manufacturing and supply chain improvements.
3.5 Potential problems with cost reduction programmes

While companies seek to reduce costs to remain competitive, taking the process too far can have
adverse effects. Managers have to think about the extent to which cost reduction can be sustained
before the business starts to suffer in other ways. Companies whose marketing strategies are based on
low costs will probably get away with cost cutting for longer but if you work in an organisation that has
always promoted high quality goods and services, it is unlikely that extreme cost reduction programmes
will be viewed positively either by customers or the financial markets. Regardless of how it is marketed,
cost reduction is seen by outsiders as not only reducing expenditure but reducing quality and service as
well.
Always bear in mind that cost reduction, whilst tempting in order to get ahead of competitors, should
only be undertaken to the extent that it adds value to the company. As soon as shareholders' wealth
starts to suffer the programme should be halted.

Case example: Public sector cost cutting
How to cut public sector expenditure has been the subject of considerable debate in the UK, due to the
perceived need to reduce the public sector deficit.
Techniques that have been suggested as particularly relevant for the public sector include the
application of lean manufacturing principles to ensure that expenditure that does not add value is not
undertaken, and quality management techniques such as Six sigma that aim to eliminate errors in
service delivery. Improving procurement skills has been identified as another priority area, given that the
public sector is a huge buyer of products and services. Improvements in the transparency and quality of
publicly available information will, it's claimed, help stimulate performance, as will using other countries'
performance as 'competitive' benchmarks.
One area in which public sector expenditure may increase is on cost-cutting consultants. A story in the
Daily Telegraph in July 2010 claimed that public sector bodies could recruit up to 200 cost-cutting
consultants on wages of up to 1,000 a day. Doug Baird, Managing Director of consultants Interim
Partners, claimed that:
'Experienced efficiency experts do not come cheap, but they can deliver a huge return on investment
and improve service delivery. A poorly executed cost-cutting programme can leave staff demoralised
and undermine productivity.'
3.6 Summary of cost reduction

Cost reduction should not be a one-off exercise. Companies should continually review their costs to
determine whether the same level of operations, service and quality could be maintained while reducing
costs. Innovation is often the key to successful cost reduction programmes management should not
automatically assume that the most obvious areas for cost reduction are always going to be the right
ones. There should be focus not only on the costs themselves but also on in-house procedures and
processes. Despite this, however, companies should pay close attention to how far they can take their
cost reduction programmes before performance both financial and operational is adversely affected.
Case example: Svenska Handelsbanken

Swedish bank, Svenska Handelsbanken's, low costs are the product of several factors:
(a) Small head office staff, and a flat, simple hierarchy.
(b) People in regions and branches are self sufficient and well-trained and are measured by competitive
results, which has produced an attitude keen to weed out unwarranted expenses.
(c) Lower credit losses because front line staff feel more concerned to make sure that the information
on which they base lending decisions is correct.
(d) Central services and costs are negotiated rather than allocated.
(e) Internet technology is used to reduce costs, with the benefit accruing to the customer's own
branch.
The European Vice President of Svenska Handelsbanken believes that 'devolving responsibility for results,
turning cost centres into profit centres; squeezing central costs, using technology and eradicating the
budgeting "cost entitlement" mentality are just some of the actions we have taken to place costs under
constant pressure'.

4 The supply chain
Section overview
Whatever the exact nature of supplier bargaining power, many firms aim to build closer
relationships for the sake of efficiency.
A firm can make strategic gains from managing stakeholder relationships, such as those with
customers and suppliers.
Supply chain management is about optimising the activities of companies working together to
produce goods and services. Supply chain relationships are becoming increasingly more co-
operative rather than adversarial.
4.1 Introduction
Market and competitive demands are, however, compressing lead times and businesses are reducing
inventories, holding costs and excess capacity. Linkages between businesses in the supply chain must
therefore become much tighter.
This has had major consequences on the distribution methods of companies in these supply chains,
delivering to their customers on a just in time (JIT) basis. The adversarial, arms length relationship with a
supplier has been replaced by one which is characterised by closer co-operation.
C
4.2 Supply chain management H
A
Supply chain management is about optimising the activities of companies working together to produce P
goods and services. T
E
Supply chain management (SCM) is a means by which the firm aims to manage the chain from input R
resources to the consumer. It involves the following.
Reduction in the number of suppliers.
3
Reduction in customers served, in some cases, for the sake of focus, and concentration of the
company's resources on customers of high potential value.
Price and inventory co-ordination. Firms co-ordinate their price and inventory policies to avoid
problems and bottlenecks caused by short-term surges in demand, such as promotions.
Linked computer systems electronic data interchange saves on paperwork and warehousing
expense.
Early supplier involvement in product development and component design.
Logistics design. Hewlett-Packard restructured its distribution system by enabling certain product
components to be added at the distribution warehouse rather than at the central factory, for
example user-manuals which are specific to the market (ie user manuals in French would be added
at the French distribution centre).
Joint problem solving.
Supplier representative on site.
Point to note: The aim is to co-ordinate the whole chain, from raw material suppliers to end customers.
The chain should be considered as a network rather than a pipeline a network of vendors support a
network of customers, with third parties such as transport firms helping to link the companies.
As well as tactical issues, what might be the underlying strategic concerns?
Close partnerships are needed with suppliers whose components are essential for the business unit.
A firm should choose suppliers with a distinctive competence similar to its own. A firm selling
'cheap and cheerful' goods will want suppliers who are able to supply 'cheap and cheerful'
subcomponents.

Problems with the partnership approach to supply chain management are these.
Each partner needs to remain competitive in the long term
There is a possible loss of flexibility
The relative bargaining power may make partnership unnecessary
Arguments about sharing profits
5 Business process re-engineering
Section overview
Business process re-engineering involves focusing attention inwards to consider how business
processes can be redesigned or re-engineered to improve efficiency.
This section examines the business process re-engineering concept in detail, including looking at
the types of organisations that might employ this process to improve efficiency and reduce costs.
5.1 General overview

Business process re-engineering (BPR) involves focusing attention inwards to consider how business
processes can be redesigned or re-engineered to improve efficiency. It can lead to fundamental changes
in the way an organisation functions. Properly implemented BPR may help an organisation to reduce
costs, improve customer services, cut down on the complexity of the business and improve internal
communication.
At best it may bring about new insights into the objectives of the organisation and how best to
achieve them.
At worst, BPR is simply a synonym for squeezing costs (usually through redundancies). Many
organisations have taken it too far and become so 'lean' that they cannot respond when demand
begins to rise.
The main writing on the subject is Hammer and Champy's Reengineering the Corporation (1993), from
which the following definition is taken.
Definition
Business process re-engineering (BPR) is the fundamental rethinking and radical redesign of business
processes to achieve dramatic improvements in critical contemporary measures of performance, such as
cost, quality, service and speed.
The key words here are fundamental, radical, dramatic and process.
Fundamental and radical indicate that BPR is somewhat akin to zero base budgeting: it starts by
asking basic questions such as 'why do we do what we do', without making any assumptions or
looking back to what has always been done in the past.
Dramatic means that BPR should achieve 'quantum leaps in performance', not just marginal,
incremental improvements.
Process. BPR recognises that there is a need to change functional hierarchies: 'existing hierarchies
have evolved into functional departments that encourage functional excellence but which do not
work well together in meeting customers' requirements' (Rupert Booth, Management Accounting,
1994).
A process is a collection of activities that takes one or more kinds of input and creates an output.
For example, order fulfilment is a process that takes an order as its input and results in the delivery of
the ordered goods. Part of this process is the manufacture of the goods, but under BPR the aim of
manufacturing is not merely to make the goods. Manufacturing should aim to deliver the goods that

were ordered, and any aspect of the manufacturing process that hinders this aim should be re-
engineered. The first question to ask might be 'Do they need to be manufactured at all?'
A re-engineered process has certain characteristics.
Often several jobs are combined into one
Workers often make decisions
The steps in the process are performed in a logical order
Work is performed where it makes most sense
Checks and controls may be reduced, and quality 'built-in'
One manager provides a single point of contact
The advantages of centralised and decentralised operations are combined
Case example: Car manufacturer

Based on a problem at a major car manufacturer.
A company employs 25 staff to perform the standard accounting task of matching goods received notes
with orders and then with invoices. About 80% of their time is spent trying to find out why 20% of the
set of three documents do not agree.
One way of improving the situation would have been to computerise the existing process to facilitate
matching. This would have helped, but BPR went further: why accept any incorrect orders at all? What if
all the orders are entered onto a computerised database? When goods arrive at the goods inwards
department they either agree to goods that have been ordered or they don't. It's as simple as that.
Goods that agree to an order are accepted and paid for. Goods that are not agreed are sent back to the
C
supplier. There are no files of unmatched items and time is not wasted trying to sort out these files. H
A
P
T
E
5.2 Examples of business process re-engineering R
Some organisations have redesigned their structures on the lines of business processes, adopting BPR to
avoid all the co-ordination problems caused by reciprocal interdependence.
3
A move from a traditional functional plant layout to a JIT cellular product layout is a simple
example.
Elimination of non-value-adding activities. Consider a materials handling process, which
incorporates scheduling production, storing materials, processing purchase orders, inspecting
materials and paying suppliers.
This process could be re-engineered by sending the production schedule direct to nominated
suppliers with whom contracts are set up to ensure that materials are delivered in accordance with
the production schedule and that their quality is guaranteed (by supplier inspection before
delivery).
Such re-engineering should result in the elimination or permanent reduction of the non-value-
added activities of storing, purchasing and inspection.
Be prepared to apply your knowledge of BPR to a particular scenario or to examples that you are
aware of from your reading or own experience. The examiner has stated that good answers often
draw on the candidate's own experience in the context of the question set.
Interactive question 5: Business process re-engineering [Difficulty level: Intermediate]

AB Ltd was established over a century ago and manufactures water pumps of various kinds. Until
recently it has been successful, but imports of higher quality pumps at lower prices are now rapidly
eroding its market share. The managing director feels helpless in the face of this onslaught from
international competitors and is frantically searching for a solution to the problem. In his desperation, he
consults a range of management journals and comes across what seems to be a wonder cure by the
name of Business Process Re-engineering (BPR). According to the article, the use of BPR has already
transformed the performance of a significant number of companies in the USA which were mentioned
in the article, and is now being widely adopted by European companies. Unfortunately, the remainder

of the article which purports to explain BPR is full of management jargon and he is left with only a
vague idea of how it works.
Requirements
(a) Explain the nature of BPR and describe how it might be applied to a manufacturing company like
AB Ltd.
(b) Describe the major pitfalls for managers attempting to re-engineer their organisations.
5.3 Implications of BPR for accounting systems

Issue Implication
Performance Performance measures must be built around processes not departments: this may
measurement affect the design of responsibility centres.
Reporting There is a need to identify where value is being added.
Activity ABC might be used to model the business processes.
Structure The complexity of the reporting system will depend on the organisational
structure. Arguably the reports should be designed round the process teams, if
there are independent process teams.
Variances New variances may have to be developed.
6 Outsourcing
Section overview
Often money and other resources are wasted trying to perform operations in which the
organisation in question has little or no expertise.
Outsourcing may be the answer to this problem organisations are increasingly turning to
external experts to perform such functions.
One particular example is the outsourcing of IT services which will be considered in this section.
6.1 The use of outsourcing in business

Outsourcing can be defined as the use of external suppliers as a source of finished products,
components or services. Use of outsourcing has been driven often by it being the most cost-effective
way of providing a service, particularly for smaller organisations.
In addition the supplier of the outsourced service can provide specialist expertise which is not available
in-house or it would not be worth maintaining in-house.
Outsourcing should have also the major advantage of reducing the workload or the organisation's
managers, thus freeing more time to concentrate on core competences.
Generally speaking, outsourcing is appropriate for peripheral activities: to attempt to outsource core
competences would be to invite the collapse of the organisation. However, it can be difficult to identify
with clarity just what are an organisation's core competences and it is not too difficult to imagine an
organisation whose core competence was, in fact, outsourcing. Certainly, the motor manufacturing
industry seems to be moving in this direction.
A further advantage of outsourcing is that external suppliers may capture economies of scale and
experience effects that mean that costs may be reduced by using their services rather than in-house
provision.
Getting the best out of outsourcing depends on successful relationship management rather than
through the use of formal control systems.

6.2 Successful outsourcing
Successful outsourcing depends on three things.
The ability to specify with precision what is to be supplied: this involves both educating suppliers
about the strategic significance of their role and motivating them to high standards of
performance.
The ability to measure what is actually supplied and thus establish the degree of conformity with
specification.
The ability to make adjustments elsewhere if specification is not achieved.
There are also practical considerations relating to outsourcing.
It can save on costs by making use of supplier economies of scale.
It can increase effectiveness where the supplier deploys higher levels of expertise.
It can lead to loss of control, particularly over quality.
It means giving up an area of threshold competence that may be difficult to reacquire.
Outsourcing of non-core activities is widely acknowledged as having the potential to achieve important
cost savings. However, some organisations are wary of delegating control of business functions to
outsiders because of the difficulty of assessing the cost-effectiveness of what is purchased: cost should
be fairly clear, but the quality of what is purchased is extremely difficult to assess in advance. The
adoption of quality standards may help to overcome this problem. By utilising such standards,
businesses will have more confidence in the quality of the service being provided and suppliers will
know what is expected of them.
C
H
Case example: Mars and Cadbury's A
P
' chocolate confectionery companies in the UK will sell Easter eggs promoting their brands and T
products every spring. Mars, for instance, will provide chocolate eggs containing mini Mars products, or E
in packaging highlighting Mars products around the egg. The reason that you might be tempted to buy R
one of these eggs is because it has Mars products associated with it. Mars therefore doesn't have to
produce the egg itself that activity can be outsourced. After all, it would be expensive to maintain
production facilities for chocolate eggs for only a couple of months a year. 3
On the other hand, Cadbury has focused on marketing and sales activities to develop the Cadbury's
Crme Egg into a product that is sold all year round, thereby making the operation viable. The decision
whether or not to outsource can often be bound strongly to an organisation's competitive strategy and
focuses on how strategic the activity is to the organisation.'
The extract above was written before Kraft's acquisition of Cadbury in 2010. After the acquisition Kraft
went ahead with the controversial plan to close Cadbury's Keynsham plant, but pledged there would be
no further closures of manufacturing sites in the UK, and no further compulsory redundancies in
manufacturing in the UK in the next two years.
Interactive question 6: Outsourcing [Difficulty level: Intermediate]

Bonanza plc is a financial services company that offers a credit card service on a global scale. Bonanza
currently operates in more than 100 countries and offers a telephone customer service facility. Due to
changes in technology and pressure from competitors' activities, Bonanza has set up a call centre facility
to handle customer queries, and is increasingly outsourcing this facility to locations offering lower labour
costs. However, this has led to staff unrest due to the loss of UK jobs and there have been an increasing
number of customer complaints about the level of service from the call centres, owing mainly to a lack
of helpfulness and general language difficulties.
Bonanza is in a dilemma and is wondering if the customer service function should have been retained
in-house.

Requirement
What are the advantages and disadvantages of outsourcing the customer enquiry function?
6.3 The value chain, core competences and outsourcing

Core competences are the basis for the creation of value; activities from which the organisation does not
derive significant value may be outsourced.
The purpose of value chain analysis is to understand how the company creates value. It is unlikely that
any business has more than a handful of activities in which it outperforms its competitors. There is clear
link here with the idea of core competences: a core competence will enable the company to create
value in a way that its competitors cannot imitate. These value activities are the basis of the company's
unique offering.
There is a strong case for examining the possibilities of outsourcing non-core activities so that
management can concentrate on what the company does best.
6.4 Outsourcing IT/IS services

This section looks at a specific example of outsourcing namely IT/IS services and the advantages and
disadvantages of outsourcing such a key business function.
The arrangement varies according to the circumstances of both organisations.
Outsourcing arrangement
Feature Timeshare Service Facilities Management (FM)
What is it? Access to an Focus on An outside agency manages the

external specific organisation's IS/IT facilities. The
processing system function, eg client retains equipment but all
on a time-used payroll services provided by FM company
basis
Management Mostly retained Some retained Very little retained

responsibility
Focus Operational A function Strategic
Timescale Short-term Medium-term Long-term
Justification Cost savings More efficient Access to expertise; better service;

management can focus on core
business activities
Managing such arrangements involves deciding what will be outsourced, choosing a supplier and the
supplier relationship.
6.4.1 How to determine what will be outsourced?

What is the system's strategic importance? A third party IT specialist cannot be expected to possess
specific business knowledge.
Functions with only limited interfaces are most easily outsourced, eg payroll.
Do we know enough about the system to manage the arrangement?
Are our requirements likely to change?
The arrangement is incorporated in a contract sometimes referred to as the Service Level Contract (SLC)
or Service Level Agreement (SLA).

Element Comment
Service level Minimum levels of service with penalties for example:

Response time to requests for assistance/information
System 'uptime' percentage
Deadlines for performing relevant tasks
Exit route Arrangements for an exit route, transfer to another supplier or move
back in-house.
Timescale When does the contract expire? Is the timescale suitable for the
organisation's needs or should it be renegotiated?
Software ownership This covers software licensing, security and copyright (if new software is
to be developed).
Dependencies If related services are outsourced, the level of service quality agreed
should group these services together.
Employment issues If the organisation's IT staff are to move to the third party, employer
responsibilities must be specified clearly.
Case example: Barclays

In January 2010 Barclays decided to bring IT application development back in-house after deciding not
C
to renew a 400m outsourcing agreement with Accenture after 6 years. 230 staff that had moved to
H
Accenture at the start of the agreement were to move back to Barclays. Around the same time Barclays A
also decided to bring the management of its desktop facilities back in-house. P
T
The decision to return application development in-house resulted from a strategic review and a desire to E
have the most efficient model that supported its business. Commentators suggested that Barclays had R
faced a situation where the costs of outsourcing had significantly increased because of the extra
expensive services added on to the original outsourcing contract. It might have reached the point where
it had become more cost-effective to take the work back in-house. 3
6.5 Current trends in outsourcing

In an effort to cut costs, many organisations are now outsourcing activities both near shore (such as
Eastern Europe) and offshore (such as the Far East and India).
Improvements in technology and telecommunications and more willingness for managers to manage
people they can't see have fuelled this trend.
Before taking the decision to outsource overseas, a number of points should be considered.
(a) Environmental (location, infrastructure, risk, cultural compatibility, time differences)
(b) Labour (experience in relevant fields, language barriers, size of labour market)
(c) Management (remote management)
(d) Bad press associated with the perception of jobs leaving the home country
Case example: Call centres

The inside of a call centre will look virtually the same wherever it is in the world, similar headsets,
hardware and software being used, for example. With pressure to provide adequate customer service at
low cost, many organisations are closing call centres in parts of Western Europe and relocating to low-
cost countries and regions, such as India and South Africa.
It is claimed that savings on call centre costs range from 35% to 55% for near shore outsourcing and
50% to 75% for offshore outsourcing.

6.5.1 Outsourcing to Eastern Europe
The newly-enlarged EU is providing organisations in Western Europe with a range of outsourcing
opportunities. The vast manufacturing facilities that were used to produce for the massive Soviet market,
many of which have been re-equipped, provide the opportunity for manufacturing to be outsourced.
At the moment, labour is relatively cheap in Eastern Europe, and it is closer than the Far East an
important consideration in today's rapidly-moving environment. The fact that English is widely taught
and the existence of a Western culture are added attractions.
There are problems associated with outsourcing to Eastern Europe, however. Operations in many
countries are bound by an excess of red tape, for example, and current political and market uncertainty
in Russia could constrain growth there for some time.
Case example: DHL

In September 2003, DHL, the logistics firm, announced it was shifting its data centre in Britain and parts
of its IT operations in Switzerland to a state-of-the-art services centre in Prague that will oversee all of
the organisation's European IT operations.
6.5.2 Outsourcing to India

Moving back-office functions 'offshore' began in earnest in the early 1990s when organisations such as
American Express, British Airways, General Electric and Swissair set up their own 'captive' outsourcing
operations in India.
The low labour cost in India has always made the outsourcing option attractive. But not only is it cheap,
it is highly skilled. India has one of the most developed education systems in the world. One third of
college graduates speak more than two languages fluently and of the two million graduates per annum,
80% speak English. These language skills, along with improved telecomms capabilities, make it an ideal
choice for call centres. GE, Accenture and IBM have all set up call centres in India.
The vast majority of service jobs being outsourced offshore are paper-based back office ones that can be
digitalised and telecommunicated anywhere around the world, and routine telephone enquiries that can
be bundled together into call centres.
Case example: UK companies outsourcing to India

The number of UK companies outsourcing to near shore or offshore destinations rose from 47% to 57%
in 2007 with all of them using India at least once as the offshore destination of choice. Phil Morris,
managing director of EquaTerra for Europe (an advisory company), explained that India offered all of
the economic advantages that companies were looking for, the legacy of an education system and
somewhere where there is relatively good English.
However in 2011 a trend appeared to be developing for call centre jobs to be moved back to the UK. In
July 2011 telecommunications company, New Call Telecom, announced that it was moving one of its
call centres from India back to the UK. The main reason for this decision was increased salaries and
property and accommodation costs in India.
Also in July 2011 the bank Santander announced it was moving its call centres back to the UK in an
effort to please customers. Santander's chief executive commented that customers had said that this
issue was the most important factor in terms of their satisfaction with the bank. Reports suggested that
Santander had had one of the worse complaints records in the banking industry in 2011.

Summary
Traditional management As more and more

accounting techniques have organisations strive to
numerous limitations in the reduce costs, new
face of the ever-changing techniques have evolved to
business environment. help increase business
efficiency.
C
H
A
P
T
E
R
3
Business process Outsourcing may be
re-engineering focuses employed by organisations
attention on the internal to avoid wasting resources
functions of the on functions that can be
organisation to determine better provided by experts.
how these functions can be
redesigned to improve
efficiency.

Self-test
1 Conrad Furniture
Conrad Furniture Company produces good quality furniture in a central workshop and sells it
through its 10 retail stores across the UK. The furniture is manufactured to a high standard and
appeals to customers looking for excellent quality but without the 'frills' expected of a bespoke
manufacturer. Conrad's main expenses are materials for the furniture, direct labour and rental
costs for the retail stores. It holds very little inventory and has been advertising heavily in good
quality home magazines.
With a recent downturn in the furniture market, Conrad is becoming concerned about its cost
levels and the increasing popularity of cheaper furniture. Competitors appear to be moving their
retail outlets away from the high street to out of town malls in a bid to reduce rental costs. As a
result, Conrad's management is considering an intensive cost reduction programme to keep
Conrad competitive in the furniture market.
Requirement
Advise Conrad's management team on the issues they should consider when devising the cost
reduction programme.
2 ABC
ABC has a chain of 20 supermarkets. When inventory items reach their re-order level in a
supermarket the in-store computerised inventory system informs the inventory clerk. The clerk then
raises a request daily to the ABC central warehouse for replenishment of inventories via fax or e-
mail. If the local warehouse has available inventory, it is forwarded to the supermarket within 24
hours of receiving the request. If the local warehouse cannot replenish the inventory from its
inventory holding, it raises a purchase order to one of its suppliers. The supplier delivers the
inventory to the warehouse and the warehouse then delivers the required inventory to the
supermarkets within the area. The ABC area warehouse staff conduct all business communication
with suppliers.
ABC recently contracted an IT consultant to analyse and make recommendations concerning their
current supply chain briefly described above. Following the initial investigation the consultant
reported.
'To enable an established traditional company like ABC to develop a virtual supply chain system it
may be necessary to employ a business process re-engineering (BPR) approach.'
Requirement
With reference to the above scenario, describe what is meant by a business process re-engineering
approach.
3 Controlling outsourcing costs
Explain how control can be exercised over the cost of outsourced services.
4 Coming up Roses
Maggie Flowers is the owner of Coming up Roses, a company specialising in growing plants for
sale to garden centres and to specialist garden designers. With the growth in home ownership and
an increase in leisure time this sector of the economy has seemed recession-proof. The company
has grown over the past 10 years and now has 30 employees, several glasshouses and a turnover of
almost 5 million. The company is located on one site near to a rapidly expanding urban area. The
site is relatively large but there is no room for expansion. If the company is to increase its profits as
a garden nursery it must either acquire additional land for growing plants or it must direct more of
its sales to the ultimate user (the general public) and move away from sales to other intermediaries
(the garden centres) and so obtain higher margins.
Maggie is annoyed when she sees garden centres putting large margins on her products for re-sale.
Why can't Coming up Roses take advantage of these profits, she wonders? She is now
contemplating re-focusing her activities on selling plants and not producing them. It has been
suggested that she turns her growing areas into a garden centre, buying in from other specialist
nurseries and transforming her glasshouse space into selling areas. There is a large market nearby,
with several new housing developments, all generating a huge demand for horticultural products.

Maggie has read that the further one moves downstream in the business chain into dealing
directly with the consumer the greater is the profit margin. She is very tempted by this strategy,
but is not fully convinced of the wisdom of such a move.
Requirements
(a) Examine the arguments that may be used to support or reject such a 'buy instead of grow'
strategy for Coming up Roses.
(b) Outsourcing has become a popular strategy for many companies in attempting to reduce
their commitment to non-core activities. Identify the main management problems such a
policy might generate.
C
H
A
P
T
E
R

1 Conrad Furniture
The first thing Conrad has to consider is its future positioning in the market. It is neither appealing
to the top quality bespoke market nor to the customers looking for low prices. If it still wants to be
seen as offering 'middle of the road' quality it should be able to get away with a certain amount of
cost reduction, as there does not appear to be any great expectations from customers. However, if
it does not want to compromise its quality reputation, it should guard against cutting costs too
much, as there comes a point when customers will start to notice differences in the furniture and in
the levels of service.
Conrad has noticed that competitors are moving their retail outlets away from the high street to
save rental costs. This may seem like a good idea but Conrad should determine whether they are
actually in direct competition with these retailers. Are they offering similar quality of products and
similar levels of service? Would Conrad's customers be prepared to switch to these retailers on the
basis of cost alone? Remaining in the high street may be more expensive but might give Conrad
an advantage over these other retailers by being easily accessible, which could lead to more
custom. Conrad should also consider how its customers would view a move to a retail park or
mall. Would it adversely affect its reputation as being a provider of good quality and service?
Retail parks may not be prestigious enough for some customers, although this should not be too
much of a problem given that most of Conrad's customers are looking for excellent quality but
'without the frills'.
A move to an entirely different type of location may affect Conrad's marketing strategy. Is one of
its marketing ploys the fact that the stores are easily accessible, in town centre locations? If so
and if this is the reason the stores attract a lot of trade relocation may not be such a good idea.
Conrad has identified its other main costs as being materials and labour. While these are obvious
targets for a cost reduction programme, Conrad should think about whether using cheaper
materials will affect the quality of its furniture. Likewise, if the manufacture of furniture relies on
specialist labour, it may be difficult to get people of such calibre at a cheaper price. Conrad might
want to consider whether its current sources of materials are offering the best deals in terms of
price but should think carefully before deciding whether cheaper materials could be used. For a
company whose reputation is based on quality, this could be disastrous.
Advertising in expensive magazines may be something to consider. Does this advertising generate
large amounts of revenue? Are expensive magazines reaching the type of customer that Conrad
attracts or is the company being too ambitious? There may be better ways of reaching potential
customers, although Conrad should guard against opting for the cheapest option simply on the
grounds of cost. If it starts advertising in what might be seen as lower quality magazines, this may
again harm its reputation.
Conrad should guard against panicking about costs and take an organised approach to the
programme. While it is correct to be concerned about its cost levels, it should think about the
effects of cutting certain costs on its strategy. The most obvious costs are not always the ones that
should be cut in Conrad's case the materials, labour and rent. Conrad should look at all costs to
determine where the savings could best be made. Are there too many layers of management? Is
there potential for savings in electricity, gas and telephone charges? Just focusing on certain costs
means there is a danger of these costs cut to the extent that the business cannot operate properly.
2 ABC
Business Process Re-engineering (BPR) is the fundamental rethinking and radical design of
business processes to achieve dramatic improvements in critical contemporary measures of
performance, such as cost, quality, service and speed.
In other words, BPR involves significant change in the business rather than minimal or incremental
changes to processes. This is essentially different from procedures such as automation where
existing processes are simply computerised. Although some improvements in speed may be
obtained, the processes are essentially the same. For example, the local warehouse could use EDI to
send an order to the supplier, which may be quicker than email. However, the process of sending
the order and receiving the goods to the warehouse is the same.

Using BPR, the actual reasons for the business processes being used can be queried, and where
necessary replaced with more efficient processes. For example, rather than inventory being ordered
from the store via the central warehouse, the supplier could monitor inventories in each store using
an extranet. When goods reach re-order level, the supplier is aware of this and can send goods
directly to the store. Not only does this provide inventory replenishment much more quickly, it is
also more cost effective for the supplier as the central warehouse effectively becomes redundant.
Key features of BPR involve the willingness of the organisation to accept change and the ability to
use new technologies to achieve those changes. In the example, ABC may have to clearly explain
the benefits to staff from the new systems, to ensure that they are accepted. ABC may also need to
obtain additional skills in terms of IT and ability to implement and use those systems. New
hardware and software will also certainly be required. The aim of BPR is to provide radical
improvements in efficiency and cost savings of up to 90%. Amending the supply chain as noted
above will help to achieve these benefits.
3 Controlling outsourcing costs
The most significant controls will need to be implemented at the planning stage of the
process of outsourcing a service.
The organisation should document details of the level and quality of the service it requires
from the external organisation.
External organisations should then be invited to tender for providing the service. A
documented policy as to the tendering process is required and should cover factors such as
the number of bids required, whether the bids should be sealed and so on.
The organisation must confirm a price for the service with the successful bidder. C
H
On-going control involves ensuring that the service delivered is actually of the contracted A
level and quality (for example, a service level agreement). P
T
The organisation must also give consideration to drawing up policies to deal with problems E
which could arise in the following areas. R
(i) Judging the quality of service provided

(ii) Approving any costs in excess of those agreed 3
(iii) Including a get-out clause in the contract (to be used if the contractor becomes
complacent following a desire by the organisation to build up a long-term relationship)
(iv) Including a price increase clause in the contract (for example, due to inflation or
variations in the quantity of throughput subject to outsourcing)
(v) Reducing prices if the level of service is lower than anticipated
4 Coming up Roses
(a) Coming up Roses is currently profitable and growing. However, the opportunities for
additional growth are limited on the current site. The options are either to acquire new
land or to switch from the current strategy of growing in order to sell to distributors to one of
buying plants from other suppliers to sell direct to the public. There are arguments both for
and against this proposed new strategy.
Arguments for buying instead of growing
Probably the main argument for the proposed switch in strategy would be the higher profit
margins that would be available. At the moment, Maggie is unable to obtain good margins
on her output because she is selling to commercial purchasers who will inevitably seek the
best value for money they can achieve, squeezing Maggie's margins against her production
costs. By moving down the value chain, Maggie could escape this price pressure, since garden
centre products are 'lifestyle' rather than essential purchases and many customers are not
particularly price-sensitive when making such purchases.
At the same time, Maggie could reverse her current position. She would be buying from a
number of specialist nurseries and could seek the best terms available. These could be lower
than her own current production costs, especially where large suppliers are achieving greater
economies of scale than she can in her existing scale of operations.

At the same time, Maggie would have access to a wider range of products from general and
specialist suppliers. This would enhance the attractiveness of her garden centre at little cost.
She would be able to make use of her suppliers' expertise in cultivating delicate or exotic
plants in that they would both produce saleable specimens for her and provide advice on how
best to keep and display them.
Arguments against buying instead of growing
Perhaps the most persuasive argument against this strategy is that of core competences. At
the moment, Maggie and the Coming up Roses staff have expertise in growing plants; they
are not used to the processes involved either in buying plants from other suppliers or in selling
to the general public. Not only would working practices have to change, but there may also
be a requirement for new staff with selling rather than horticultural skills.
A further major hurdle is that Maggie would have to finance considerable capital investment
in order to convert the glasshouses into a suitable garden centre.
By buying plants from other suppliers rather than growing them, Coming up Roses risks losing
a degree of control over the quality of the products that it sells. If poor quality products are
sold to the public, this will reflect on Coming up Roses rather than on the original supplier.
It could be argued that Coming up Roses risks disruption to its supplies if it moves away from
growing its own plants. However, as the intention is to buy from a number of suppliers, this is
probably not a major problem. There might also be the fear that if Coming up Roses is not
successful in this new retail operation it may not be able to re-enter the production market.
However as the expertise, technology and capital cost requirements of production are fairly
low, it should not be too difficult a task to re-enter the production market if required.
(b) Outsourcing
Outsourcing enables organisations to concentrate resources on their value-adding core
activities. Despite the popularity of this strategy, however, there are a number of problems
that management may face when outsourcing.
One of the main problems is that of lack of direct control. If a function of a business is
outsourced, its management loses direct managerial control over it. The danger is that this
may result in a poor quality of service, which may require expense and time to remedy.
If outsourcing is to be used successfully, then management must negotiate carefully and set
up systems for review and monitoring of the contract and the services provided under it.
There must also be a system set up for dealing with disputes over quality or service.
A further potential problem related to lack of direct control is that of responsibility. If an
activity is dealt with in-house, then there will be an individual who is directly responsible for
that activity who will report to management on it. If there are problems, the individual
responsible is clearly identifiable. However, if the activity is outsourced it may be harder to
determine who is responsible in the outsourcing agency and therefore disputes may be
harder to settle.
A further problem is the loss of internal competences that accompanies outsourcing. Staff
may leave or be transferred, and those who remain will lose their skills. Plant and equipment
also will be sold or transferred. Finally, this surrender of competence prevents further
improvement in the outsourced function.


WORKINGS
Budgeted fixed production cos ts
(1) Fixed production costs absorbed per unit =
Budgeted production
110,000
=
2,200
= 50 per unit
Therefore full cost (absorption cost) per unit = 50 + 70 = 120
(2) Under-/over-absorption of overheads
July August
Actual production 2,000 2,500
Expected production 2,200 2,200
(Under-)/over-production (200) 300
Fixed costs per unit 50 50
(Under-)/over-absorption (10,000) 15,000
Income statements absorption costing
July August C
H
A
Sales (150 per unit) 225,000 450,000 P
Cost of sales: T
Opening inventory Nil 60,000 E
Production 240,000 300,000 R
Less: closing inventory (60,000) Nil
(180,000) (360,000)
Gross profit 45,000 90,000 3
(Under-)/over-absorption (10,000) 15,000
35,000 105,000
Income statements marginal costing

July August

Sales 225,000 450,000
Cost of sales
Opening inventory Nil 35,000
Production 140,000 175,000
Less closing inventory (35,000) Nil
(105,000) (210,000)
Contribution 120,000 240,000
Less fixed costs (110,000) (110,000)
Net profit 10,000 130,000
Difference in profits
July August

Absorption cost profit 35,000 105,000
(Increase)/decrease in
inventory and fixed costs
charged against sales (25,000) 25,000 (500 50)
Marginal cost profit 10,000 130,000
Profits are different under each method due to the fixed costs that are included in closing inventory
with absorption costing.

(a)
Overhead cost Cost driver
Set up costs Number of set ups
Materials handling costs Number of times materials handled
Ordering costs Number of orders
Engineering costs Number of spare parts required
(b) Set-up costs per unit
=
(Number of setups per product / Total number of setups) Total set up cos ts
Number of units produced
[(20 / 100) 25,000]

Alpha = = 10.00/unit
500
[(15 / 100) 25,000]

Bravo = = 12.50/unit
300
[(30 / 100) 25,000]
Echo = = 18.75/unit
400
[(35 / 100) 25,000]
Oscar = = 43.75/unit
200
Material handling costs per unit =
(Number of times mats handled per product / Total times mats handled) Total handling cos ts
[(3 / 15) 69,000]

500
Bravo = 61.33/unit
Echo = 23.00/unit
Oscar = 138.00/unit
Ordering costs per unit =

No of orders per product / total no of orders) Total ordering cos ts
[(11/ 64) 32,000]

500
Bravo = 20.00/unit
Echo = 20.00/unit
Oscar = 62.50/unit
Engineering costs/unit =
(No of spare parts per product / total spare parts) Total engineering cos ts
[(15 / 60) 45,000]

Alpha = =22.50/unit
500
Bravo = 50.00/unit
Echo = 18.75/unit
Oscar = 56.25/unit

Total cost per unit
Alpha Bravo Echo Oscar

Direct costs:
Material 60.00 42.00 80.00 100.00
Labour 32.00 20.00 35.00 50.00
Other costs:
Set-up costs 10.00 12.50 18.75 43.75
Material handling costs 27.60 61.33 23.00 138.00
Ordering costs 11.00 20.00 20.00 62.50
Engineering costs 22.50 50.00 18.75 56.25
163.10 205.83 195.50 450.50
Note: Remember to include the direct costs that were given in the question when calculating the
total cost per unit. This is a common mistake in exam situations.

Total fixed cos ts 425,000
(a) Break even point = = =14,167 pairs of roller skates
Contribution / unit (55 25)
(b) Margin of safety = Current sales units Break even sales units
= 20,000 14,167
= 5,833 pairs of roller skates (29%)
C
Total fixed cos ts Re quired profit H
(c) Required sales revenue to ensure a profit of 25,000: = A
Contribution ratio
P
T
where:
E
Contribution per unit R
Contribution ratio =
Selling price per unit
(65 25) 3
=
65
40
=
65
465,000 25,000
Required sales revenue =
(40 / 65)
= 796,250

The first step is to calculate contribution per unit:
McEnrova Grafassi Federdal
Total sales units 8,000 6,000 4,000
Total contribution () 144,000 132,000 120,000
Contribution per unit 18 22 30
The lowest common denominator for the sales mix is 4:3:2. Assume that sale of racquets in the next
period will be in this mix.
Total contribution for the standard batch is 198 (4 18 + 3 22 + 2 30).
306,900
Break even point in batches = = 1,550 batches
198

The number of units of each model that has to be sold in order to break even is:
McEnrova: 1,550 4 = 6,200
Grafassi: 1,550 3 = 4,650
Federdal: 1,550 2 = 3,100
The break even point in terms of sales revenue is:

McEnrova 248,000 (40 6,200)
Grafassi 279,000 (60 4,650)
Federdal 310,000 (100 3,100)
837,000
Check:
McEnrova Grafassi Federdal Total
Sales units 6,200 4,650 3,100
Contribution per unit 18 22 30
Total Contribution () 111,600 102,300 93,000 306,900
Total Fixed Costs () 306,900
Profit/(loss) NIL

(a) The nature of BPR and its application to AB Ltd
A process is 'a collection of activities that takes one or more types of input and creates output that
is of value to the customer'.
Part of this process is manufacture of goods, and so is relevant to AB Ltd. However, a process is
more than just manufacturing, it involves the ordering and delivery of goods to the customer.
Arguably, AB Ltd does not need to manufacture. All aspects of the process, from ordering to
delivery, must be considered.
Key features of BPR
(i) Focus on the outcome, not the task.
(ii) Ignore the current way of doing business. For example, AB Ltd may be divided into
departments. The current organisation structure is not relevant to the process. Indeed having
a large number of departments may make the process harder to manage, as it is split between
several different responsibilities. The same customer's order may be passed from department
to department.
(iii) Carefully determine how to use technology. IT has often been used to automate existing
processes rather than redesign new ones. This means that AB Ltd must have an information
strategy for the company as a whole.
(iv) Review job design. Scientific management split jobs into their smallest components. BPR
suggests that, in some cases, enlarged jobs are more efficient if they lead to fewer people
being involved in the process.
(v) Do the work where it makes most sense. This might affect where sales order processing and
credit controls are carried out.
(vi) Work must be done in logical sequence. This can affect factory layout but also the sequence of
clerical activities.
(vii) Those who perform the process should manage it. The distinction between managers and
workers should be eroded; decision aids such as expert systems should be provided.
(viii) Information provision should be included in the work that produces it.
(ix) The customer should have a single point of contact in the organisation.
In effect, BPR requires the asking of the fundamental question: 'If we were starting from scratch,
what would we do?'

(b) Pitfalls
(i) BPR is an all or nothing proposition. It is thus expensive and risky, requiring major expenditure
on consultancy, investment in IT systems and disruption. It is not worth doing unless there is a
good reason.
(ii) AB Ltd is concerned about overseas competition. There may be other competitive responses
more appropriate than BPR, such as improving quality, outsourcing, a focus strategy or a
differentiation strategy.
(iii) Implementation is difficult, as organisations fail to think through what they are trying to
achieve, and the process becomes captured by departmental interest groups. In AB Ltd, the
production director, sales director and finance director may well conflict. The customer may
deal with all three of them.
(iv) Managers take a departmental view, rather than the view of the business as a whole.
(v) BPR becomes associated only with across the board cost cutting rather than a fundamental re-
evaluation of the business. Managers will fight very hard to avoid any threats to their position.
(vi) Management consultants responsible for the ideas often fail to come up with realistic
strategies for implementation. Managers are thus left with a BPR formula that they may not
fully understand and have to implement it in a hostile work environment.

Outsourcing has always been a feature of business life. It is the natural way to fit a business into the
upstream supply chain, for both goods and services. 'Make or buy' is a classic cost accounting
problem. Also, it has long been used by businesses too small to be able to establish in-house sources of C
highly specialised or expensive goods and services such as legal services and safety equipment. H
A
More recently, in an increasingly competitive and globalised business environment, outsourcing has P
become popular largely because it holds out the promise of reduced costs. Cost reductions become T
E
possible for two main reasons. First, the provider may be able to achieve economies of scale by
R
concentrating some aspect of the production or service process. Second, particularly in work employing
low-skilled labour, a major employer is better placed to exert downward pressure on wage rates than
are a large number of businesses employing a few staff each, especially when casual, part-time or
3
temporary work patterns predominate.
A further potential advantage is the increased effectiveness that can arise from greater specialisation.
This can be achieved both by the supplier, who concentrates on a particular type of work, and by the
purchaser, whose executives are liberated from the management of peripheral activities.
Bonanza seems to be in the middle of outsourcing its call-centre operation and is wondering how far to
take it. It could certainly expect to achieve the cost reductions mentioned above. It is now quite
common for call centre work to be outsourced to countries with lower labour costs, such as India.
However, there have been complaints from customers about poor service, so the potential for
improved efficiency has not yet been achieved. This may illustrate an important disadvantage of
outsourcing, which is the potential for loss of control of the work involved.
The significance of this loss extends beyond concerns about quality. There is also a loss of managerial
expertise relating to the outsourced function or activity. This means that when changes occur in the
market or the environment, it may be much more difficult to plan a suitable response. It will be
necessary to consult with the service providers concerned and, naturally enough, they will have their
own priorities that affect their stance.
The customer dissatisfaction and staff union resistance illustrate a further disadvantage to outsourcing,
which is its potential for generating stakeholder concern. It is natural enough that staff union
organisers should be opposed to anything that threatens their members' livelihood and their own status.
Managing this opposition would be difficult enough; when customers find a reason to be sympathetic
to the unions' stand, Bonanza is likely to find itself having to adjust its policy.
Stakeholder concern about outsourcing was of particular importance to British Airways in 2005, when a
dispute arose at Gate Gourmet, its Heathrow in-flight catering supplier. Gate Gourmet had, in fact, been
spun off from BA some years previously. The dispute caused extensive delays to BA flights out of
Heathrow, not merely because of disruption to catering supplies, but because BA's baggage handlers,
many of whom were related to Gate Gourmet staff, stopped work in sympathy.

CHAPTER 4
Investment appraisal
Introduction
Topic List
1 Overview of investment appraisal techniques
2 Adjusted present value
3 Modified internal rate of return
4 Real options
5 Firms with product options
6 Investment appraisal and risk
7 International investment appraisal
157
Introduction
Demonstrate a detailed understanding and application of the investment appraisal

techniques studied at the Professional stage that is, Payback, Accounting Rate of Return,
Net Present Value and Internal Rate of Return
Apply advanced knowledge and understanding of Modified Internal Rate of Return and
Adjusted Present Value through calculations. These techniques were also covered at the
Professional stage
Demonstrate and apply more advanced knowledge of real options, including the options
to abandon, expand, delay and redeploy
Demonstrate and apply detailed knowledge of the quantitative and qualitative issues
surrounding international investment appraisal

1 Overview of investment appraisal techniques
Section overview
This section reviews investment appraisal techniques that were covered in detail at the Professional
stage. Detailed knowledge of Payback, Accounting Rate of Return (ARR), Net Present Value (NPV),
Internal Rate of Return (IRR) and Adjusted Present Value (APV) are still expected at the Advanced
stage and you should refer to earlier materials for an in-depth analysis of each of these techniques.
1.1 Summary of techniques

1.1.1 Payback period
Payback is the amount of time it takes to recover the cash paid for the initial investment that is, the
time it takes for cash inflows = cash outflows. The project will be feasible if actual payback period is less
than (<) predetermined acceptable payback period.
1.1.2 Discounted payback

The discounted payback period is the time it will take before a project's cumulative NPV turns from
being negative to being positive. A company can set a target discounted payback period (say, five years)
and choose not to undertake any projects with a period in excess of this target.
1.1.3 Accounting rate of return (ARR)

This can be calculated in two ways:
Average annual profit from investment
ARR = 100
Initial investment
Average annual profit from investment

Or 100
Average investment
Initial outlay Scrap value

where average investment =
2
Note: profit is after depreciation
C
Project will be feasible if project ARR is greater than (>) predetermined minimum acceptable ARR. H
A
P
1.1.4 Net present value (NPV) T
E
The net present value of a prospective project with a life of N years is defined as follows. R
N NCFt
NPV -i
t 0
t 1 (1 k) 4
where:
NCFt is the net cash flow that is received in period t
k is the cost of capital for the project
i0 is the initial investment
Firms should invest in projects whose NPV > 0 and should not invest in those projects whose NPV 0.
1.1.5 Internal rate of return (IRR)

The internal rate of return in any investment is the discount rate that equates the present value of its
expected net revenue stream to its initial outlay. For normal projects (that is, initial investment followed
by a series of cash inflows), the project is feasible if IRR > cost of capital. The main problem with IRR is
that it assumes that cash flows will be reinvested at the IRR rather than at the cost of capital.
Investment appraisal 159

1.2 Other issues inflation and taxation
1.2.1 Inflation
The relationship between money rate of return, real rate of return and inflation rate is as follows.
(1 + m) = (1 + r) (1 + i)
Where: m is the money rate of return
r is the real rate of return
i is the inflation rate
If cash flows are stated in money terms, they should be discounted at the money rate; if cash flows are
stated in real terms, they should be discounted at the real rate.
1.2.2 Taxation
Tax writing-down allowances (WDA) are available on non-current assets which allows a company's tax
bill to be reduced. Unless told otherwise, WDA will be 20% reducing balance and tax is paid on profits
in the same year.
Interactive question 1: Investment appraisal techniques [Difficulty level: Easy]

Robbie plc is considering investing in a new piece of machinery which will cost 500,000. The
company has already spent 15,000 on exploratory work on the new machine.
Net cash inflows from the machine are expected to be 200,000 per annum. The machine has a useful
life of four years after which it will be sold for 50,000. Depreciation is charged on the straight-line
basis and Robbie plc's cost of capital is 10%.
Requirement
Calculate the following.
(i) Payback period
(ii) Accounting Rate of Return
(iii) Net Present Value
(iv) Internal Rate of Return
Interactive question 2: NPV with inflation and taxation [Difficulty level: Intermediate]
Bazza plc is considering the purchase of some new equipment on 31 December 20X0 which will cost
350,000. The equipment has a useful life of five years and a scrap value on 31 December 20X5 of
60,000.
Annual cash inflows generated from the equipment are expected to be 110,000, with operating cash
outflows of 15,000 per annum.
Inflation is running at 4% per annum over the life of the project and tax allowances are available on a
20% reducing balance basis. Tax is paid in the same year as the profits on which the tax is charged.
Corporation tax rate is 23% per annum and there is no writing-down allowance in the year of sale.
Bazza's cost of capital is 12%.
Requirement
Calculate the NPV of the project based on the above information and advise Bazza plc on whether the
project should be undertaken.

2 Adjusted present value
Section overview
Adjusted Present Value (APV) combines the ungeared value of a cash flow stream with the tax
effect of any borrowings as a separate element of value.
The adjusted present value (APV) calculation starts with the valuation of a company without debt then,
as debt is added to the firm, considers the net effect on firm value by looking at the benefits and costs
of borrowing. The primary benefit of borrowing is assumed to be the tax benefit (interest is tax
deductible) whilst the main cost of borrowing is the added risk of bankruptcy.
The decision rule is to accept the project as long as its total worth is greater than the outlay required.
2.1 Estimating the value of the firm with APV

The value of the firm is estimated in three steps. The first step is to estimate the value of the firm with
no gearing. The present value of the interest tax savings generated by borrowing a given amount of
money is then considered. Finally, an evaluation of the effect of borrowing the said amount on the
probability of the firm going bankrupt is carried out, together with the expected cost of bankruptcy.
Worked example: APV valuation

A company has a current annual cash flow to the firm of 10m which is expected to grow at 3% in
perpetuity.
The equity beta of the company is 1.2; market debt to equity ratio is 80%; and the tax rate is 23%.
The company has 120 million debt. The risk premium for the market portfolio is 8% and the risk-free
interest rate is 6%. What is the value of the firm using the APV method?
Solution
(i) Calculate the ungeared beta using the following formula:
D(1 T)
e = a (1 + )
E C
H
Where: A
P
e = beta of equity in the geared firm
T
a = ungeared (asset) beta E
R
D = market value of debt
E = market value of equity
4
T = corporate tax rate
1.2 = a [1 + (0.8) (1 0.23)]
1.2 = 1.616a
a = 0.74
(ii) Estimate ungeared cost of equity using CAPM:
Ungeared cost of equity = 6% + 0.74(8%) = 11.92%, say 12%
(iii) Calculate value of ungeared firm:
FCFF0 (1 g) (1 T)NOI(1 g)
VU
k e,u g k e,u g

where:
FCFF is free cash flow of the firm
ke, u is the cost of capital of the ungeared firm
NOI is net operating income before interest and tax
g is the growth rate
T is the corporate tax rate
Using the free cash flow to the firm that we have been given as 10m and the growth rate of 3%,
the ungeared firm value is estimated as:
Ungeared firm value = (1 0.23) 10 1.03/ (0.12 0.03) = 88.1 million
(iv) Tax benefits from debt:
The tax benefits from debt are computed based on the company's existing sterling debt of 120m
and the tax rate of 23%:
Expected tax benefits in perpetuity = Tax rate (Debt) = 0.23(120) = 27.6m
(v) Estimate the value of the firm:
Value of geared firm = Ungeared firm value + PV of tax benefits = 88.1m + 27.6m = 115.7m
What should be remembered is that the true worth of the tax shield may be zero (Miller's 1977
conclusion). Although this is still subject to empirical testing in the real world, the value of the tax
shield, while maybe not zero, may be substantially less than that suggested by Modigliani and
Miller's with-tax analysis. Where this is the case, the APV method may have little benefit over the
NPV method.
Interactive question 3: APV valuation [Difficulty level: Intermediate]

Mega Millions Inc is considering investing in a project with annual after-tax cash flows of 2.5 million
per annum for five years. Initial investment cost is 8 million.
The debt capacity of the company will increase by 10 million over the life of the project, with issue
costs of debt of 300,000. Interest rates are expected to remain at 8% for the duration of the project.
The existing cost of equity for the company is 14% and the current ratio of market value of debt: market
value of equity is 1:3. Corporation tax is 23% and the company's current equity beta is 1.178. The risk
free rate of interest is 7% and the market risk premium is 6%.
Requirement
Calculate the APV of the project and recommend whether Mega Millions should undertake the
investment with the proposed method of financing.
3 Modified internal rate of return
Section overview
The modified internal rate of return (MIRR) is the IRR that would result without the assumption
that project proceeds are reinvested at the IRR rate.
In comparing the IRR to the NPV criterion in Section 1 above, we identified the assumption of
reinvestment rate as one of the problems with the IRR. A way to resolve this problem is to allow the
specification of the reinvestment rate. This modification is known as the modified internal rate of return
(MIRR).

3.1 Calculating the MIRR
Worked example: Modified IRR

Consider a project requiring an initial investment of $24,500, with cash inflows of $15,000 in years 1
and 2 and cash inflows of $3,000 in years 3 and 4. The cost of capital is 10%.
Solution
If we calculate the IRR:
Discount Present Discount Present
Year Cash flow factor value factor value
$ 10% $ 25% $
0 (24,500) 1.000 (24,500) 1.000 (24,500)
1 15,000 0.909 13,635 0.800 12,000
2 15,000 0.826 12,390 0.640 9,600
3 3,000 0.751 2,253 0.512 1,536
4 3,000 0.683 2,049 0.410 1,230
5,827 (134)
5,827
IRR = 10% + (25% 10%) = 24.7%
5,827 134
The MIRR is calculated on the basis of investing the inflows at the cost of capital.
The table below shows the values of the inflows if they were immediately reinvested at 10%. For
example the $15,000 received at the end of year 1 could be reinvested for three years at 10% pa
(multiply by 1.1 1.1 1.1 = 1.331).
Interest rate Amount when
Year Cash inflows multiplier reinvested
$ $
1 15,000 1.331 19,965
2 15,000 1.21 18,150
3 3,000 1.1 3,300
4 3,000 1.0 3,000
44,415
C
The total cash outflow in year 0 ($24,500) is compared with the possible inflow at year 4, and the H
resulting figure of: A
P
24,500 T
= 0.552 E
44,415
R
is the discount factor in year 4. By looking along the year 4 row in present value tables you will see that
this gives a return of 16%. This means that the $44,415 received in year 4 is equivalent to $24,500 in
year 0 if the discount rate is 16%. 4
Alternatively, instead of using discount tables, we can calculate the MIRR as follows.
44,415
Total return = = 1.813
24,500
4
MIRR = 1.813 1
= 1.16 1
= 16%
In theory the MIRR of 16% will be a better measure than the IRR of 24.7% (see below).

3.2 Decision criterion
The decision criterion of the MIRR is the same as the IRR that is:
If MIRR is larger than the required rate of return: ACCEPT
If MIRR is lower than the required rate of return: REJECT
Interactive question 4: Modified IRR [Difficulty level: Easy]

The following cash flows are relevant for a project:
Year 0 Year 1 Year 2 Year 3
Cash outflows () 10,000 0 0 0
Cash inflows () 0 3,000 5,000 7,000
If the discount rate is 10% what is the modified internal rate of return?
3.3 Advantages of modified internal rate of return

There are two main technical advantages to the MIRR. First, it avoids any potential problems with
multiple IRRs, and additionally, it will not provide decision-making advice concerning mutually exclusive
projects that conflicts with the NPV decision. The second problem arises as a result of the IRR decision
being incorrectly based on the assumption that cash flows would be reinvested at the IRR. With MIRR, it
is assumed that cash flows are reinvested at the project's opportunity cost of capital, which is consistent
with NPV calculations.
MIRR could be seen as being the best of both worlds, as it is underpinned by NPV, but at the same time
presents results in the more understandable percentage format.
3.4 Disadvantages of modified internal rate of return

However, MIRR, like all rate of return methods, suffers from the problem that it may lead an investor to
reject a project which has a lower rate of return but, because of its size, generates a larger increase in
wealth.
In the same way, a high-return project with a short life may be preferred over a lower-return project
with a longer life.
4 Real options
Section overview
Real options give the right to the management of a company to make decisions when it is
profitable for the company. Real options were covered at the Professional stage. However, the
topic is taken further at the Advanced stage by providing greater detail of the types of options
available and also considering the process of how to value such options.
Real options are not derivative instruments in the way that traded options such as those for
interest rate and foreign currency hedging are. Real options are very useful in the context of
selecting strategies.
A real option is the right, but not the obligation, to undertake a business decision, such as capital
investment for example, the option to open a new branch is a real option. Unlike financial options,
real options are not tradable for example, the company cannot sell the right to open another branch
to a third party. While the term 'real option' is relatively new, businesses have been making such
decisions for a long time.

This type of option is not a derivative instrument, in the same way as foreign currency and interest rate
options. Real options pertain to physical or tangible options (that is, choice) hence the name. For
example, with research and development, firms have the option (choice) to expand, contract or
abandon activities in a particular area in the future. Pharmaceutical companies such as GlaxoSmithKline
are making such choices all the time.
Real options can have a significant effect on the valuation of potential investments, but are typically
ignored in standard discounted cash flow analysis, where a single expected NPV is computed.
In this section we review the various options embedded in projects and provide examples. In Chapter 7
we illustrate how to estimate the value of real options using the Black-Scholes method.
4.1 Option to delay

When a firm has exclusive rights to a project or product for a specific period, it can delay taking this
project or product until a later date. A traditional investment analysis just answers the question of
whether the project is a 'good' one if taken at a particular point in time eg today. Thus, the fact that a
project is not selected today either because its NPV is negative, or its IRR is less than its cost of capital,
does not mean that the rights to this project are not valuable.
Take a situation where a company is considering paying an amount C to acquire a licence to mine
copper. The company needs to invest an extra amount I in order to start operations. The company has
three years over which to develop the mine, otherwise it will lose the licence. Suppose that today
copper prices are low and the NPV from developing the mine is negative. The company may decide not
to start the operation today, but it has the option to start any time over the next three years provided
that the NPV is positive. Thus the company has paid a premium C to acquire an American-style option
on the present value of the cash flows from operation, with an exercise price equal to the additional
investment (I). The value of the option to delay is therefore:
NPV = PV I if PV > I
NPV = 0 otherwise
The payoff of the option to delay is shown below and it is the same as the payoff of a call option: the
only difference being that the underlying is the present value and the exercise price is the additional
investment.
C
H
A
P
T
E
R
4.2 Option to expand

The option to expand exists when firms invest in projects which allow them to make further investments
in the future or to enter new markets. The initial project may be found in terms of its NPV as not worth
undertaking. However, when the option to expand is taken into account, the NPV may become positive
and the project worthwhile. The initial investment may be seen as the premium required to acquire the
option to expand.

Expansion will normally require an additional investment, call it I . The extra investment will be
undertaken only if the present value from the expansion will be higher than the additional investment,
ie when PV > I . If PV I , the expansion will not take place. Thus the option to expand is again a call
option of the present value of the firm with an exercise price equal to the value of the additional
investment.
4.3 Option to abandon

Whereas traditional capital budgeting analysis assumes that a project will operate in each year of its
lifetime, the firm may have the option to cease a project during its life. This option is known as an
abandonment option. Abandonment options, which are the right to sell the cash flows over the
remainder of the project's life for some salvage value, are like American put options. When the present
value of the remaining cash flows (PV) falls below the liquidation value (L) , the asset may be sold.
Abandonment is effectively the exercising of a put option. These options are particularly important for
large capital intensive projects such as nuclear plants, airlines, and railroads. They are also important for
projects involving new products where their acceptance in the market is uncertain and companies
would like to switch to more profitable alternative uses.

4.4 Option to redeploy
The option to redeploy exists when the company can use its assets for activities other than the original
one. The switch from one activity to another will happen if the PV of cash flows from the new activity
exceeds the costs of switching. The option to abandon is a special case of an option to redeploy.
These options are particularly important in agricultural settings. For example, a beef producer will value
the option to switch between various feed sources, preferring to use the cheapest acceptable alternative.
These options are also valuable in the utility industry. An electric utility, for example, may have the
option to switch between various fuel sources to produce electricity. In particular, consider an electric
utility that has the choice of building a coal-fired plant or a plant that burns either coal or gas.
Nave implementation of discounted cash flow analysis might suggest that the coal-fired plant be
constructed since it is considerably cheaper. Whereas the dual plant costs more, it provides greater
flexibility. Management has the ability to select which fuel to use and can switch back and forth
depending on energy conditions and the relative prices of coal and gas. The value of this operating
option should be taken into account.
4.5 Valuation of real options

The valuation of options will be dealt with in Chapter 7 Financial Engineering.
5 Firms with product options
Section overview
A product option is where the firm has the ability to sell a product in the future but does not have
the obligation to do so.
Traditional valuation techniques may not be suitable for such organisations.
The option-based approach to valuation may be more suitable.
Examples of product options are patents and copyrights, and firms owning natural resources. Firms that
have product options are often research and technology-based.
C
When a firm has a product option that is not currently generating cash flow, there is a risk that a
H
discounted cash flow approach to valuation will not fully reflect the full value of the option. This is A
because a DCF approach may not incorporate all the possible future cash flows of the company. P
T
E
5.1 Problems with traditional DCF techniques R
In the context of a product option, the DCF approach is not fully appropriate, for the following reasons.
The options represent a current asset of the business, but are not generating any cash flows. 4
Any cash flows expected to be generated by the product could be outside of the detailed
forecasting period.
5.2 Possible solutions to the valuation problem

There are three possible methods of valuing product options.
Value the option on the open market. This is only possible if there is a traded market in such
options. If there is no active market or if the option is difficult to separate from the other operations
of the firm, this approach is probably not feasible.
Use a traditional DCF framework and factor in a higher growth rate than would be justified given
the existing assets of the firm. The problem with this is that any growth rate used will be
subjective. In addition, it expresses contingent cash flows as expected cash flows.
Use an option-based approach to valuation. This is considered below.

5.3 Use of option pricing models
The principles of option pricing are discussed in detail in Chapter 7 Financial Engineering.
5.3.1 Problems with using option pricing models to value product options
The problems of using option pricing models, such as Black-Scholes, are as follows.
They need the underlying asset to be traded. This is because the model is based on the principle
of arbitrage, which means that the underlying asset must be easy to buy and sell. This is not a
problem when valuing options on quoted shares. However, the underlying asset in the context of
product options will not be traded, meaning that arbitrage is not possible.
They assume that the price of the underlying asset follows a continuous pattern. While this
may be a reasonable approximation most of the time for quoted shares, it is clearly inappropriate
in the context of product options. The impact of this is that the model will undervalue deeply out-
of-the-money options, since it will underestimate the probability of a sudden large increase in the
value of the underlying asset.
They assume that the standard deviation of price of the underlying asset is known and does
not vary over the life of the option. While this may be a reasonable assumption in the context of
short-dated equity options, it is not appropriate for long-term product options.
They assume that exercise occurs at a precise point in time. In the case of product options,
exercise may occur over a long period of time. For example, if a firm has the right to mine natural
resources, it will take time to extract the resources. This will reduce the present value of the asset.
5.3.2 Using option pricing models to value product patents

When valuing product patents as options, the key inputs for an option pricing will need to be identified,
being the underlying asset price, the strike price, the expected volatility of the underlying asset price
and the time to expiry. The following approach could be adopted.
Identify the value of the underlying asset. This will be based on the expected cash flows that the
asset can generate. Given the uncertain nature of the cash flows and the distant time periods in
which they may arise, it clearly will be difficult to value the underlying asset precisely.
Identify the standard deviation of the cash flows above. Again this will be difficult to identify,
owing to changes in the potential market for the product, changes in technology and so on. It
would, however, be possible to use techniques such as scenario analysis. The higher the standard
deviation, the more valuable the asset.
Identify the exercise price of the option. This is the cost of investing in the resources needed to
produce the asset. It is typically assumed that this remains constant in present value terms, with
any uncertainty being reflected in the cash flows of the asset.
Identify the expiry date of the option. This is when the patent expires. Any cash flows after this
date are expected to have an NPV of zero, since there will be generic competition after patent
protection ends.
Identify the cost of delay. If the product is not implemented immediately, this will reduce the
value of the cash flows from the project as competing products will enter the market in future
years.
A similar approach could be adapted to valuing other product options, such as natural resources. Where a
company is investing in research and development, but has no patents developed, the same approach will
apply, but the value of the option is clearly even more uncertain due to the greater uncertainty of the
inputs.

6 Investment appraisal and risk
Section overview
Risk was covered in detail in Chapter 2 and was also dealt with in the Professional stage Financial
Management paper. This section deals with risk from the viewpoint of how it affects investment
appraisal.
Risk can be applied to a situation where there are several possible outcomes and, on the basis of
past relevant experience, probabilities can be assigned to the various outcomes that could prevail.
Uncertainty can be applied to a situation where there are several possible outcomes but there is
little past relevant experience to enable the probability of the possible outcomes to be predicted.
There is a wide range of techniques for incorporating risk into project appraisal. This section
examines the use of sensitivity analysis and expected values as ways of incorporating risk.
A distinction should be made between the terms risk and uncertainty.
Risk Several possible outcomes

On basis of past relevant experience, assign probabilities to outcomes
Uncertainty Future possible outcomes

Little past experience, thus difficult to assign probabilities to outcomes
A risky situation is one where we can say that there is a 70% probability that returns from a project will
be in excess of 100,000 but a 30% probability that returns will be less than 100,000. If however, no
information can be provided on the returns from the project, we are faced with an uncertain situation.
In general, risky projects are those whose future cash flows, and hence the project returns, are likely to
be variable. The greater the variability is, the greater the risk. The problem of risk may be more acute
with capital investment decisions than other decisions for the following reasons.
Estimates of capital expenditure might be for several years ahead, such as for major construction
projects. Actual costs may escalate well above budget as the work progresses.
Estimates of benefits will be for several years ahead sometimes 10, 15 or 20 years ahead or even C
longer, and such long-term estimates can at best be approximations. H
A
An investment decision may be significant in scale compared to most operating decisions. P
T
A major investment may be part of a new business strategy, or new venture, which may be more E
uncertain than operating decisions which are part of an ongoing strategy. R
6.1 Sensitivity analysis 4

Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used to
calculate the NPV. One particular approach to sensitivity analysis the certainty-equivalent approach
involves the conversion of the expected cash flows of the project to riskless equivalent amounts.
The basic approach of sensitivity analysis in the context of an investment decision is to calculate the
project's NPV under alternative assumptions to determine how sensitive it is to changing conditions. An
indication is thus provided of those variables to which the NPV is most sensitive and the extent to which
those variables would need to change before the investment results in a negative NPV.
The NPV could depend on a number of uncertain independent variables.
Selling price
Sales volume
Cost of capital
Initial cost
Operating costs

Benefits
Cost savings
Residual value
Sensitivity analysis therefore provides an indication of why a project might fail. Management should
review critical variables to assess whether or not there is a strong possibility of events occurring which
will lead to a negative NPV. Management should also pay particular attention to controlling those
variables to which the NPV is particularly sensitive, once the decision has been taken to accept the
investment.
A simple approach to deciding which variables the NPV is particularly sensitive to is to calculate the
sensitivity of each variable.
NPV
Sensitivity = %
Pr esent value of project var iable
The lower the percentage, the more sensitive is NPV to that project variable as the variable would need
to change by a smaller amount to make the project non-viable.
Worked example: Sensitivity analysis

Kenney Co is considering a project with the folowing cash flows.
Year Initial investment Variable costs Cash inflows Net cash
flows
'000 '000 '000 '000
0 7,000
1 (2,000) 6,500 4,500
2 (2,000) 6,500 4,500
Cash flows arise from selling 650,000 units at 10 per unit. Kenney Co has a cost of capital of 8%.
Requirement
Measure the sensitivity of the project to change in variables.
Solution
The PVs of the cash flow are as follows.
Discount PV of initial PV of variable PV of cash PV of net
Year factor 8% investment costs inflows cash flow
'000 '000 '000 '000
0 1.000 (7,000) (7,000)
1 0.926 (1,852) 6,019 4,167
2 0.857 (1,714) 5,571 3,857
(7,000) (3,566) 11,590 1,024
The project has a positive NPV and would appear to be worthwhile. The sensitivity of each project variable
is as follows.
(a) Initial investment

1,024
Sensitivity = 100 = 14.6%
7,000
(b) Sales volume

1,024
11,590 3,566
(c) Selling price

1,024
11,590

(d) Variable costs
1,024
3,566
(e) Cost of capital. We need to calculate the IRR of the project. Let us try discount rates of 15% and 20%.
Net cash Discount Discount
Year flow factor PV factor PV
15% 20%
'000 '000 '000
0 (7,000) 1 (7,000) 1 (7,000)
1 4,500 0.870 3,915 0.833 3,749
2 4,500 0.756 3,402 0.694 3,123
NPV 317 NPV (128)
317 _
IRR = 0.15 + (0.20 0.15) = 18.56%
317 128
The cost of capital can therefore increase by 132% before the NPV becomes negative.
The elements to which the NPV appears to be most sensitive are the selling price followed by the
sales volume. Management should thus pay particular attention to these factors so that they can be
carefully monitored.
6.1.1 Weakness of this approach to sensitivity analysis

These are as follows:
The method requires that changes in each key variable are isolated. However, management is more
interested in the combination of the effects of changes in two or more key variables.
Looking at factors in isolation is unrealistic since they are often interdependent.
Sensitivity analysis does not examine the probability that any particular variation in costs or
revenues might occur.
C
Critical factors may be those over which managers have no control. H
A
In itself it does not provide a decision rule. Parameters defining acceptability must be laid down by P
the managers. T
E
R
Interactive question 5: Sensitivity analysis [Difficulty level: Easy]
Nevers Ure Co has a cost of capital of 8% and is considering a project with the following 'most-likely'
4
cash flows.
Year Purchase of plant Running costs Cost savings

0 (7,000)
1 2,000 6,000
2 2,500 7,000
Requirement
Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and
savings.

6.2 The certainty-equivalent approach
Worked example: Certainty-equivalent approach

Dark Ages Co, whose cost of capital is 10%, is considering a project with the following expected cash
flows.
Year Cash flow Discount factor Present value
10%
$ $
0 (9,000) 1.000 (9,000)
1 7,000 0.909 6,363
2 5,000 0.826 4,130
3 5,000 0.751 3,755
NPV + 5,248
The project seems to be clearly worthwhile. However, because of the uncertainty about the future cash
receipts, the management decides to reduce them to 'certainty-equivalents' by taking only 70%, 60%
and 50% of the Years 1, 2 and 3 cash flows respectively. (Note that this method of risk adjustment
allows for different risk factors in each year of the project.) These 'certainty-equivalents' should then be
discounted at a risk free rate.
Requirement
On the basis of the information set out above, assess whether the project is worthwhile. Assume that the
risk free rate is 5%.
Solution
The risk-adjusted NPV of the project is as follows.
Year Cash flow Discount factor Present value
5%
$ $
0 (9,000) 1.000 (9,000)
1 4,900 0.952 4,667
2 3,000 0.826 2,721
3 2,500 0.864 2,160
NPV 548
The project appears to be worthwhile after adjusting for uncertainty and should be accepted.
6.3 Probability analysis

A probability analysis of expected cash flows can often be estimated and used both to calculate
expected NPV and to measure risk. The standard deviation of the NPV can be calculated to assess risk
when the construction of probability distributions is complex.
A probability distribution of 'expected cash flows' can often be estimated, recognising there are several
possible outcomes, not just one. This may be used to do the following.
Step 1 Calculate an expected value of NPV
Step 2 Measure risk, for example in the following ways

By calculating the worst possible outcome and its probability
By calculating the probability that the project will fail to achieve a positive NPV

Worked example: Probability estimates of cash flows
A company is considering a project involving the outlay of 300,000 which it estimates will generate
cash flows over its two year life at the probabilities shown in the following table.
Year 1
Cash flows Probability

100,000 0.25
200,000 0.50
300,000 0.25
1.00
Year 2
If cash flow in Year 1 is: there is a probability of: that the cash flow in Year 2 will
be:

100,000 0.25 Nil
0.50 100,000
0.25 200,000
1.00
200,000 0.25 100,000
0.50 200,000
0.25 300,000
1.00
300,000 0.25 200,000
0.50 300,000
0.25 350,000
1.00
The company's cost of capital is 10%.

Requirement
Calculate the expected value (EV) of the project's NPV and the probability that the NPV will be negative.
Solution
Step 1 Calculate expected value of the NPV
First, we need to draw up a probability distribution of the expected cash flows. We begin by calculating C
the present values of the cash flows. H
A
Year Cash Discount Present P
flow factor value T
10% E
'000 '000 R
1 100 0.909 90.9
1 200 0.909 181.8
1 300 0.909 272.7 4
2 100 0.826 82.6
2 200 0.826 165.2
2 300 0.826 247.8
2 350 0.826 289.1

Year 1 PV of Probability Year 2 PV of Probability Joint Total PV of EV of PV of
cash flow cash flow probability cash inflows cash inflows
'000 '000 '000 '000
(a) (b) (c) (d) (b) (d) (a) + (c)
90.9 0.25 0.0 0.25 0.0625 90.9 5.681
90.9 0.25 82.6 0.50 0.1250 173.5 21.688
90.9 0.25 165.2 0.25 0.0625 256.1 16.006
181.8 0.50 82.6 0.25 0.1250 264.4 33.050
181.8 0.50 165.2 0.50 0.2500 347.0 86.750
181.8 0.50 247.8 0.25 0.1250 429.6 53.700
272.7 0.25 165.2 0.25 0.0625 437.9 27.369
272.7 0.25 247.8 0.50 0.1250 520.5 65.063
272.7 0.25 289.1 0.25 0.0625 561.8 35.113 3
344.420

EV of PV of cash inflows 344,420
Less: project cost 300,000
EV of NPV 44,420
Step 2 Measure risk
Since the EV of the NPV is positive, the project should go ahead unless the risk is unacceptably high. The
probability that the project will have a negative NPV is the probability that the total PV of cash inflows is
less than 300,000. From the column headed 'Total PV of cash inflows' we can establish that this
probability is 0.0625 + 0.125 + 0.0625 + 0.125 = 0.375 or 37.5%. This might be considered an
unacceptably high risk.
6.3.1 Problems with expected values

There are the following problems with using expected values in making investment decisions.
An investment may be one-off, and 'expected' NPV may never actually occur.
Assigning probabilities to events is highly subjective.
Expected values do not evaluate the range of possible NPV outcomes.
7 International investment appraisal
Section overview
International investment appraisal was covered briefly at the Professional stage but is analysed in
more depth here.
Many of the projects that companies appraise may have an international dimension. Companies
that undertake overseas projects are exposed to such risks as exchange rate movements, political,
cultural, litigation and taxation risks, all of which will be considered in this section.
Investment appraisal techniques for multinational companies must therefore incorporate these
additional complexities into the decision-making process.
With international investment appraisal, multinational companies must take into account factors that
affect the behaviour of the economies of those countries which have an impact on their projects. For
example, in appraising a tourist development, a company may be making assumptions about the
number of tourists from abroad who may be visiting. This will be affected by such factors as interest
rates, tax rates and inflation in the countries from which tourists may visit. If interest and tax rates rise,
potential tourists will have less money to spend and spending on such luxuries as foreign holidays may
decline. Exchange rates will also have an impact on the number of foreign visitors for example, there
would be an increase in the number of UK visitors to the USA if the pound strengthened significantly
against the US dollar.

7.1 Effects of exchange rate assumptions on project values
Changes in exchange rates are as important as the underlying profitability in selecting an overseas
project.
In a domestic project the NPV was calculated using the formula:
n NCF TV
NPV = t + n -I
t 0
t = 1 1+ WACC 1+ WACC n
where:
NCF is net cash flow
WACC is the weighted average cost of capital
TV is the terminal value
I is the initial investment
When a project in a foreign country is assessed we must take into account some specific considerations
such as local taxes, double taxation agreements, and political risk that affect the present value of the
project. The main consideration of course in an international project is the exchange rate risk, that is the
risk that arises from the fact that the cash flows are denominated in a foreign currency. An appraisal of
an international project requires estimates of the exchange rate.
7.1.1 Calculating NPV for international projects

There are two alternative methods for calculating the NPV from an overseas project. For a UK company
investing overseas, we can:
(a) Convert the project cash flows into sterling and then discount at a sterling discount rate to
calculate the NPV in sterling terms;
(b) Discount the cash flows in the host country's currency from the project at an adjusted discount rate
for that currency, and then convert the resulting NPV at the spot exchange rate.
Worked example: Overseas investment appraisal

Bromwich plc, a UK company, is considering undertaking a new project in Portugal. This will require
initial capital expenditure of 1,250m, with no scrap value envisaged at the end of the five-year lifespan.
C
There will also be an initial working capital requirement of 500m, which will be recovered at the end of
H
the project. The initial capital will therefore be 1,750m. Pre-tax net cash inflows of 800m are A
expected to be generated each year from the project. P
T
Company tax will be charged in Portugal at a rate of 40%, with depreciation on a straight-line basis E
being an allowable deduction for tax purposes. Portuguese tax is paid at the end of the year following R
that in which the taxable profits arise.
There is a double taxation agreement between the UK and Portugal, which means that no UK tax will be
4
payable on the project profits.
The current / spot rate is 1.6, and the euro is expected to appreciate against the by 5% per year.
A project of similar risk recently undertaken by Bromwich plc in the UK had a required post-tax rate of
return of 10%.
Requirement
Calculate the present value of the project.

Solution
Method 1 conversion of flows into sterling and discounting at the sterling discount rate
0 1 2 3 4 5 6
Euro flows (m)
Capital 1750 500
Net cash flows 800 800 800 800 800
Depreciation 250 250 250 250 250
Tax 220 220 220 220 220
1750 800 580 580 580 1080 220
Exchange rate 1.60 1.52 1.44 1.37 1.30 1.24 1.18
/
Cash flows in
sterling 1093.75 526.32 401.66 422.80 445.05 872.34 187.05
Discount factor 1.000 0.909 0.826 0.751 0.683 0.621 0.564
PV* 1093.75 478.47 331.95 317.66 303.98 541.65 105.59
NPV in sterling 774.37
*
using unrounded discount rates
Interactive question 6: International investment appraisal [Difficulty level: Intermediate]

Donegal, a UK company, is considering whether to establish a subsidiary in Ruritania (where the
currency is the $), at a cost of $2,400,000. This would be represented by non-current assets of
$2,000,000 and working capital of $400,000. The subsidiary would produce a product which would
achieve annual sales of $1,600,000 and incur cash expenditures of $1,000,000 a year.
The company has a planning horizon of four years, at the end of which it expects the realisable value of
the subsidiary's non-current assets to be $800,000. It expects also to be able to sell the rights to make
the product for $500,000 at the end of four years.
It is the company's policy to remit the maximum funds possible to the parent company at the end of each
year.
Tax is payable at the rate of 35% in Ruritania and is payable one year in arrears.
Tax allowable depreciation is at a rate of 20% on a straight line basis on all non-current assets.
Administration costs of 100,000 per annum will be incurred each year in the UK over the expected life
of the project.
The UK taxation rate on UK income and expenditure is 23%, payable one year in arrears. Assume there
is full double taxation relief in operation between the UK and Ruritania.
The Ruritanian $: exchange rate is 5:1.
The company's cost of capital for the project is 10%.
Requirement
Calculate the NPV of the project.
Method 2 discounting foreign cash flows at an adjusted discount rate

When we use the second method we need to find the cost of capital for the project in the host country.
If we are to keep the cash flows in euros, and they need to be discounted at a rate that takes account of
both the UK discount rate (10%) and the rate at which the exchange rate is expected to decrease (5%).
As this is an application of the international Fisher effect which is covered in Chapter 7 Financial
Engineering, we will demonstrate the calculations for this method in that chapter.

7.1.2 The effect of exchange rates on NPV
Now that we have created a framework for the analysis of the effects of exchange rate changes on the
net present value from an overseas project we can calculate the impact of exchange rate changes on the
sterling denominated NPV of a project.
When there is a devaluation of sterling relative to a foreign currency, the sterling value of the cash flows
increases and the NPV increases. The opposite happens when the domestic currency appreciates. In this
case the sterling value of the cash flows declines and the NPV of the project in sterling declines. The
relationship between NPV in sterling and the exchange rate is shown in the diagram below (where 'e' is
the exchange rate):
NPV
0 e
Worked example: Effect of changes in the exchange rate

Calculate the NPV for the Portugal project of Bromwich plc (see previous worked example on overseas
investment appraisal for details) under three different scenarios.
(a) The exchange rate remains constant at 1.60 for the duration of the project
(b) Sterling appreciates 5 per cent every year
(c) Sterling depreciates 5 per cent every year.
Solution
The NPV under the three scenarios is given in the table below.
Cash flows in m
Constant C
H
Cash flows exchange Sterling depreciates 5% Sterling appreciates 5%
A
Period in m rate per year per year P
0 1750 1093.75 1093.75 1093.75 T
1 E
800 500 526.32 476.19
R
2 580 362.5 401.66 328.80
3 580 362.5 422.80 313.14
4 580 362.5 445.05 298.23 4
5 1080 675 872.34 528.88
6 220 137.5 187.05 102.60
Present
value in 521.83 774.38 320.32
sterling
7.2 Forecasting cash flows from overseas projects
7.2.1 Effect on exports

When a multinational company sets up a subsidiary in another country, in which it already exports, the
relevant cash flows for the evaluation of the project should take into account the loss of export earnings
in the particular country. The NPV of the project should take explicit account of this potential loss by
deducting the loss of export earnings from the relevant net cash flows.

7.2.2 Taxes
Taxes play an important role in the investment appraisal as they can affect the viability of a project. The
main aspects of taxation in an international context are:
Corporate taxes in the host country
Investment allowances in the host country
Withholding taxes in the host country
Double taxation relief in the home country
Foreign tax credits in the home country
The importance of taxation in corporate decision-making is demonstrated by the use of tax havens by
some multinationals as a means of deferring tax on funds prior to their repatriation or reinvestment.
A tax haven is likely to have the following characteristics.
(a) Tax on foreign investment or sales income earned by resident companies, and withholding tax on
dividends paid to the parent, should be low.
(b) There should be a stable government and a stable currency.
(c) There should be adequate financial services support facilities.
The international aspects of the effects of taxes on investment appraisal are covered fully in the
Advanced stage Tax Study Manual.
For example, suppose that the tax rate on profits in the Federal West Asian Republic is 20% and the
UK corporation tax is 23%, and there is a double taxation agreement between the two countries. A
subsidiary of a UK firm operating in the Federal West Asian Republic earns the equivalent of 1 million in
profit, and therefore pays 200,000 in tax on profits. When the profits are remitted to the UK, the UK
parent can claim a credit of 200,000 against the full UK tax charge of 230,000, and hence will only
pay 30,000.
7.2.3 Subsidies
Many countries offer concessionary loans to multinational companies in order to entice them to invest in
the country. The benefit from such concessionary loans should be included in the NPV calculation. The
benefit of a concessionary loan is the difference between the repayment when borrowing under market
conditions and the repayment under the concessionary loan.
7.2.4 Exchange restrictions

In calculating the NPV of an overseas project, only the proportion of cash flows that are expected to be
repatriated should be included in the calculation of the NPV.
7.2.5 Impact of transaction costs on NPV for international projects

Transaction costs are incurred when companies invest abroad due to currency conversion or other
administrative expenses. These should also be taken into account.
7.3 Transaction, translation and economic exposure

7.3.1 Transaction exposure
Transaction exposure occurs when a company has a future transaction that will be settled in a foreign
currency. This gives rise to a foreign exchange exposure. The cost of foreign obligations could rise as a
result of the home currency weakening, or the home currency value of foreign revenues could
depreciate as a result of a stronger home currency.
7.3.2 Translation exposure

Translation exposure occurs in multinational corporations that have foreign subsidiaries with assets and
liabilities denominated in foreign currency. Translation exposure occurs because the value of these
amounts is eventually stated as per IAS 21 in the presentation currency (normally the domestic currency
of the parent) in the company's financial statements. In general, as exchange rates change, the home
currency value of the foreign subsidiaries' assets and liabilities will change. Such changes can result in

translation losses or gains, which will be recognised in financial statements. The nature and structure of
the subsidiaries' assets and liabilities determine the extent of translation exposure to the parent
company.
It could be argued that translation exposure does not constitute a risk to an organisation as it is simply
an accounting problem and does not affect the inflow or outflow of cash. The extent to which it
constitutes a risk depends on the significance placed on the published accounting numbers.
7.3.3 Economic exposure

Economic exposure is the degree to which the present value of a firm's future cash flows is affected by
fluctuations in exchange rates.
It differs from transaction exposure in that exchange rate changes may affect the value of the firm even
though the firm is not involved in foreign currency transactions. Consider, for example, a UK
manufacturer producing a product for the UK market only. It does not use any imported materials and
does not export to other countries. The manufacturer does not have transaction exposure but does
have economic exposure as an appreciation of the pound in relation to other currencies may make
imports cheaper, potentially leading to UK consumers preferring the products of overseas competitors.
Revenue and profits will therefore fall.
Even when the exchange rate of the home currency remains constant, exporting firms still face
economic exposure. Consider a UK manufacturer that exports to the US and whose main competitor is a
Japanese firm. A devaluation of the yen relative to the US dollar will make Japanese imports cheaper in
the US, thus reducing demand for UK goods. The dollar/sterling exchange rate has not moved, but the
UK manufacturer is still experiencing economic exposure.
7.4 Political risk

Political risk was covered at the Professional stage. However, it is useful to remind ourselves of its
meaning and how it may affect a company's position.
Definition
Political risk is the possibility that political actions in another country will affect the investing company's
value and position.
C
H
A
As soon as a multinational company decides to operate in another country, it is exposing itself to P
political risk. Host countries' governments, in an attempt to protect domestic industries or to protect T
their countries from exploitation, may impose such measures as quotas, tariffs or legal safety and quality E
standards, which can affect the efficient and effective operation of the multinational's activities. R
Multinationals can assess the extent of political risk by considering such factors as government stability,
level of import restrictions and economic stability in the country in which it proposes to invest. 4
7.5 Cultural risk

Cultural risk was considered briefly at the Professional stage but is examined in more detail here.
Cultural risk affects the products and services produced and the way in which organisations are
managed and staffed. Businesses should take cultural risks into account when deciding where to sell
abroad and the extent to which activities should be centralised.
Whenever a business operates in a foreign country, it exposes itself to the additional uncertainty of
dealing with unfamiliar languages, customs and laws. Communications between parties may be difficult
and business opportunities jeopardised through ignorance of how transactions should be conducted. In
Asian countries for example, a business card must be presented with both hands and the recipient
should study it briefly rather than just putting it into a briefcase or pocket. Any other behaviour is
considered to be rude and may get business relationships off on the wrong footing.

Businesses should familiarise themselves with:
Cultures and practices of customers and consumers in different markets
Media and distribution systems in host countries
Different ways of doing business overseas
The degree to which national cultural differences matter for the product concerned
The degree to which a firm can use its own national culture as a selling point
7.5.1 Deciding which markets to enter

Making the right choices about which markets to enter is a key element in dealing with cultural risk.
Some products are extremely sensitive to the environmental differences, which bring about the need
for adaptation; others are not at all sensitive to these differences, in which case standardisation is
possible.
Environmentally sensitive Environmentally insensitive
Adaptation necessary Standardisation possible

Fashion clothes Industrial and agricultural products
(commodity type products)
Convenience foods World market products, eg jeans
7.5.2 Management of human resources

The balance between local and expatriate staff must be managed. There are a number of influences.
The availability of technical skills such as financial management
The need for control
The importance of product and company experience
The need to provide promotion opportunities
Costs associated with expatriates such as travel and higher salaries
Cultural factors
For an international company, which has to think globally as well as act locally, there are a number of
problems.
Do you employ mainly expatriate staff to control local operations?
Do you employ local managers, with the possible loss of central control?
Is there such a thing as the global manager, equally at home in different cultures?
7.6 Litigation risk

Litigation risks can be reduced by keeping abreast of changes, acting as a good corporate citizen and
lobbying. Failure to do so may result in infringements of local laws and policies, potentially leading to
costly lawsuits.
7.6.1 Legal impacts

Companies may face government legislation or action in any jurisdiction that extend over the whole
range of activities. Important areas may include:
Export and import controls for political, environmental or health and safety reasons. Such controls
may not be overt but instead take the form of bureaucratic procedures designed to discourage
international trade or protect home producers.
Favourable trade status for particular countries for example, EU membership.
Acceptance of international trademark, copyright and patent conventions. Not all countries
recognise such international conventions.
Restrictions on promotional messages, methods and media.

One example of the problems of enforcing intellectual property legislation in certain markets is the case
of Imperial Tobacco. The British company had major problems enforcing its rights in Indonesia where a
local company, Sumatra, stole the trademark of Imperial Tobacco's premium cigarette brand, Davidoff.
The problem was not with the law, but its enforcement, and it took a ruling by the Indonesian Supreme
Court to enforce Imperial Tobacco's rights.
7.6.2 Dealing with legal risks

Consequences of non-compliance. Businesses that fail to comply with the law run the risk of legal
penalties and bad publicity. Issues of legal standards and costs have significant implications for
companies that trade internationally. Companies that meet a strict set of standards in one country
may be accused of hypocrisy if their practices are laxer elsewhere. High costs of compliance may
ultimately lead to enforced relocation.
Keep up to date with likely changes in policy, despite the fact that policies in many areas may be
slow to change in reality.
Good citizenship compliance with best practice and being responsive to ethical concerns can
help to minimise the risk of government intervention. Today's best practice often becomes
tomorrow's legislation.
Ensure that the company keeps abreast of changes in the law and that staff are kept fully informed.
C
H
A
P
T
E
R

Summary

Self-test
1 A project has the following estimated cash flows:
Year 0 Year 1 Year 2 Year 3 Year 4
Initial investment -75,000 0 0 0 0
Net cash inflows 0 19,000 25,000 30,000 32,000
What is the modified internal rate of return if the project's cost of capital is 8%? Based on this
information, should the company invest in the project? Give reasons for your answer.
2 PG plc
PG plc is considering investing in a new project in Canada which will have a life of four years.
The initial investment is C$150,000, including working capital. The net after-tax cash flows which
the project will generate are C$60,000 per annum for Years 1, 2 and 3 and C$45,000 in Year 4.
The terminal value of the project is estimated at C$50,000, net of tax.
The current spot rate of C$ against sterling is 1.7000. Economic forecasters expect sterling to
strengthen against the Canadian dollar by 5% per annum over the next four years.
The company evaluates UK projects of similar risk at 14%.
Requirement
Calculate the NPV of the Canadian project.
3 Muggins plc
Muggins plc is evaluating a project to produce a new product. The product has an expected life of
four years. Costs associated with the product are expected to be as follows.
Variable costs per unit
Labour: 30
Materials:
6kg of material X at 1.64 per kg
3 units of component Y at 4.20 per unit
Other variable costs 4.40
Indirect costs each year
C
Apportionment of head office salaries 118,000 H
A
Apportionment of general building occupancy 168,000 P
T
Other overheads 80,000 of which 60,000 represent additional cash expenditures (including rent E
of machinery). R
To manufacture the product a production manager will have to be recruited at an annual gross
cost of 34,000 and one assistant manager, whose current annual salary is 30,000, will be
4
transferred from another department, where he will be replaced by a new appointee at a cost of
27,000 a year.
The necessary machinery will be rented. It will be installed in the company's factory. This will take
up space that would otherwise be rented to another local company for 135,000 a year. This rent
(for the factory space) is not subject to any uncertainty, as a binding four-year lease would be
created.
60,000 kg of material X are already in inventory, at a purchase value of 98,400. They have no use
other than the manufacture of the new product. Their disposal value is 50,000.

Expected sales volumes of the product, at the proposed selling price of 125 a unit, are as follows.
Year Expected sales
Units
1 10,000
2 18,000
3 18,000
4 19,000
All sales and costs will be on a cash basis and should be assumed to occur at the end of the year.
Ignore taxation.
The company requires that certainty-equivalent cash flows have a positive NPV at a discount rate of
14%. Adjustment factors to arrive at certainty-equivalent amounts are as follows.
Year Costs Benefits
1 1.1 0.9
2 1.3 0.8
3 1.4 0.7
4 1.5 0.6
Requirement
Assess on financial grounds whether the project is acceptable.
4 Zedland Postal Services
The general manager of the nationalised postal service of a small country, Zedland, wishes to
introduce a new service. This service would offer same-day delivery of letters and parcels posted
before 10am within a distance of 150km. The service would require 100 new vans costing $8,000
each and 20 trucks costing $18,000 each. 180 new workers would be employed at an average
annual wage of $13,000 and five managers at average annual salaries of $20,000 would be moved
from their existing duties, where they would not be replaced.
Two postal rates are proposed. In the first year of operation letters will cost $0.525 and parcels
$5.25. Market research undertaken at a cost of $50,000 forecasts that demand will average 15,000
letters each working day and 500 parcels each working day during the first year, and 20,000 letters
a day and 750 parcels a day thereafter. There is a five day working week and a 52 week year.
Annual running and maintenance costs on similar new vans and trucks are estimated in the first
year of operation to be $2,000 a van and $1,000 a truck. Annual running and maintenance costs
on new vans and trucks will increase by 25% a year. Vehicles are depreciated over a five year
period on a straight line basis. Depreciation is tax allowable and the vehicles will have negligible
scrap value at the end of five years. Advertising in year one will cost $1,300,000 and year two
$263,000. There will be no advertising after year two. Existing premises will be used for the new
service but additional costs of $150,000 a year will be incurred in year 1.
All the above data are based on price levels in the first year and exclude any inflation effects. Staff
and premises costs are expected to rise because of inflation by approximately 5% a year during the
five year planning horizon of the postal service. The government of Zedland will not allow the
prices charged by nationalised industries to increase by more than 5%.
Nationalised industries are normally required by the government to earn at least an annual after tax
return of 5% on average investment and to achieve, on average, at least zero net present value on
their investments.
The new service would be financed half with internally generated funds and half by borrowing on
the capital market at an interest rate of 12% a year. The opportunity cost of capital for the postal
service is estimated to be 14% a year. Corporate taxes in Zedland, to which the postal service is
subject, are at the rate of 30% for annual profits of up to $500,000 and 40% for the balance in
excess of $500,000. Tax is payable one year in arrears. The postal service's taxable profits from
existing activities exceed $10,000,000 a year. All transactions may be assumed to be on a cash
basis and to occur at the end of the year with the exception of the initial investment which would
be required almost immediately.

Requirements
Acting as an independent consultant prepare a report advising whether the new postal service
should be introduced. Include in your report a discussion of other factors that might need to be
taken into account before a final decision is made on the introduction of the new postal service.
State clearly any assumptions that you make.
C
H
A
P
T
E
R

1 PVOUTFLOWS = I0 = 75,000
3 2
TV = 19,000 x 1.08 + 25,000 1.08 + 30,000 x 1.08 + 32,000
= 117,495
117,495 0.25
MIRR 1 0.1188 or 11.88%
75,000
As MIRR > required rate of return (8%), the company should accept the project.
2 PG plc
Investment C$'000 (150) 50
After tax cash flows C$'000 60 60 60 45
Net cash C$'000 (150) 60 60 60 95
Exchange rate 1.7000 1.7850 1.8743 1.9680 2.0664
Net cash '000 (88.24) 33.61 32.01 30.49 45.97

14% discount factors 1.000 0.877 0.769 0.675 0.592
PV in '000 (88.24) 29.48 24.62 20.58 27.21
NPV in '000 13.65
3 Muggins plc
Certainty-equivalent cash flows
Year 1 Year 2 Year 3 Year 4
'000 '000 '000 '000
Sales (W1) 1,125 1,800 1,575 1,425
Material X (W2) 50 230 248 280

Other variable costs (W3) 517 1,100 1,184 1,340
Management salaries (W4) 67 79 85 92
Rental: opportunity cost 135 135 135 135
Other overheads 66 78 84 90
835 1,622 1,736 1,937
Sales less cash costs 290 178 (161) (512)
Discount factor at 14% 0.877 0.769 0.675 0.592
Present value 254 137 (109) (303)
The net present value is -21,000, so the project is not acceptable.

WORKINGS
Year 1 10,000 125 0.9
(1) Sales
Year 2 18,000 125 0.8
Year 3 18,000 125 0.7
Year 4 19,000 125 0.6
(2) Material X Year 1 50,000 opportunity cost
Year 2 18,000 6 1.64 1.3
Year 3 18,000 6 1.64 1.4
Year 4 19,000 6 1.64 1.5
(3) Other variable costs Per unit: 30 + 3 + (3 4.20) + 4.40 = 47
Year 1 10,000 47 1.1
Year 2 18,000 47 1.3
Year 3 18,000 47 1.4
Year 4 19,000 47 1.5

(4) Management salaries Year 1 34,000 + 27,000 = 61,000 1.1
Year 2 61,000 1.3
Year 3 61,000 1.4
Year 4 61,000 1.5
4 Zedland Postal Services
From: A N Accountant
To: The Board of directors
Date: 1 April 20X9
Subject: Proposed new same day service
Introduction
This report considers whether the proposed new service will meet the two targets of a return on
investment of at least 5% and a non-negative net present value. It also considers other factors
which may be relevant. Calculations are set out in the Appendix.
Recommendation
The proposed new service has an annual average return on average investment of 30%, but it
has a negative net present value ($24,000). Because projects must meet both targets to be
acceptable, it is recommended that the service is not provided. However, this is subject to the
further factors considered below.
Non-financial factors
The proposed service might well be of great value to the public. It should perhaps be provided on
that ground.
If the postal service's other projects have large positive net present values, it might be possible to
net them off against the negative net present value here, to give an acceptable overall result. This
is, of course, tantamount to cross-subsidisation.
It may be that charges could be increased and/or costs reduced, so that the net present value
could become positive.
Before any final decision is taken, the reliability of all forecasts should be reviewed, and a
sensitivity analysis should be carried out.
APPENDIX C
H
1 Return on average investment A
P
Year 1 2 3 4 5 T
$'000 $'000 $'000 $'000 $'000 E
R
Revenue
Letters 2,048 2,867 3,010 3,160 3,318
Parcels 682 1,075 1,129 1,185 1,244 4
2,730 3,942 4,139 4,345 4,562
Expenses
Staff 2,340 2,457 2,580 2,709 2,844
Premises 150 158 165 174 182
Vehicle maintenance
Vans 200 250 313 391 488
Trucks 20 25 31 39 49
Advertising 1,300 263
Depreciation 232 232 232 232 232
4,242 3,385 3,321 3,545 3,795
Revenue less expenses (1,512) 557 818 800 767
Taxation (40%) 605 (223) (327) (320) (307)
Profit after tax (907) 334 491 480 460

Total profit after tax = $858,000
Average profit after tax = $858,000/5 = $171,600
Average investment =$1,160,000/2 = $580,000
$171,600
Average annual after tax return on investment = 100% = 30%
$580,000
2 Net present value

Year 0 1 2 3 4 5 6
$'000 $'000 $'000 $'000 $'000 $'000 $'000
Revenue less expenses (1,512) 557 818 800 767
Add depreciation 232 232 232 232 232
Taxation 605 (223) (327) (320) (307)
Initial investment (1,160)
Cash flow (1,160) (1,280) 1,394 827 705 679 (307)
Discount factor (14%) 1 0.877 0.769 0.675 0.592 0.519 0.456
Present value (1,160) (1,123) 1,072 558 417 352 (140)
Net present value = ($24,000).
3 Assumptions made
(a) The inflation rate, for both revenue per unit and costs (excluding depreciation) will
be 5%.
(b) The cost of preliminary research is to be ignored, as it has already been incurred.
(c) If the five managers were not needed for this new service, they would remain in their
present posts rather than being made redundant.
(d) Return on average investment is to be computed ignoring financing costs.


Note: The exploratory work of 15,000 is a sunk cost and is therefore not relevant when appraising the
project.
(i) Payback period
In this case, the payback period will be the amount of time it will take Robbie plc to earn
500,000.
Cumulative
Year Cash flow cash flow

1 200,000 200,000
2 200,000 400,000
3 200,000 600,000
Payback is therefore 2 years + (100,000/200,000) = 2.5 years
(ii) Accounting rate of return (ARR)
Average Accounting Pr ofit
ARR
Average Investment
Accounting Profit = Cash flow Depreciation

Cost Re sale value
Depreciation
Useful life
500,000 50,000
=
4
= 112,500pa
Average profit per annum = 200,000 112,500
= 87,500 C
H
Cost Re sale value A
Average Investment =
2 P
T
500,000 50,000 E
= = 275,000 per annum R
2
87,500
ARR = 31.8%
275,000 4
(iii) Net present value


Initial investment (500,000)
Cash flow 200,000 200,000 200,000 200,000
Resale proceeds 50,000
Net cash flow (500,000) 200,000 200,000 200,000 250,000
Discount factor (10%) 1.000 0.909 0.826 0.751 0.683
Discounted cash flow (500,000) 181,800 165,200 150,200 170,750
NPV = 167,950
(iv) Internal rate of return (IRR)
To calculate IRR, we generally find one discount rate with a positive NPV and another discount rate
that results in NPV being negative. This is generally carried out using trial and error.

We already have a positive NPV when the discount rate is 10%. When trial and error is applied, we
find that NPV at a 30% discount rate is (49,300).
167,950
IRR = 10 + (30 10)
(167,950 49,300)
IRR = 25.5%

WORKINGS (all figures in )
(1) Tax writing-down allowances (WDA)
Year WDA/Written-down value Tax saved
at 23%
20X0 350,000
WDA (20%) (70,000) 16,100
20X1 280,000
WDA (56,000) 12,880
20X2 224,000
WDA (44,800) 10,304
20X3 179,200
WDA (35,840) 8,243
20X4 143,360
WDA (28,672) 6,595
20X5 114,688
Proceeds (60,000)
Balancing all 54,688 12,578
(2) Inflation computations
20X1 20X2 20X3 20X4 20X5
Net cash inflows 95,000 98,800 102,752 106,862 111,136
(3) Tax computations
20X1 20X2 20X3 20X4 20X5
Tax at 23% of net
cash inflows 21,850 22,724 23,633 24,578 25,561
NPV calculation
20X0 20X1 20X2 20X3 20X4 20X5
Initial (350,000)
Investment
Cash (net) 95,000 98,800 102,752 106,862 111,136
Tax (23%) (21,850) (22,724) (23,633) (24,578) (25,561)
WDA/Bal all 16,100 12,880 10,304 8,243 6,595 12,578
Sale 60,000
(333,900) 86,030 86,380 87,362 88,879 158,153
Dis. factor 1.000 0.893 0.797 0.712 0.636 0.567
DCF (333,900) 76,825 68,845 62,202 56,527 89,673
NPV = 20,172
As NPV is positive, the project is feasible and should be undertaken.

Step 1 Calculate NPV of the project with the original cost of equity with no gearing.
Ungeared beta
D(1 T)
e = a (1 + )
E
1.178 = a (1 + (1 (1 0.23/3)))
a = 0.94
Ungeared cost of equity (using CAPM)
= Rf + a market premium
= 7 + 0.94 6
= 12.6% (say 13%)
Discounted cash flow using 13% as the discount rate
Year 0 12345
m m m m m m
Initial investment (8)
Annual cash flow 2.5 2.5 2.5 2.5 2.5
Annuity factor (13% for 5 years) = 3.517
NPV = (8m) + 3.517 2.5m = 0.79m
Step 2 Calculate the present value of the tax shield from debt financing.
Interest payable = 10m 8% = 0.8m
Tax saved = 0.8 23% = 0.184m
Discount at cost of debt (8%) over 5 years = 0.184 3.993
= 0.735m
Step 3 Issue costs = 300,000

APV = 0.79m 0.3m + 0.74m
C
= 1.23m H
A
As APV is positive, the project should be undertaken with the proposed method of P
financing. T
E
R
PVOUTFLOWS = 10,000
4
Value of inflows if reinvested at the 10% cost of capital
Interest rate Amount when
Year Cash inflows multiplier reinvested

1 3,000 1.21 3,630
2 5,000 1.1 5,500
3 7,000 1.0 7,000
16,130
3
MIRR = (16,130/10,000) 1 = 17.28%
[The IRR for the project is 20.13%. The reason it is higher is because the IRR assumes a reinvestment rate
of 20.13% rather than 10% which we have used.]

The PVs of the cash flows are as follows.
Year Discount factor PV of plant PV of running PV of savings PV of net cash
8% cost costs flow

0 1.000 (7,000) (7,000)
1 0.926 (1,852) 5,556 3,704
2 0.857 (2,143) 5,999 3,856
(7,000) (3,995) 11,555 560
The project has a positive NPV and would appear to be worthwhile. Sensitivity of the project to changes
in the levels of expected costs and savings is as follows.
560
(a) Plant costs sensitivity = 100 8%
7,000
560
(b) Running costs sensitivity = 100 14%
3,995
560
(c) Savings sensitivity = 100 4.8%
11,555

Time
0 1 2 3 4 5
$'000 cash flows
Sales receipts 1,600 1,600 1,600 1,600
Costs (1,000) (1,000) (1,000) (1,000)
Tax allowable depreciation (brought
in to calculate taxable profit) (400) (400) (400) (400)
$ taxable profit 200 200 200 200
Taxation (70) (70) (70) (70)
Add back tax allowable depreciation
(as not a cash flow) 400 400 400 400
Capital expenditure (2,000)
Scrap value 800
Tax on scrap value (W1) (140)
Terminal value 500
Tax on terminal value (175)
Working capital (400) 400
(2,400) 600 530 530 2,230 (385)
Exchange rates 5:1 5:1 5:1 5:1 5:1
'000 cash flows
From/(to) Ruritania (480) 120 106 106 446 (77)
Additional UK expenses/income (100) (100) (100) (100)
UK tax effect of UK expenses/income 23 23 23 23
Net sterling cash flows (480) 20 29 29 369 (54)
UK discount factors 1 0.909 0.826 0.751 0.683 0.621
Present values (480) 18.2 24.0 21.8 252.0 (33.5)
NPV = (197,500), therefore the company should not proceed.
WORKINGS
(1) Tax is payable on $400,000 as tax written down value = $2,000,000 (4 $400,000) = $400,000

CHAPTER 5
Business and securities

valuation
Introduction
Topic List
1 Valuation techniques
2 Company valuation: general principles
3 Valuing acquisitions
4 Valuing debt
5 Unquoted companies and start-ups
193
Introduction
Demonstrate a detailed understanding and application of different methods of business

and securities valuation, including asset-based, income-based and cash-based methods
Demonstrate a detailed knowledge and understanding of when the use of each valuation
technique is most appropriate
Apply appropriate techniques to the valuation of acquisitions and mergers and
demonstrate ability to perform relevant calculations to value such activities
Demonstrate a detailed understanding and application of methods of valuing debt

1 Valuation techniques
Section overview
This section looks at the valuation techniques you may be required to use in an exam situation.
You should be familiar with the Shareholder value analysis (SVA) technique that was covered in
the Professional stage Financial Management paper.
1.1 Shareholder value

1.1.1 Value-based management (VBM)
VBM starts with the philosophy that the value of a company is measured by its discounted future cash
flows. Value is created only when companies invest capital at returns that exceed the cost of that
capital. VBM extends this philosophy by focusing on how companies use the idea of value creation to
make both major strategic and everyday operating decisions. So VBM is an approach to management
that aligns the strategic, operational and management processes to focus management decision-making
on what activities create value.
1.1.2 Value drivers

A value driver is any variable that affects the value of the company. They should be ranked in terms of
their impact on value and responsibility assigned to individuals who can help the organisation meet its
targets. Value drivers can be difficult to identify as it requires an organisation to think about its
processes in a different way and existing reporting systems are often not equipped to supply the
necessary information. It has been suggested that a good way of relating a range of value drivers is to
use scenario analysis (covered in Chapter 2). It is a way of assessing the impact of different sets of
mutually consistent assumptions on the value of a company or its business units.
1.1.3 Shareholder value analysis (SVA)

SVA is the process of analysing how certain decisions affect the net present value of cash to
shareholders. At the corporate level it provides a framework for evaluating options for improving
shareholder value by determining the trade-offs between reinvesting cash in the company, distributing
cash to shareholders and investing in new businesses.
SVA consists of three primary analyses:
Determining the present value of the costs of all investments using the appropriate cost of capital
Estimating the economic value of the business by discounting its expected cash flows to find their
present values
Determining the economic value of the business by finding the difference between the above
elements
1.1.4 Economic Value Added (EVA)

EVA = Net Operating Profit after Tax (NOPAT) WACC Capital Employed C
H
OR
A
EVA = (ROIC WACC) Capital Employed (where ROIC = Return on invested capital) P
T
E
R
Business and securities valuation 195

Case example: EVA
The derivation of EVA can be illustrated using an example.
Year 20X5 20X6
Sales 2,000
Expenses other than interest 800
Depreciation 300
Earnings before interest and taxes (EBIT) 900
Taxes on EBIT @ 23% 207
Earnings before interest and after taxes (NOPAT) 693
Current assets less excess cash and securities 400 380

Non-interest bearing current liabilities 100 120
Adjusted net working capital 300 260
Gross property, plant and equipment 3,200 3,500

Accumulated depreciation 1,000 1,300
Net property, plant and equipment 2,200 2,200
Invested capital 2,500 2,460

Return on invested capital (NOPAT/invested capital) 27.72%
Based on previous year's invested capital
The calculation of EVA takes place as follows.
EVA calculation: Method 1

Invested capital 2,500
Times cost of capital 12%
Capital charge 300
NOPAT 693
Less capital charge (300)
EVA 393
EVA calculation: Method 2

ROIC 27.72%
Less: cost of capital 12%
Excess return 15.72%
Invested capital 2,500

Times: excess return 15.72%
EVA 393
Essentially EVA is an estimate of the amount by which earnings exceed or fall short of the required
minimum rate of return for shareholders or lenders at similar risk. It can be used at divisional as well as
corporate level and is based on the idea that a business must cover both its operating costs and its
capital costs. It can be used for such purposes as capital budgeting, performance measurement and
corporate valuation.
The NOPAT figure should not be that taken directly from the financial statements, but will contain
numerous adjustments (eg current values rather than historic costs, R & D expenditure, unusual items)
to make the figure more meaningful in the context of a valuation.

The use of EVA to value a company will be discussed in Section 3.4 of this chapter.

1.1.5 Cash flow return on investment (CFROI)
This technique is an Economic Profit (Cash Flow) based valuation framework.
CFROI is a real rate of return measure (that is, it excludes inflation) that identifies the relationship
between the cash generated by a business relative to the cash invested in it. It represents the discount
rate at which the discounted future annual cash flows expected to be generated over the useful life of a
firm's assets are equal to the current cash value of the firm's net operating assets.
CFROI can be used at divisional level and can also be applied to privately held firms.
1.1.6 Market value added (MVA)

The MVA of a company is defined as:
MVA = Market value of debt + Market value of equity Book value of equity
The MVA shows how much the management of a company has added to the value of the capital
contributed by the capital providers.
The MVA is related to EVA because MVA is simply the present value of the future EVAs of the company.
If the market value and the book value of debt is the same, then the MVA simply measures the
difference between the market value of common stock and the equity capital of the firm.
A firm's equity MVA is sometimes expressed as a market to book ratio:
MVA
book value
The higher the MVA the better for the company as a high MVA indicates that the company has created
wealth for its shareholders.
The main problem with MVA is that it does not take opportunity cost of capital into account, nor does it
account for intermediate cash returns to shareholders.
1.1.7 Total shareholder return

This technique measures the change in capital value of a listed company over a period (typically at least
one year) plus cash payouts to shareholders expressed as a percentage of the initial share price at the
start of the period. The formula is:
(Share price at end - share price at beginning) Cash paid to shareholders

TSR =
Share price at beginning
The cash payouts to shareholders will include regular and special dividends, share buy-backs and any
other cash payments.
Its very nature prevents TSR being used for organisations that are not listed. It can be easily compared
across companies of different sizes and benchmarked against industry or market returns without the
complication of size bias.
1.2 Valuation techniques

C
H
1.2.1 Dividend valuation model A
This model states that a company's value is the present value of all the future cash flows to investors P
T
discounted at the investors' required rate of return for that company. There are two types of model E
the constant annual dividends model and the constant growth model. R
Constant annual dividends:
D0 D0 D0 D 5
P0 = .... 0
(1 k e ) (1 k )2 (1 k e )3 ke
e
where P0 = Ex dividend market value of the shares

D0 = Constant annual dividend
ke = Shareholders' required rate of return
Constant growth model
D0 (1 g) D (1 g)2 D (1 g) D1
P0 = 0 .... 0 =
(1 k e ) (1 k e ) 2 (k e g) k e g
where D0 = Current year's dividend

g = Growth rate in earnings and dividends
D0 (1 + g) = Expected dividend in one year's time (D1)
ke = Shareholders' required rate of return
P0 = Market value excluding any dividend currently payable
Interactive question 1: Dividend valuation models [Difficulty level: Easy]

Target has just paid a dividend of 250,000. The current return to shareholders of companies in the
same industry as Target is 12%, although it is expected that an additional risk premium of 2% will be
applicable to Target, being a smaller and unquoted company. Compute the expected valuation of
Target, if:
(a) The current level of dividend is expected to continue into the foreseeable future, or
(b) The dividend is expected to grow at a rate of 4% pa into the foreseeable future.
1.2.2 Income dividend yield

The dividend yield is calculated as follows:
Dividend per share

Dividend yield 100
Market price per share
With dividend yield we are looking at the effect of gearing on the market price of shares. If additional
debt finance is expected to be used to generate good returns in the long-term, it is possible that the
dividend yield might fall significantly in the short-term because of a fall in short-term dividends.
However, the market price may rise to reflect expectations of enhanced long-term returns. How
shareholders view this movement will depend on their preference between short-term and long-term
returns.
Dividend yield is also covered in Chapter 16 Financial statement analysis of the Advanced level Corporate
Reporting text.
1.2.3 Income P/E ratio

The P/E ratio is the most important yardstick for assessing the relative worth of a share. The P/E ratio is
calculated as:
Market price of share Total market value of equity

which is the same as
EPS Total earnings
The value of the P/E ratio reflects the market's appraisal of the share's future prospects. It is an
important ratio as it relates two key considerations for investors the market price of a share and its
earnings capacity. An EPS ratio that changes substantially and frequently may indicate an earnings
volatility issue that could increase the perceived risk of the company. This can also impact on periodic
P/E ratios.
IAS 33 Earnings Per Share prescribes principles for the determination and presentation of EPS. This
Standard is covered in the Advanced Stage Corporate Reporting manual. The main issue with using
ratios for valuation purposes is that they can be manipulated by company management, either directly

or indirectly. Before the EPS can be considered to be useful by analysts trying to value the company, the
earnings figure must be adjusted to reflect the sustainable earnings of the company. The result of this
process is a 'normalised earnings' figure, the calculations of which are covered in the Financial Statement
Analysis chapter of the Advanced level Corporate Reporting manual. You should also refer to this
chapter to familiarise yourself with the limitations of the use of financial ratios for analysis purposes.
Interactive question 2: Valuations [Difficulty level: Easy]

Flycatcher wishes to make a takeover bid for the shares of an unquoted company, Mayfly. The earnings of
Mayfly over the past five years have been as follows.
20X0 50,000 20X3 71,000
20X1 72,000 20X4 75,000
20X2 68,000
The average P/E ratio of quoted companies in the industry in which Mayfly operates is 10. Quoted
companies which are similar in many respects to Mayfly are:
(a) Bumblebee, which has a P/E ratio of 15, but is a company with very good growth prospects.
(b) Wasp, which has had a poor profit record for several years, and has a P/E ratio of seven.
Requirements
What would be a suitable range of valuations for the shares of Mayfly?
1.2.4 Income discounted cash flow

The value of a company is basically the present value of all its future expected cash flows. This method
of valuation may be appropriate when one company intends to buy the assets of another company and
to make further investments in order to improve cash flows in the future.
Interactive question 3: Discounted cash flow basis of valuation

[Difficulty level: Intermediate]
Diversification plc wishes to make a bid for Tadpole Ltd. Tadpole makes after-tax profits of 40,000 a
year. Diversification believes that if further money is spent on additional investments, the after-tax cash
flows (ignoring the purchase consideration) could be as follows.
Year Cash flow (net of tax)

0 (100,000)
1 (80,000)
2 60,000
3 100,000
4 150,000
5 150,000
The after-tax cost of capital of Diversification is 15% and the company expects all its investments to pay
back, in discounted terms, within five years. What is the maximum price that the company should be
willing to pay for the shares of Tadpole?
C
See Answer at the end of this chapter. H
A
P
T
E
R

1.2.5 Asset-based measures
If the net asset method of valuation is used, the value of a share in a particular class is equal to the net
tangible assets attributable to that class divided by the number of shares in the class. Remember to
exclude intangible assets (which include goodwill) unless they have a market value (such as patents and
copyrights).
The main difficulty in an asset valuation method is establishing the asset values to use. Values ought to
be realistic. The figure attached to an individual asset may vary considerably depending on whether it is
valued on a going concern or a break-up basis. Possibilities include the historic basis (although this is
unlikely to be relevant), replacement basis and realisable basis.
2 Company valuation: general principles
Section overview
Accountants can be involved in the valuation of shares for numerous purposes.
The purpose for which a share is valued will determine the value that is placed on the share.
2.1 So what is a company worth?

There is no precise answer to this question. The value of the company will change depending on the
purpose for which it is valued. We covered valuation techniques in Section 1 above.
Companies could be worth:
The tangible assets
The assets plus goodwill
Whatever someone is prepared to pay for them
BizStats.com is a web site that provides useful financial ratios and statistics for company valuation.
Industry statistics can be used for benchmarking purposes when undertaking valuations. Some rules of
thumb for valuing companies in different industries are given by BizStats.com as follows:
Type of business 'Rule of Thumb' valuation
Accounting firms 100 125% of annual revenues
Book stores 15% of annual sales + inventory
Coffee shops 40 45% of annual sales + inventory
Petrol stations 15 25% of annual sales + equipment/inventory
2.1.1 What affects the value of a company?

Company value is not just affected by sales and profit forecasts. Value can be influenced by the type of
industry the company operates in, the level of competition faced by the company and the customer
base. If a company has a popular product or product range that the public will want to buy, its value
will increase, provided of course that the people who want to buy it can actually afford to do so.
2.2 Distortions in accounting figures

Anyone undertaking a valuation using accounting figures will need to be aware of possible distortions in
those figures. These are covered in detail in Chapter 16 Financial statement analysis of the Corporate
Reporting text and may involve distortions in assets, liabilities, equity or earnings.
To combat problems with earnings, it may be necessary to produce a normalised earnings figure, to
reflect the sustainable earnings of a company. This figure excludes profits from discontinued operations,
changes in estimates and fair values, profits/losses from the sale of non-current assets and start-ups,
restructuring and redundancy costs amongst other adjustments.
If cash flows are used rather than earnings, period figures may be distorted by the timing of receipts or
payments or unusual items.

3 Valuing acquisitions
Section overview
This section looks at the various ways in which the target company in an acquisition or merger
situation can be valued, and how to value the combined company after the acquisition or merger
takes place.
3.1 Asset-based model

The asset-based approach to valuation was reviewed in Section 1.2.5 above. These models use the
statement of financial position as the starting point in the valuation process.
Worked example: Asset-based model

The summary statement of financial position of Cactus is as follows.
Non-current assets
Land and buildings 160,000
Plant and machinery 80,000
Motor vehicles 20,000
260,000
Goodwill 20,000
Current assets
Inventory 80,000
Receivables 60,000
Short-term investments 15,000
Cash 5,000
160,000
Current liabilities
Payables 80,000
Taxation 20,000
(100,000)
60,000
340,000
12% loan notes (60,000)
Deferred taxation (10,000)
270,000
Ordinary shares of 1 80,000
Reserves 140,000
220,000
4.9% preference shares of 1 50,000
270,000
Requirement
What is the value of an ordinary share using the net assets basis of valuation?
Solution
If the figures given for asset values are not questioned, the valuation would be as follows. C
H
A
Total value of assets less current liabilities 340,000
P
Less intangible asset (goodwill) 20,000 T
Total value of assets less current liabilities 320,000 E
Less: preference shares 50,000 R
loan notes 60,000
deferred taxation 10,000
120,000 5
Net asset value of equity 200,000
Number of ordinary shares 80,000
Value per share 2.50

3.2 Market relative model (the P/E ratio)
The P/E method of valuation was reviewed in Section 1.2.3 above. The P/E ratio produces an earnings-
based valuation of shares. This is done by deciding a suitable P/E ratio and multiplying this by the EPS
for the shares which are being valued. The EPS could be a historical EPS or a prospective future EPS. For
a given EPS figure, a higher P/E ratio will result in a higher price. A high P/E ratio may indicate:
(a) Optimistic expectations
Expectations that the EPS will grow rapidly in the years to come, so that a high price is being paid
for future profit prospects. Many small but successful and fast-growing companies are valued on
the stock market on a high P/E ratio. Some stocks (for example, those of some internet companies
in the late 1990s) have reached high valuations before making any profits at all, on the strength of
expected future earnings.
(b) Security of earnings
A well-established low-risk company would be valued on a higher P/E ratio than a similar company
whose earnings are subject to greater uncertainty.
(c) Status
If a quoted company (the predator) made a share-for-share takeover bid for an unquoted company
(the target), it would normally expect its own shares to be valued on a higher P/E ratio than the
target company's shares. A quoted company ought to be a lower-risk company; but in addition,
there is an advantage in having shares which are quoted on a stock market: the shares can be
readily sold. The P/E ratio of an unquoted company's shares might be around 50% to 60% of the
P/E ratio of a similar public company with a full Stock Exchange listing (and perhaps 70% of that of
a company whose shares are traded on the AIM).
Case example: P/E ratios

Some sample P/E ratios taken from the Financial Times on 13 June 2013
Market indices
FTSE 100 12.60
FTSE all-share 13.58
FTSE all-small 54.29
FTSE AIM Negative
Industry sector averages (main market)
Chemicals 21.59
Construction 38.38
Food producers 11.07
General retailers 15.66
Pharmaceutical and Biotechnology 16.27
Mobile telecommunications 11.60
Worked example: Takeover offer price

Spider plc is considering the takeover of an unquoted company, Fly Ltd. Spider's shares are quoted on
the Stock Exchange at a price of 3.20 and since the most recent published EPS of the company is 20p,
the company's P/E ratio is 16. Fly Ltd is a company with 100,000 shares and current earnings of
50,000, 50p per share. How might Spider plc decide on an offer price?

Solution
The decision about the offer price is likely to be preceded by the estimation of a 'reasonable' P/E ratio in
the light of the particular circumstances.
(a) If Fly Ltd is in the same industry as Spider plc, its P/E ratio ought to be lower, because of its lower
status as an unquoted company.
(b) If Fly Ltd is thought to be growing fast, so that its EPS will rise rapidly in the years to come, the
P/E ratio that should be used for the share valuation will be higher than if only small EPS growth is
expected.
(c) If the acquisition of Fly Ltd would contribute substantially to Spider's own profitability and
growth, or to any other strategic objective that Spider has, then Spider should be willing to offer a
higher P/E ratio valuation, in order to secure acceptance of the offer by Fly's shareholders.
Of course, the P/E ratio on which Spider bases its offer will probably be lower than the P/E ratio that
Fly's shareholders think their shares ought to be valued on. Some haggling over the price might be
necessary.
Spider might decide that Fly's shares ought to be valued on a P/E ratio of 60% 16 = 9.6, that is, at
9.6 50p = 4.80 each.
Fly's shareholders might reject this offer, and suggest a valuation based on a P/E ratio of, say, 12.5, that
is, 12.5 50p = 6.25.
Spider's management might then come back with a revised offer, say valuation on a P/E ratio of 10.5,
that is, 10.5 50p = 5.25.
The haggling will go on until the negotiations either break down or succeed in arriving at an agreed
price.
3.3 Free cash flow model

The free cash flow approach has been explained in detail in Chapter 4 in the context of project appraisal
and is also briefly covered in Chapter 16 Financial statement analysis of the Advanced level Corporate
Reporting text. The procedure for valuing a target company on the basis of its predicted cash flow is
similar to that used for investment appraisal.
Step 1 Calculate the free cash flow

The free cash flow to the firm is defined as:
FCF = EARNINGS BEFORE INTEREST AND TAXES (EBIT)
Less: TAX ON EBIT
Add back: NON CASH CHARGES
Less: CAPITAL EXPENDITURE
Less: NET WORKING CAPITAL INCREASES
Plus: NET WORKING CAPITAL DECREASES C
H
Plus: SALVAGE VALUES RECEIVED A
P
Example T
E
R
Earnings before interest and taxes (EBIT) 80,000
Remove taxes (1 Tax rate, T) 77%
Operating income after taxes 61,600
5
Depreciation (non cash item) 14,000
Less: capital expenditure (9,000)
Less: changes to working capital (1,000)
Free cash flow 65,600

Step 2 Forecast FCF and terminal value
For a time horizon of six years the following values need to be estimated:
FCF1 FCF2 FCF3 FCF4 FCF5 FCF6

TERMINAL VALUE
Step 3 Calculate the weighted average cost of capital (WACC).

The WACC is calculated using the cost of equity (ke) and cost of debt (kd).
E D
WACC = ke + kd
ED ED
where: D = the value of debt
E = the value of equity
(Note that kd is the cost of debt after tax).
Step 4 Discount free cash flow at WACC to obtain value of the firm.
Step 5 Calculate equity value

Equity value = Value of the firm Value of debt
Worked example: Calculating value per share

You have completed the following forecast of free cash flows for an eight year period, capturing the
normal business cycle of Marathon plc.
Year FCFF
20X7 1,860
20X8 1,887.6
20X9 1,917.6
20Y0 1,951.2
20Y1 1,987.2
20Y2 2,016
20Y3 2,043.6
20Y4 2,070
Marathon has non-operating assets with an estimated present value of 400 million. Based on the
present value of future interest payments, the present value of its outstanding debt is 3,000 million.
Free cash flows are expected to grow at 3% beyond 20Y4. The WACC is assumed to be 12%. Marathon
has 8,000 million shares in issue.
Requirement
What is Marathon's value per share?

Solution
Present
Year FCFF(m) PV @ 12% value (m)
20X7 1,860.0 0.893 1,660.98
20X8 1,887.6 0.797 1,504.42
20X9 1,917.6 0.712 1,365.33
20Y0 1,951.2 0.636 1,240.96
20Y1 1,987.2 0.567 1,126.74
20Y2 2,016.0 0.507 1,022.11
20Y3 2,043.6 0.452 923.71
20Y4 2,070.0 0.404 836.28
9,680.00
m
Total present value for forecast period (see above) 9,680
Terminal value = (2,070 1.03)/(0.12 0.03) 0.404 9,571
Value of non-operating assets 400
Total value of Marathon 19,651
Less: Value of debt (3,000)
Value of equity 16,651
Shares outstanding 8,000
Value per share 2.08
Interactive question 4: Valuing an acquisition using free cash flow model

The management of Atrium plc, a company in the DIY industry, considers making a bid for Tetrion plc a
rival company. The current market price of Tetrion is 29 per share and a 20 per cent premium will
persuade Tetrion shareholders to sell. In order to convince its shareholders, a valuation of Tetrion is
undertaken. The following information is used.
Statement of financial position
20X4 20X3 Change

Cash 300 100 200
Receivables 2,500 1,500 1,000
Inventory 2,600 1,400 1,200
Property, plant & equipment 5,800 4,000 1,800
Accum depreciation 750 500 250
Net property, plant & equipment 5,050 3,500 1,550
Total assets 10,450 6,500 3,950
Payables 3,600 2,560 1,040
Long-term debt 2,000 2,000
Equity 4,850 1,940 2,910
Total liabilities and owners' equity 10,450 6,500 3,950
Income statement C
H
20X4 A
P
Sales 12,000 T
E
Cost of sales 3,500
R
Selling: General administrative 3,000
Depreciation 250
Total expense 6,750
5
Interest 0,100
Income before tax 5,150
Taxes (23%) 1,185
Net income 3,965

Free cash flows
20X4
Cash flows Operations
Revenue 12,000
Cash expenses (6,500)
Taxes (1,265)
Total 4,235
Cash flows Investments
Working capital 1,360
Non-current assets 1,800
Total 3,160
Free cash flow 1,075
The following predictions are made by the management of Atrium for the next five years
20X5 20X6 20X7 20X8 20X9

Free cash flows
Sales 12,000 15,000 18,750 23,438 29,297
Operating costs excluding
depreciation 6,500 8,125 10,156 12,696 15,869
EBDIT 5,500 6,875 8,594 10,742 13,428
Depreciation 250 300 360 432 519
EBIT 5,250 6,575 8,234 10,310 12,909
Less: Tax on EBIT @ 23% 1,208 1,512 1,894 2,371 2,969
Plus depreciation 250 300 360 432 518
Less: Capital expenditure 1,800 2,160 2,592 3,110 3,732
Less: Additions to working capital 1,360 1,700 2,125 2,656 3,320
Free cash flow 1,132 1,503 1,983 2,605 3,406
Terminal value (3,406/0.12) 28,383
Total free cash flow 1,132 1,503 1,983 2,605 31,789
Requirement
If the WACC is 12% and there are 100 shares outstanding what is the value of each share of Tetrion plc?
At the current market price of Tetrion of 29 per share should the shareholders of Atrium agree to the
acquisition of Tetrion?
3.4 EVA approach

EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate
of return that shareholders and debt holders could get by investing in other securities of comparable
risk. It can be used as a performance evaluation tool (see Section 1.1.4 above) and can also be relevant

to valuing acquisitions. The present value of the company using EVA is given by:
EVA1 EVA 2
PV = C + + +
1 WACC (1 WACC)2
where C is the invested capital. The value of the company is equal to the value of the invested capital
plus the present value of the economic profits from operations.
To arrive at the value of the equity as in the case of the free cash flow valuation, we need to subtract the
value of debt from the value of the company. An example of how to calculate the value of a company
using EVA is shown below.

Worked example: Valuation: EVA approach
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Invested capital 2,000 1,600 1,200 800 400
NOPAT 88 160 400 440 200
Less: Change in invested capital (2,000) 400 400 400 400 400
Free cash flow (2,000) 488 560 800 840 600
PV factor (WACC 10%) 1 0.91 0.83 0.75 0.68 0.62
PV of cash flow (2,000) 444 465 600 571 372
Cumulative PV (2,000) (1,556) (1,091) (491) 80 452
NPV 452
Alternative approach
ROIC (NOPAT/previous year's
invested capital) 4.4% 10% 33.3% 55% 50%
EVA = (ROIC WACC) x capital (112) 280 360 160
PV factor 1 0.91 0.83 0.75 0.68 0.62
PV of EVA (102) 210 245 99
Cumulative PV (102) (102) 108 353 452
Total PV of EVA 452
3.4.1 Advantages of EVA

The EVA approach focuses on long-term net present value. By including a financing element, it brings
home to managers the costs of capital used, thus emphasising the importance of careful investment and
control of working capital.
3.4.2 Disadvantages of EVA

The EVA approach suffers from the usual problems of being based on historical accounting figures that
can be distorted.
3.5 Adjusted present value approach

Adjusted Present Value was covered in detail in Chapter 4 in the context of investment appraisal. Cash
flows of the company are discounted using the ungeared cost of equity, with the present value of the
tax shield being added back. If APV is positive then the acquisition should be undertaken.
C
H
A
P
T
E
R

Worked example: APV of acquisition
Suppose that the management of XERON plc is considering the acquisition of NERON Ltd. an unquoted
company. The owners of NERON want 500m for the business. The analysis of the prospects of NERON
by XERON is reflected in the following income statements and statements of financial position.
PROFORMA INCOME STATEMENTS AND STATEMENTS OF FINANCIAL POSITION
Current Years
20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3
m m m m m m m
Sales 620.00 682.00 750.20 825.22 907.74 998.52 998.52
Less: Cost of goods
sold (410.00) (441.00) (475.10) (512.61) (553.87) (599.26) (599.26)
Gross profit 210.00 241.00 275.10 312.61 353.87 399.26 399.26
Operating expenses (133.00) (144.30) (156.53) (169.78) (184.16) (199.78) (199.78)
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Less: Interest
expense (32.00) (26.88) (20.19) (11.73) (1.27)
Earnings before tax 77.00 64.70 91.69 122.64 157.98 198.21 199.48
Less: Taxes (17.71) (14.88) (21.09) (28.21) (36.34) (45.59) (45.88)
Net income 59.29 49.82 70.60 94.43 121.64 152.62 153.60
Current assets 100.00 100.00 100.00 100.00 100.00 242.90 404.55
Non-current assets 400.00 378.00 354.00 328.00 300.00 270.00 238.00
Total assets 500.00 478.00 454.00 428.00 400.00 512.90 642.55
Debt 400.00 335.95 252.35 146.63 15.94
Equity 100.00 142.05 201.65 281.37 384.06 512.90 642.55
Total assets 500.00 478.00 454.00 428.00 400.00 512.90 642.55
Assumptions:
Growth rate for sales (until 20Y3) 10%
Depreciation expense (20X7) 40m
Accounting depreciation equals tax depreciation
Interest rate on debt 8%
Tax rate 23%
All debt is interest bearing
Capital expenditures/year 20m
All available cash flow is applied to repaying debt until repaid in full
Ungeared beta 1.1
Terminal value reflects level perpetuity equal to 20Y3 cash flow
Risk free rate 6.0%
Market risk premium 7.5%
Requirement
Calculate the APV of NERON and determine on the basis of your answer whether XERON should
proceed with the acquisition.

Solution
Step 1 Calculation of firm free cash flow
20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3
m m m m m m m
EBIT(1 Tax rate) (m) 59.29 74.46 91.30 109.98 130.68 153.60 153.60
Plus: Depreciation
expense 40.00 42.00 44.00 46.00 48.00 50.00 52.00
Less: CAPEX (20.00) (20.00) (20.00) (20.00) (20.00) (20.00) (20.00)
Firm free cash flow 79.29 96.46 115.30 135.98 158.68 183.60 185.60
Step 2 Calculation of APV

The firm free cash flow is discounted at the ungeared cost of equity capital which is:
keu = rf + a (rm rf) = 6 + 1.1 7.5 = 14.25%
The tax shield is discounted at the gross cost of debt (8%).
20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3
m m m m m m m
Interest tax savings (m) - 7.36 6.18 4.64 2.70 0.29 -
Discount factor at 8% 0.926 0.857 0.794 0.735 0.681
Present value 6.82 5.30 3.68 1.98 0.20
Step 3 Calculation of terminal value

The terminal value under the no-growth assumption is:
185.60/0.1425 = 1,302.46m
The present value of the terminal value is:
6
1, 302.46m/ (1.1425) = 585.64m
20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 Total
m m m m m m m m
Firm free cash flows 96.46 115.30 135.98 158.68 183.60 185.60
Discount factor at 14.25% 0.875 0.766 0.671 0.587 0.514 0.450
PV of free cash flows 84.40 88.32 91.24 93.15 94.37 83.52 535.00
PV of interest tax savings 6.82 5.30 3.68 1.98 0.20 nil 17.98
Terminal value 585.64
Total firm value 1,138.62
Less: Debt value 400.00
Equity value 738.62
The APV is therefore, APV = 738.62 million 500 million = 238.62 million
The managers of XERON plc should proceed with the acquisition.
3.6 Synergy C
The existence of synergies may increase shareholder value in an acquisition. The identification, H
A
quantification and announcement of these synergies are essential as shareholders of the companies
P
involved in the acquisition process may need persuasion to back the merger. T
E
The two examples below show how estimates of synergies may be announced.
R

Case example: Euronext
Euronext says the $10 billion takeover proposal by NYSE would generate cost and revenue synergies of
$375 million, of which $250 million will result from rationalising the combined group's IT platforms.
The Exchange says these synergies should kick in over the first two or three years following the merger.
As a result, Euronext says it is considering the 'progressive reduction' of trading fees on its equity
markets by between 10 and 15% during that timeframe.
Case example: Merger of Informa and Taylor & Francis

Proposed merger of Informa and Taylor & Francis
Released: 2 March 2004
Proposed merger of Informa and Taylor & Francis to create a new force in specialist information.
The boards of Informa and Taylor & Francis announce a proposed merger to create T & F Informa, a
new international force in the provision of specialist information through its combined publishing and
events businesses. T & F Informa will be a leading provider of high value specialist information to
Informa and Taylor & Francis' overlapping academic, scientific and commercial customer communities.
Its geographic, customer and product presence and enhanced financial strength will enable it to drive
both organic and acquisition-led growth.
T & F Informa will benefit from:
The existing strong momentum and prospects for both Informa and Taylor & Francis;
Enhanced revenue opportunities arising from new products and brand extensions across the
enlarged group's markets;
The cross-over demand for information in the academic, scientific, professional and commercial
communities;
A well balanced and robust portfolio of assets combining operationally geared professional and
commercial operations with resilient and stable academic publishing;
Increased operational and financial scale and geographic reach;
Annual pre-tax cost savings of at least 4.6 million by the beginning of 2005.
The one-off cost of achieving these savings is estimated at 1.3 million in 2004.
3.6.1 Revenue synergy

Revenue synergy exists when the acquisition of the target company will result in higher revenues for the
acquiring company, higher return on equity or a longer period of growth. Revenue synergies arise from
(a) Increased market power
(b) Marketing synergies
(c) Strategic synergies
Revenue synergies are more difficult to quantify relative to financial and cost synergies. When companies
merge, cost synergies are relatively easy to assess pre-deal and to implement post-deal. But revenue
synergies are more difficult. It is hard to be sure how customers will react to the new situation (in
financial services mergers, massive customer defection is quite common), whether customers will
actually buy the new, expanded 'total systems capabilities, and how much of the company's declared
cost savings they will demand in price concessions (this is common in automotive supplier M&A where
the customers have huge purchasing power over the suppliers). Nevertheless, revenue synergies must
be identified and delivered. The stock markets will be content with cost synergies for the first year after
the deal, but thereafter they will want to see growth. Customer Relationship Management and Product
Technology Management are the two core business processes that will enable the delivery of revenue.

3.6.2 Cost synergy
A cost synergy results primarily from the existence of economies of scale. As the level of operation
increases, the marginal cost falls and this will be manifested in greater operating margins for the
combined entity. The resulting costs from economies of scale are normally estimated to be substantial.
3.6.3 Financial synergy

Diversification
Acquiring another firm as a way of reducing risk cannot create wealth for two publicly traded firms,
with diversified stockholders, but it could create wealth for private firms or closely held publicly
traded firms. A takeover, motivated only by diversification considerations, has no effect on the
combined value of the two firms involved in the takeover. The value of the combined firms will
always be the sum of the values of the independent firms. In the case of private firms or closely
held firms, where the owners may not be diversified personally, there might be a potential value
gain from diversification.
Cash slack
When a firm with significant excess cash acquires a firm, with great projects but insufficient capital,
the combination can create value. Managers may reject profitable investment opportunities if they
have to raise new capital to finance them. It may therefore make sense for a company with excess
cash and no investment opportunities to take over a cash-poor firm with good investment
opportunities, or vice versa. The additional value of combining these two firms lies in the present
value of the projects that would not have been taken if they had stayed apart, but can now be
taken because of the availability of cash.
Case example: Softscape Inc

Assume that Softscape Inc, a hypothetical company, has a severe capital rationing problem, which
results in approximately $500 million of investments, with a cumulative net present value of $100
million, being rejected. IBM has far more cash than promising projects, and has accumulated $4 billion
in cash that it is trying to invest. It is under pressure to return the cash to the owners. If IBM takes over
Softscape Inc, it can be argued that the value of the combined firm will increase by the synergy benefit
of $100 million, which is the net present value of the projects possessed by the latter that can now be
taken with the excess cash from the former.
Tax benefits
The tax paid by two firms combined together may be lower than the taxes paid by them as
individual firms. If one of the firms has tax deductions that it cannot use because it is losing money,
while the other firm has income on which it pays significant taxes, the combining of the two firms
can lead to tax benefits that can be shared by the two firms. The value of this synergy is the
present value of the tax savings that accrue because of this merger. The assets of the firm being
taken over can be written up to reflect new market value, in some forms of mergers, leading to
higher tax savings from depreciation in future years.
Debt capacity
By combining two firms, each of which has little or no capacity to carry debt, it is possible to create
a firm that may have the capacity to borrow money and create value. Diversification will lead to an C
increase in debt capacity and an increase in the value of the firm. It has to be weighed against the H
A
immediate transfer of wealth that occurs to existing bondholders in both firms from the
P
stockholders. When two firms in different businesses merge, the combined firm will have less T
variable earnings, and may be able to borrow more (have a higher debt ratio) than the individual E
firms. R

3.7 Accounting policies and pensions
3.7.1 Accounting policies

Accounting policies can have a significant impact on the valuation of acquisitions. They can either work
to inflate or depress the share price. Optimistic accounting policies, valuing assets generously, bringing
forward revenue recognition and delaying provisions may inflate the company position and share price.
On the other hand accelerating expenses or making very conservative estimates of future earnings may
depress share prices. There may be agency issues with both approaches. Directors who wish to retain
their own jobs may attempt to boost earnings, and hence share prices to deter takeovers. On the other
hand directors who feel they can benefit if a takeover occurs may be tempted to depress a company's
market valuation, even though shareholders may lose out as a result.
3.7.2 Pensions
Pension issues may also act as a deterrent to takeover. A pension parachute is a type of 'poison pill', a
deterrent to takeover. It prevents the acquiring firm in a hostile takeover from using surplus cash in the
pension fund to finance the takeover. The arrangement ensures that the fund's assets remain the
property of its participants.
A large deficit in a defined benefit pension fund can also be a deterrent in a merger or acquisition,
because of the risks involved. Under UK pension regulations, employers operating schemes that have
deficits have to agree with the scheme's trustees a plan to pay off the deficit, generally by making extra
payments. The aim normally used to be to clear the deficit within 10 years, although the UK pensions
regulator has indicated that more flexibility will be allowed during the current recession. The
requirement for three yearly full valuations of pension schemes, taking into account new actuarial
assumptions, can cause companies to reappraise their plans.
A study by Cocco and Volpin published in April 2012 did not find clear evidence of whether or not
markets were able to correctly price companies with defined benefit pension plans. What was important
was investor uncertainty about the value of liabilities, as the deficit in pension plans was difficult to
determine, company insiders had better information than external investors and managers might also
manipulate the assumptions used for the valuation of scheme assets and liabilities.
Case example: British Airways

British Airways (BA) and Spanish airline Iberia eventually agreed to merge in 2010, after having had
discussions for some time. There were a number of positive strategic reasons for the merger spreading
the cost base and competing more effectively with other European airlines. The two were also a good
match, because they had few overlapping routes.
The merger had however been delayed because of problems with BA's pension funds. Its two final salary
schemes had a combined deficit of 3.7 bn in 2010. The schemes were a problem despite having been
closed to new members for many years one since 2003 and the other since 1984. The larger NAPS
scheme, which closed in 2003, had the bigger deficit of over 2bn, but still had staff contributing to it
as well as pensioners. In 2007 the scheme became less generous to contributing staff, but poor
investment returns and increases in pensioners' longevity outweighed the impact of the tougher
conditions. In 2010 BA agreed new plans with unions to increase pension contributions in order to
reduce the deficit.

4 Valuing debt
Section overview
The basic idea behind debt valuation is that the value is the present value of all future cash flows
to the investor (that is, interest plus capital redemption) discounted at the debt investor's required
rate of return.
Different types of debt (irredeemable, redeemable and convertible) are valued in different ways.
4.1 Notes on debt calculations

(a) Debt is usually quoted in 100 nominal units, or blocks (euro loans are usually quoted in 1,000
blocks); always use 100 nominal values as the basis to your calculations unless told otherwise.
(b) Debt can be quoted in % or as a value, eg 97% or 97. Both mean that 100 nominal value of
debt is worth 97 market value.
(c) Interest on debt is stated as a percentage of nominal value. This is known as the coupon rate. It is
not the same as the redemption yield on debt or the cost of debt.
(d) Sometimes people quote an interest yield, defined as coupon/market price, but this is only a crude
approximation unless the debt is irredeemable and there is no tax effect.
(e) Always use ex-interest prices in any calculations, unless the debt is specifically described as cum
interest.
4.2 Irredeemable debt

For irredeemable debentures or loan stock, where the company will go on paying interest every year in
perpetuity, without ever having to redeem the loan, the valuation formula (ignoring taxation) is:
i
P0
rd
where: P0 = the market price of the stock ex interest, that is, excluding any interest payment
that might soon be due
i = the annual interest payment on the stock
rd = the return required by the loan stock investors
Irredeemable (undated) debt, paying annual after tax interest i (1 T) in perpetuity, where P0 is the ex-
interest value:
i(1 T)
P0 =
kd
where kd is the after tax cost to the company.
C
4.3 Redeemable debt H
The valuation of redeemable debt depends on future expected receipts. The market value is the A
P
discounted present value of future interest receivable, up to the year of redemption, plus the discounted T
present value of the redemption payment (ignoring tax). E
R
Value of debt = (Interest earnings Annuity factor) + (Redemption value Discounted cash flow factor)

Worked example: Market value of debentures
Furry has in issue 12% debentures with par value 100,000 and redemption value 110,000, with
interest payable quarterly. The redemption yield on the bonds is 8% annually and 2% quarterly. The
debentures are redeemable on 30 June 20X4 and it is now 31 December 20X0.
Requirement
Calculate the market value of the debentures.
Solution
You need to use the redemption yield cost of debt as the discount rate, and remember to use an
annuity factor for the interest. We are discounting over 14 periods using the quarterly discount rate
(8%/4).
Period Cash flow Discount factor Present value

2%
114 Interest 3,000 12.11 36,330
14 Redemption 110,000 0.758 83,380
119,710
Market value is 119,710.
Interactive question 5: Value of redeemable debt [Difficulty level: Easy]

A company has issued some 9% debentures, which are redeemable at par in three years' time. Investors
now require a redemption yield of 10%. What will be the current market value of each 100 of
debenture?
4.4 Convertible debt

When convertible loan notes are traded on a stock market, the minimum market price will be the price
of straight loan notes with the same coupon rate of interest. If the market value falls to this minimum, it
follows that the market attaches no value to the conversion rights.
The actual market price of convertible loan notes will depend on:
The price of straight debt
The current conversion value
The length of time before conversion may take place
The market's expectation as to future equity returns and the associated risk
If the conversion value rises above the straight debt value then the price of convertible loan notes will
normally reflect this increase.
n
Conversion value = P0 (1 + g) R
where: P0 is the current ex-dividend ordinary share price
g is the expected annual growth of the ordinary share price
n is the number of years to conversion
R is the number of shares received on conversion
The current market value of a convertible bond where conversion is expected is the sum of the present
values of the future interest payments and the present value of the bond's conversion value.
Worked example: Convertible debt

What is the value of a 9% convertible bond if it can be converted in five years' time into 35 ordinary
shares or redeemed at par on the same date? An investor's required return is 10% and the current
market price of the underlying share is 2.50 which is expected to grow by 4% per annum.

Solution
n 5
Conversion value = P0 (1 + g) R = 2.50 1.04 35 = 106.46
Present value of 9 interest per annum for five years at 10% = 9 3.791 = 34.12
Present value of the conversion value = 106.46 0.621 = 66.11
Current market value of convertible bond = 34.12 + 66.11 = 100.23
Debt is covered in more detail in Chapter 6 Section 3, where we look at Bonds.
5 Unquoted companies and start-ups
Section overview
While it is possible to value quoted companies given the availability of vast quantities of
information, unquoted companies are more difficult to value.
Shares are not quoted on the Stock Exchange, therefore the companies themselves have to be
valued before the share price can be determined.
Share price volatilities also have to be determined before any share-based payments (such as share
option schemes) can be valued.
The size of the holding may affect the control of the company and this might have a significant
effect on the valuation.
Start-ups can be valued using the models we have described previously although there may be
problems related to the uncertainties surrounding forecast figures used.
When trying to value a company's shares, one of the most frequent errors is to assume that this exercise
can be conducted without taking into account the value of the entire enterprise. Sole reliance on such
measures as the P/E ratio for comparable quoted companies can result in valuable information being
omitted from the valuation process, leading to potential under- or over-valuation.
P/E ratios of comparable quoted companies are directly affected by these companies' levels of gearing,
which may be very different from the unquoted company whose value is trying to be ascertained.
The value of unquoted companies may be affected by the existence of certain rights and obligations
attached to preference shares, convertible bonds and so on.
5.1 Why value unquoted shares?

Unquoted shares are valued for all sorts of purposes, for example:
To sell the company
As part of a divorce settlement
For taxation purposes
To raise capital from investors C
H
The important thing to note is that, as soon as you change the purpose of the valuation, you will
A
change the share price. Shares are valued on different bases for different purposes; there are many P
sources of information on which share values can be based. Just as changing an accounting policy will T
change your reported figures, changing the valuation basis will affect the item you are trying to value. E
R
5.2 How do we value unquoted shares?

5
The valuation of unquoted shares is not an exact science and as mentioned above there may be a range
of possible values.
When unquoted shares are being valued for tax purposes, the valuation method used tends to be, with
a few exceptions, the estimated price that the shares would achieve if sold on the open market.

Various Court decisions over the years have given us guidance as to how we can use an imaginary
market sale to arrive at a value. For this purpose, the valuer should consider:
The sustainable future reported earnings after tax.
The company's performance as shown in its financial statements, and any other information
normally available to its shareholders.
The commercial and economic background at the valuation date.
The size of the shareholding, and the shareholders' rights.
The company's dividend policy.
Appropriate yields and price/earnings ratios.
The value of the company's assets.
Any other relevant factors.
5.3 Valuing majority shareholdings

The valuation of a majority shareholding must reflect the extent to which a potential buyer of the shares
can or cannot control or influence the company. There are many degrees of control which are
usually determined by the voting power of a particular block of shares. These range from full control
(including the power to liquidate the company), to a small or non-existent influence over the company's
affairs of a minority shareholding.
Unless there are exceptional circumstances, if the degree of control is less than complete, the value of
the shares will be less than a pro-rata proportion of the overall value of the company.
In order to value a majority shareholding, you should consider the following:
The rights and prospects attached to the shareholding for example, the right to appoint
directors.
Whether restrictions apply to, for example, sale of shares or receipt of dividend.
Whether control is in excess of 75%, meaning that the articles of association can be changed by
the holder. A 75% holding also gives the holder the right to wind up the company.
Whether minority shareholders have contractual rights that would be expensive for majority
shareholders to buy out.
Whether the minority shareholdings are concentrated on one individual or dispersed.
When a majority shareholding is valued, there is a control premium attached to it, meaning that the
overall value will be in excess of the pro rata value to the value of the company as a whole. The extent
of the premium depends on the answers to the above factors. As a crude guidance, the following table
gives you a starting point for consideration:
Shareholding Discount on 100%
Company value
75% + Nil to 5%
> 50% but < 75% 10 15%
50% 20 30%
(but a much greater discount
if another party holds the other 50%)
5.4 Valuation of minority shareholdings

Whilst there are few differences between the value of a majority holding in a private company and that
of a quoted company, there can be major differences between the values of minority holdings. This
depends very much on the nature of the unquoted company.

An article in Finance Week on 27 March 2007 entitled 'Valuing your unquoted company's shares'
identified several factors that should be considered when valuing minority shareholdings in an unquoted
company.
Marketability this may be the only difference between the quoted company being used for
comparison purposes and the unquoted company.
Size private companies are often much smaller than quoted companies. Any size adjustment to
valuations depends very much on specific circumstances. Although the growth prospects of an
unquoted company may not be as attractive as those of a quoted company, smaller organisations
operating in a niche market may be more dynamic, therefore the adjustment in valuation may be
positive rather than negative.
Expectations of cash returns the marketability factor of unquoted companies is affected by the
likelihood of minority shareholders receiving a future cash return, either in the form of dividends or
due to the flotation of the company. Quoted companies' shareholders are more likely to receive
cash returns by way of dividends or share buybacks. If there are little or no prospects of cash
returns in the near future, there will be little or no value attached to minority shareholdings unless
some significant influence can be exerted on the directors or other shareholders.
Rather than using DCF analysis and market comparability models for valuation purposes, it is more
appropriate to value minority shareholdings of unquoted companies using the present value of
anticipated dividend streams (see Section 1.2.1 above).
Consideration should also be given, however, to any contractual protection or rights pertaining to
minority shareholdings (eg through the Articles of Association or service contracts). Similarly the
question of which parties, and how many parties, hold the majority shares may be a key issue in valuing
any tranche of minority shares. These circumstances would need to be considered on a case by case
basis.
5.5 High growth start-ups

The valuation of start-ups presents a number of challenges for the methods that we have considered so
far due to their unique characteristics which are summarised below.
Most start-ups typically have no track record
Ongoing losses
Few revenues, untested products
Unknown market acceptance, unknown product demand
Unknown competition (in infant industries)
Unknown cost structures, unknown implementation timing
High development or infrastructure costs
Inexperienced management
5.5.1 Projecting economic performance

All valuation methods require reasonable projections to be made with regard to the key drivers of the
business. The following steps should be undertaken with respect to the valuation of a high-growth start
up company.
Identifying the drivers
C
Any market-based approach or discounted cash flow analysis depends on the reasonableness of financial H
A
projections. Projections must be analysed in light of the market potential, resources of the business, the P
management team, financial characteristics of the guideline public companies, and other factors. T
E
R

Period of projection
One characteristic of high growth start-ups is that in order to survive they need to grow very quickly.
Start-ups that do grow quickly usually have operating expenses and investment needs in excess of their
revenues in the first years and experience losses until the growth starts to slow down (and the resource
needs begin to stabilise). This means that long-term projections, all the way out to the time when the
business has sustainable positive operating margins and cash flows, need to be prepared. These
projections will depend on the assumptions made about growth. However, rarely is the forecast period
less than seven years.
Forecasting growth
For most high growth start-ups the proportion of profits retained will equal the return on invested
capital as the company needs to achieve a high growth rate through investing in research and
development, expansion of distribution and manufacturing capacity, human resource development (to
attract new talent), and development of new markets, products, or techniques.
5.5.2 Valuation methods

Once growth rates have been estimated, the next step is to consider which is the most appropriate of
the valuation approaches we have considered so far: net assets, market or discounted cash flows.
Asset-based method
The asset-based method is not appropriate because the value of capital in terms of tangible assets may
not be high. Most of the investment of a start-up is in people, marketing and/or intellectual rights that
are treated as expenses rather than as capital.
Market-based methods
The market approach to valuation also presents special problems for start-ups. This valuation process
involves finding other companies, usually sold through private transactions, that are at a similar stage of
development and that focus on existing or proposed products similar to those of the company being
valued. Complicating factors include comparability problems, differences in fair market value from value
paid by strategic acquirers, lack of disclosed information, and the fact that there are usually no earnings
with which to calculate price-to-earnings ratios (in this case price-to-revenue ratios may be helpful).
Discounted cash flows
Using the DCF methodology, free cash flows are first projected and are then discounted to the present
using a risk-adjusted cost of capital. For example, one could use the constant growth model which
specifies that:
FCFF
V=
r g
where:
r = required rate of return
g = growth rate of earnings
Our discussion of the high growth start-up indicates that the growth rates of revenues and costs may
vary. Since FCF = Revenue Costs = R C, the value of company will be given by:
R C
V=
r g
Now assuming that the growth rate of revenues gR is different than the growth rate of costs gC:
R C
V=
r gR r gC

Worked example: Valuing a start-up
QuickLeg is an internet legal services provider which next year expects revenue of 100m and costs of
500m. The revenues of the firm are expected to rise by 21 per cent every year but costs will remain at
the same level. The required rate of return is assumed to 22 per cent. What is the value of QuickLeg?
Solution
100m 500m
V= = 7,727.27 million
0.22 0.21 0.22 0
The above model seems to capture the phenomenon observed in many start-ups of high losses in the
first year of operations with high values of the company.
A very important problem with the discounted flow approach is the sensitivity of the valuation model to
the underlying assumptions. Changes in the growth rate induced by changes in demand, technology,
and management of other causes can have a dramatic effect on the value of the start-up. For example
suppose that the growth rate of revenues falls from 21 per cent to 20 per cent. The value of the
company now is:
100m 500m
V= = 2,727.27 million
0.22 0.20 0.22 0
that is, the company has lost 5 billion.

Another problem with the discounted cash flow is that it cannot reflect managerial flexibilities and the
strategic options to expand, delay, abandon, or switch investments at various decision points. The best
way of incorporating uncertainty into the discounted cash flow analysis for a new company, technology,
or product is to assign probabilities of success to each of the various possibilities.
5.5.3 Probabilistic valuation methods

In a probabilistic cash flow model, we assume a number of scenarios for the drivers of value and derive a
value under each scenario. The next step is to assign probabilities to each scenario and arrive at a
weighted average value. The procedure to be followed is akin to the Monte Carlo methodology.
Interactive question 6: Valuation methods [Difficulty level: Intermediate]

Black Raven Ltd is a prosperous private company, whose owners are also the directors. The directors
have decided to sell their business, and have begun a search for organisations interested in its purchase.
They have asked for your assessment of the price per ordinary share a purchaser might be expected to
offer. Relevant information is as follows.
MOST RECENT STATEMENT OF FINANCIAL POSITION
'000 '000 '000
Non-current assets (carrying amounts)
Land and buildings 800
Plant and equipment 450 C
Motor vehicles 55 H
Patents 2 A
P
1,307 T
Current assets E
Inventory 250 R
Receivables 125
Cash 8
383 5
Current liabilities
Payables 180
Taxation 50

'000 '000 '000
230
153
1,460
Long-term liability
Loan secured on property 400
1,060
Share capital (300,000 ordinary shares of 1) 300

Reserves 760
1,060
The profits after tax and interest but before dividends over the last five years have been as follows.
Year
1 90,000
2 80,000
3 105,000
4 90,000
5 (most recent) 100,000
The company's five-year plan forecasts an after-tax profit of 100,000 for the next 12 months, with an
increase of 4% a year over each of the next four years. The annual dividend has been 45,000 for the
last six years.
As part of their preparations to sell the company, the directors of Black Raven Ltd have had the non-
current assets revalued by an independent expert, with the following results.

Land and buildings 1,075,000
Plant and equipment 480,000
Motor vehicles 45,000
The gross dividend yields and P/E ratios of three quoted companies in the same industry as Black Raven
Ltd over the last three years have been as follows.
Albatross plc Bullfinch plc Crow plc
Div. yield P/E ratio Div. yield P/E ratio Div. yield P/E ratio
% % %
Recent year 12 8.5 11.0 9.0 13.0 10.0
Previous year 12 8.0 10.6 8.5 12.6 9.5
Three years ago 12 8.5 9.3 8.0 12.4 9.0
Average 12 8.33 10.3 8.5 12.7 9.5
Large companies in the industry apply an after-tax cost of equity of about 18% to acquisition proposals
when the investment is not backed by tangible assets, as opposed to a rate of only 14% on the net
tangible assets.
Your assessment of the net cash flows after interest and tax which would accrue to a purchasing
company, allowing for the capital expenditure required after the acquisition to achieve the company's
target five-year plan, is as follows.

Year 1 120,000
Year 2 120,000
Year 3 140,000
Year 4 70,000
Year 5 120,000
Requirement
Use the information provided to suggest alternative valuations which prospective purchasers might
make.

Summary
C
H
A
P
T
E
R

Self-test
1 Profed
Profed provides a tuition service to professional students. This includes courses of lectures provided
on their own premises and provision of study material for home study. Most of the lecturers are
qualified professionals with many years' experience in both their profession and tuition. Study
materials are written and word processed in-house, but sent out to an external printing company.
The business was started fifteen years ago, and now employs around 40 full-time lecturers, 10
authors and 20 support staff. Freelance lecturers and authors are employed from time to time in
times of peak demand.
The shareholders of Profed mainly comprise the original founders of the business who would now
like to realise their investment. In order to arrive at an estimate of what they believe the business is
worth, they have identified a long-established quoted company, City Tutors, who have a similar
business, although they also publish texts for external sale to universities, colleges and so on.
Summary financial statistics for the two companies for the most recent financial year are as follows.
Profed City Tutors
Issued shares (million) 4 10
Net asset values (m) 7.2 15
Earnings per share (pence) 35 20
Dividend per share (pence) 20 18
Debt: equity ratio 1:7 1:65
Share price (pence) 362
Expected rate of growth in earnings/dividends 9% pa 7.5% pa
Notes:
1 The net assets of Profed are the net book values of tangible non-current assets plus net
working capital. However:
A recent valuation of the buildings was 1.5m above book value.
Inventory includes past editions of textbooks which have a realisable value of 100,000
below their cost.
Due to a dispute with one of their clients, an additional allowance for bad debts of
750,000 could prudently be made.
2 Growth rates should be assumed to be constant per annum; Profed's earnings growth rate
estimate was provided by the marketing manager, based on expected growth in sales
adjusted by normal profit margins. City Tutors' growth rates were gleaned from press reports.
3 Profed uses a discount rate of 15% to appraise its investments, and has done for many years.
Requirements
(a) Compute a range of valuations for the business of Profed, using the information available and
stating any assumptions made.
(b) Comment upon the strengths and weaknesses of the methods you used in (a) and their
suitability for valuing Profed.
2 Wilkinson plc
Wilkinson plc has identified Chris Limited as a potential acquisition target. It has approached you as
its financial adviser to ask for assistance in valuing the company. You have obtained the following
information about Chris Limited.
STATEMENT OF CHANGES IN EQUITY FOR THE YEARS ENDED 31 DECEMBER
20X5 20X6 20X7
'000 '000 '000
Profit after tax 280 260 410
Dividends (150) (160) (185)
Retained profit 130 100 225

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER
20X5 20X6 20X7
'000 '000 '000
Non-current assets 1,365 1,405 1,560
Working capital 810 870 940
2,175 2,275 2,500
Share capital 100 100 100
Retained earnings 875 975 1,200
10% debentures 20Y2 1,200 1,200 1,200
2,175 2,275 2,500
The non-current assets include an unused property which has a market value of 100,000. The
debentures pay a semi-annual coupon and are redeemable at the end of 20Y2. The gross
redemption yield on 20Y2 gilts paying a similar level of coupon is 11%.
The P/E ratio for the quoted company sector in which Chris Limited's activities fall is around 15
times and the sector's gross dividend yield is around 11%. The of the sector is around 0.8 and
the return on the market is around 21%.
Requirements
Estimate the value of Chris Limited, using four different methods of valuation. Explain the rationale
behind each valuation, when it would be useful and why each method gives a different value.
Discuss the limitations of your analysis and what further information you would require to conduct
a more informed valuation.
3 Cub plc
The following data relates to Cub plc
Income statement and dividend data
20X1 20X2
m m
Sales 995 1,180
Pre-tax accounting profit 201 255
Taxation 46 59
Profit after tax 155 196
Dividends 50 60
Retained earnings 105 136
Statement of financial position data

20X1 20X2
m m
Non-current assets 370 480
Net current assets 400 500
770 980
Financed by:
Shareholders' funds 595 720
Medium and long-term bank loans 175 260
770 980
Pretax accounting profit is taken after deducting the economic depreciation of the company's
C
non-current assets (also the depreciation used for tax purposes). H
Other relevant information A
P
T
(a) Economic depreciation was 95 million in 20X1 and 105 million in 20X2. E
R
(b) Interest expenses were 13 million in 20X1 and 18 million in 20X2.
(c) Other non-cash expenses (net of tax) were 32 million in 20X1 and 36 million in 20X2.
These should be added back in the calculation. 5
(d) The tax rate in 20X1 and 20X2 was 23%.

(e) Cub had non-capitalised leases valued at 35 million in each year 20X0-20X2.

(f) The company's pre-tax cost of debt was estimated as 7% in 20X1 and 8% in 20X2.
(g) The company's cost of equity was estimated as 14% in 20X1 and 16% in 20X2.
(h) The target capital structure is 75% equity, 25% debt.
(i) Statement of financial position capital employed at the end of 20X0 was 695 million. There
were no loans at that date.
Requirements
Estimate the EVA for Cub plc for 20X1 and 20X2, stating any assumptions that you make and
discussing what the calculations demonstrate about the performance of the company.

1 Profed
(a) The information provided allows us to value Profed on three bases: net assets, P/E ratio and
dividend valuation.
All three will be computed, even though their validity may be questioned in part (b) of the
answer.
Assets-based valuation
'000
Net assets at book value 7,200
Add: increased valuation of buildings 1,500
Less: decreased value of inventory and receivables (850)
Net asset value of equity 7,850
Value per share = 1.96
P/E ratio
Profed City
Tutors
Issued shares (million) 4 10
Share price (pence) 362
Market value (m) 36.2
Earnings per share (pence) 35 20
P/E ratio (share price EPS) 18.1
The P/E for a similar quoted company is 18.1. This will take account of factors such as
marketability of shares, status of company, growth potential that will differ from those for
Profed. Profed's growth rate has been estimated as higher than that of City Tutors, possibly
because it is a younger, developing company, although the basis for the estimate may be
questionable.
All other things being equal, the P/E ratio for an unquoted company should be taken as
between one half to two thirds of that of an equivalent quoted company. Being generous, in
view of the possible higher growth prospects of Profed, we might estimate an appropriate P/E
ratio of around 12, assuming Profed is to remain a private company.
This will value Profed at 12 0.35 = 4.20 per share, a total valuation of 16.8m.
Dividend valuation model
The dividend valuation method gives the share price as:
Next year ' s dividend

cos t of equity growth rate
which assumes dividends being paid into perpetuity, and growth at a constant rate.
For Profed, next year's dividend = 0.20 1.09 = 0.218 per share. C
H
While we are given a discount rate of 15% as being traditionally used by the directors of A
Profed for investment appraisal, there appears to be no rational basis for this. We can instead P
use the information for City Tutors to estimate a cost of equity for Profed. This is assuming the T
E
business risks are similar, and ignores the small difference in their gearing ratio. R
Next year's dividend
Again, from the DVM, cost of equity = + Growth rate
Market price
5
0.18 1.075
For City Tutors, cost of equity = + 0.075 = 12.84%
3.62

Using, say, 13% as a cost of equity for Profed (it could be argued that this should be higher
since Profed is unquoted so riskier than the quoted City Tutors):
0.218
Share price = = 5.45
0.13 0.09
valuing the whole of the share capital at 21.8 million.
Range for valuation
The three methods used have thus come up with a range of value of Profed as follows.
Value per share Total valuation
m
Net assets 1.96 7.9
P/E ratio 4.20 16.8
Dividend valuation 5.45 21.8
(b) Asset-based valuation
Valuing a company on the basis of its asset values alone is rarely appropriate if it is to be sold
on a going concern basis. Exceptions would include property investment companies and
investment trusts, the market values of the assets of which will bear a close relationship to
their earning capacities.
Profed is typical of a lot of service companies, a large part of whose value lies in the skill,
knowledge and reputation of its personnel. This is not reflected in the net asset values, and
renders this method quite inappropriate. A potential purchaser of Profed will generally value
its intangible assets such as knowledge, expertise, customer/supplier relationships, brands and
so on more highly than those that can be measured in accounting terms.
Knowledge of the net asset value (NAV) of a company will, however, be important as a floor
value for a company in financial difficulties or subject to a takeover bid. Shareholders will be
reluctant to sell for less than the net asset value even if future prospects are poor.
P/E ratio valuation
The P/E ratio measures the multiple of the current year's earnings that is reflected in the
market price of a share. It is thus a method that reflects the earnings potential of a company
from a market point of view. Provided the marketing is efficient, it is likely to give the most
meaningful basis for valuation.
One of the first things to say is that the market price of a share at any point in time is
determined by supply and demand forces prevalent during small transactions, and will be
dependent upon a lot of factors in addition to a realistic appraisal of future prospects.
A downturn in the market, economic and political changes can all affect the day-to-day price
of a share, and thus its prevailing P/E ratio. It is not known whether the share price given for
City Tutors was taken on one particular day, or was some sort of average over a period. The
latter would perhaps give a sounder basis from which to compute an applicable P/E ratio.
Even if the P/E ratio of City Tutors can be taken to be indicative of its true worth, using it as
a basis to value a smaller, unquoted company in the same industry can be problematic.
The status and marketability of shares in a quoted company have tangible effects on value but
these are difficult to measure.
The P/E ratio will also be affected by growth prospects the higher the growth expected,
the higher the ratio. The growth rate incorporated by the shareholders of City Tutors is
probably based on a more rational approach than that used by Profed.
If the growth prospects of Profed, as would be perceived by the market, did not coincide with
those of Profed management it is difficult to see how the P/E ratio should be adjusted for
relative levels of growth. The earnings yield method of valuation could however be useful
here.
In the valuation in (a) a crude adjustment has been made to City Tutors' P/E ratio to arrive at a
ratio to use to value Profed's earnings. This can result in a very inaccurate result if account has
not been taken of all the differences involved.

Dividend-based valuation
The dividend valuation model (DVM) is a cash flow-based approach, which values the
dividends that the shareholders expect to receive from the company by discounting them at
their required rate of return. It is perhaps more appropriate for valuing a minority
shareholding where the holder has no influence over the level of dividends to be paid than for
valuing a whole company, where the total cash flows will be of greater relevance.
The practical problems with the dividend valuation model lie mainly in its assumptions. Even
accepting that the required 'perfect capital market' assumptions may be satisfied to some
extent, in reality, the formula used in (a) assumes constant growth rates and constant
required rates of return in perpetuity.
Determination of an appropriate cost of equity is particularly difficult for an unquoted
company, and the use of an 'equivalent' quoted company's data carries the same drawbacks
as discussed above. Similar problems arise in estimating future growth rates, and the results
from the model are highly sensitive to changes in both these inputs.
It is also highly dependent upon the current year's dividend being a representative base from
which to start.
The dividend valuation model valuation provided in (a) results in a higher valuation than that
under the P/E ratio approach. Reasons for this may be:
The share price for City Tutors may be currently depressed below its normal level,
resulting in an inappropriately low P/E ratio.
The adjustment to get to an appropriate P/E ratio for Profed may have been too harsh,
particularly in light of its apparently better growth prospects.
The cost of equity used in the dividend valuation model was that of City Tutors. The
validity of this will largely depend upon the relative levels of risk of the two companies.
Although they both operate the same type of business, the fact that City Tutors sells its
material externally means it is perhaps less reliant on a fixed customer base.
Even if business risks and gearing risk may be thought to be comparable a prospective
buyer of Profed may consider investment in a younger, unquoted company to carry
greater personal risk. His required return may thus be higher than that envisaged in the
dividend valuation model, reducing the valuation.
2 Wilkinson plc
Earnings-based valuation
P/E ratio
The earnings-based valuation would be based on applying the P/E ratio for similar quoted
companies to Chris Limited's earnings.
15 410,000 = 6,150,000
This value would be the approximate value of a quoted company in the sector. Research has
indicated the acquisitions of private companies are typically priced at a discount of 30% to 40% to
the quoted sector P/E. This discount probably reflects the lack of marketability of the private
company shares compared to those of its quoted counterparts. Using a discount of 40%, the value C
of Chris Limited would be: H
A
6,150,000 60% = 3,690,000 P
T
This is the value of the earnings stream. On top of this, it should be possible to sell the unused E
property without affecting the earnings stream for around 100,000, giving a total valuation of R
3,790,000.

Limitations of the calculation
The sector P/E is an average for the sector. It is not clear whether Chris Limited is an average
company or whether it is in a more or less attractive part of the sector. It may be better to identify
specific companies in exactly the same class of business as Chris Limited.
The sector P/E reflects the expected growth in earnings in the sector. It may be that Chris Limited's
expected growth rate is better or worse than the sector average, meaning that a different P/E ratio
would be more appropriate.
The sector P/E reflects the risk of the sector in general, including business and gearing risk. If Chris
Limited has a different level of gearing or is in a part of the sector where the business risk is slightly
different, then a different P/E ratio would be appropriate.
The calculation has assumed that Wilkinson plc acquires a controlling interest and forces the sale of
the unused property.
When the calculation is useful
Use of earnings to value a company implies that the investor has control of the earnings and can
dictate dividend policy, for example. It would therefore be suitable if Wilkinson plc is aiming to get
control of the company.
Dividend-based valuation Dividend valuation model
In order to use the dividend valuation model, the cost of equity of the company must first be
estimated. This can be done with the capital asset pricing model,
ke = rf + e (rm rf)
where: ke = the company's cost of equity
rf = the risk-free rate (estimated as the yield on gilts)
and rm = the return on the market.
ke = 11 + 0.8(21 11) = 19%
The market value (MV) of the company is given by the formula MV = D1/ (ke - g) where D1 is the
prospective dividend (estimated as D0 {1 + g}), ke is the cost of equity and g is the expected
growth rate in dividends. The value of g can be estimated from extrapolating the dividend growth
of Chris Limited over the last few years and is 11% ({185/150} 1).
MV = 185 1.11/ (0.19 0.11) = 2,567,000
Since this valuation relies on the of quoted companies and would give the value of a quoted
company's dividend stream, this value should be discounted.
2,567,000 60% = 1,540,000.
Adjusting for the value of the unused property, the value of the business would be around
1,640,000.
As with the earnings estimate, use of the sector implies that Chris Limited has comparable
gearing and business risk to the sector average.
The assumption that past dividend growth of 11% will continue in the future may not be valid.
It has been assumed the company will dispose of the unused property even if Wilkinson plc only
obtains a minority holding.
When the calculation would be useful
A minority investor who only receives dividends from the company will find this most useful and
therefore it may be relevant if Wilkinson plc only intends to take a minority stake.

Dividend-based valuation Dividend yield
Dividend yield is:
1
185 1,682
0.11
Discount for lack of marketability:
1,682 60% = 1,009,000
Including the proceeds from the assumed sale of the unused property, the valuation of Chris
Limited would be 1,109,000.
As with the above methods, it assumes that Chris Limited is similar to the sector in terms of gearing
and business risk.
It has been assumed that the company will dispose of the unused property, even if Wilkinson plc
does not acquire a controlling shareholding.
As with the dividend valuation model, it is most useful for a minority investor who will only receive
a dividend flow from the company.
Asset-based valuation
Net realisable value of assets
The net book value of the company's assets is 2,500,000. To establish the value available to equity
investors, the market value of the loan stock must be deducted. This will be the present value of
the loan stock's future cash flows, discounted at the investors' required rate of return. The best
indication of required returns is given by the details on gilts for the same maturity with the same
coupon in the question. A risk premium must be added on to the yield on the gilts to compensate
for the additional risk of Chris Limited, say 3%. The resultant annual yield (11% + 3%=14%) needs
to be altered to a semi-annual rate of return of 6.8% (1.14 - 1) since the coupon is semi-annual.
Note: The precise calculation here using the square root is probably over the top and gives a
spurious level of accuracy. A six-monthly factor of 7% would be just as good.
Cash flow Discount factor Present value

Time
at 6.8%
110 60,000 7.09 425,400

10
10 1,200,000 1/1.068 621,539
1,046,939
The total value of the company's equity is therefore 2,500,000 1,047,000 = 1,453,000.
C
The only data available is net book value, which may not represent realisable value due to potential
H
revaluations, obsolescent inventories, costs of disposal, and so on. A
P
The contents of each category of asset and liability are not known. For example, non-current assets T
may include intangibles which could not easily be sold at book value. E
R
The value of intangibles such as brands and goodwill may not be included in the above valuation.
The required yield on the loan stock has been estimated and the 14% may not be appropriate.
5

Net realisable value assumes the company's assets can be sold off.
This will only be appropriate if Wilkinson plc acquires a 75% interest and can force a compulsory
liquidation. Alternatively, the company must obtain at the very least 50% to be able to force the
disposal of any surplus assets.
Replacement cost of assets may be appropriate to use for a purchaser who is considering starting
up an equivalent business from scratch. The problem will be in identifying the cost of replacing
intangible assets such as goodwill and brands.
Reasons for differences between the valuations
The earnings-based valuation is based upon an earnings figure that has grown dramatically in the
final year. The very high earnings of 410,000 may not be representative and in subsequent years
the earnings may fall back to a level similar to earlier years. Alternatively, if the earnings are going
to grow from the current base, then the earnings-based valuation is likely to be the most
appropriate of all the above.
The dividends of Chris Limited, by contrast, have grown at a reasonably constant rate over the
three-year period regardless of earnings performance. Since the dividends have grown at a much
slower rate than earnings, this explains the much lower valuations using dividends based methods.
The dividend policy may give a clue as to the directors' expectations for future profitability and
sustainable dividend growth. If this is the case, then the dividends based methods are likely to give
the most appropriate valuations.
The asset-based valuation is the lowest of the four figures. This is probably because the company
derives its value not from its assets base but from its earnings stream and cash flows.
Additional information required
Market value of assets
Existence and value of intangibles
Analysis of profits between ordinary recurring items and exceptional one-off items, which may
have distorted the profits in individual years
Details of costs or income that may be avoided or lost if the company is acquired, such as very
high directors' remuneration
Details on growth prospects
More specific details on the company's business, its business risk and gearing risk and similar
information for closely comparable quoted companies
The shareholding Wilkinson plc intends to buy
The possibilities for synergies
Cash flow details, to obtain a more fundamental cash-based valuation
Details of any comparable deals executed in the recent past
3 Cub plc
Economic value added
Economic value added = Net operating profit after tax (NOPAT) (Capital employed Cost of
capital)

Net operating profit after tax
Net operating profit after tax is arrived at after making a number of adjustments.
20X1 20X2
m m
Profit after tax 155 196
Add: Non-cash expenses 32 36
Add: Interest after tax
charge (1 0.23) 10.0 13.9
NOPAT 197.0 245.9
Capital employed
Capital employed is on start of year figures
20X1 Capital employed = Capital employed at end of 20X0 + Leases
= 695 + 35
= 730 million
20X2 Capital employed = Book value of shareholders' funds + Bank loans + Leases
= 595 + 175 + 35
= 805 million
Weighted average cost of capital
20X1 cost of capital = (0.75 14%) + (0.25 (7% (1 0.23))
= 11.8%
20X2 cost of capital = (0.75 16%) + (0.25 (8% (1 0.23))
= 13.5%
Economic value added
20X1 EVA = 197.0 (0.118 730)
= 110.9 million

20X2 EVA = 245.9 (0.135 805)
= 137.2 million
On this measure, the company has created significant value in both 20X1 and 20X2 and appears
to be on a rising trend.
C
H
A
P
T
E
R


ke = 12% + 2% = 14% (0.14) D0 = 250,000
D0 250,000
(a) P0 = = = 1,785,714
ke 0.14
D0 (1 g) 250,000(1.04)
(b) P0 = = = 2,600,000 g = 4% or 0.04
ke g 0.14 0.04

(a) Earnings. Average earnings over the last five years have been 67,200, and over the last four years
71,500. There might appear to be some growth prospects, but estimates of future earnings are
uncertain.
A low estimate of earnings in 20X5 would be, perhaps, 71,500.
A high estimate of earnings might be 75,000 or more. This solution will use the most recent
earnings figure of 75,000 as the high estimate.
(b) P/E ratio. A P/E ratio of 15 (Bumblebee's) would be much too high for Mayfly, because the growth
of Mayfly's earnings is not as certain, and Mayfly is an unquoted company.
On the other hand, Mayfly's expectations of earnings are probably better than those of Wasp.
A suitable P/E ratio might be based on the industry's average, 10; but since Mayfly is an unquoted
company and therefore more risky, a lower P/E ratio might be more appropriate: perhaps 60% to
70% of 10 = 6 or 7, or conceivably even as low as 50% of 10 = 5.
The valuation of Mayfly's shares might therefore range between:
high P/E ratio and high earnings: 7 75,000 = 525,000; and
low P/E ratio and low earnings: 5 71,500 = 357,500.

The maximum price is one which would make the return from the total investment exactly 15% over
five years, so that the NPV at 15% would be 0.
Cash flows ignoring Discount Present
Year purchase consideration factor (from tables) value
15%
0 (100,000) 1.000 (100,000)
1 (80,000) 0.870 (69,600)
2 60,000 0.756 45,360
3 100,000 0.658 65,800
4 150,000 0.572 85,800
5 150,000 0.497 74,550
Maximum purchase price 101,910

First we calculate the PV of the free cash flows over the five year planning horizon.
20X5 20X6 20X7 20X8 20X9

FCF 1,132 1,503 1,983 2,605 31,789
Discount factor at 12% 0.893 0.797 0.712 0.636 0.567
PV 1,011 1,198 1,412 1,657 18,024
Total PV = 23,302

PV @ 12% (see above) 23,302
Less: Debt 2,000
Equity value 21,302
Shares outstanding 100
Intrinsic value per share 213.02
Market share price 29.00
Price at which Tetrion shareholders will sell (29.00 120%) 34.80
Discount of selling price from value 84%
The shareholders of Atrium should buy Tetrion at the offered price.

Discount Present
Year Cash flow factor value
10%
13 Interest 9 2.486 22.37
3 Redemption value 100 0.751 75.10
97.47
Each 100 of debenture will have a market value of 97.47.

Tutorial note:
This question provides comprehensive practice of valuation techniques. You need to make clear the
basis of your calculations and the assumptions you are making (in (a) the assumption is that the
purchaser will accept the valuation, in (b) that the last five years are an appropriate indicator and so on).
Other important issues which this question raises include:
Valuation (if any) of intangible assets
Lack of likelihood that asset valuation basis would be used
Adjustment to P/E ratios used in calculations because company is unquoted
Do not take all of the figures used in this answer as the only possibilities. You could for example have
made adjustments to estimated earnings in (c) to allow for uncertainty, or used a different figure to 17%
in (d).
C
(a) Earnings-basis valuations H
A
If the purchaser believes that earnings over the last five years are an appropriate measure for P
valuation, we could take average earnings in these years, which were: T
E
465,000 R
93,000
5
An appropriate P/E ratio for an earnings basis valuation might be the average of the three publicly
quoted companies for the recent year. (A trend towards an increase in the P/E ratio over three 5
years is assumed, and even though average earnings have been taken, the most recent year's P/E
ratios are considered to be the only figures which are appropriate.)

P/E ratio
Albatross plc 8.5
Bullfinch plc 9.0
Crow plc 10.0
Average 9.167 (i)
Reduce by about 40% to allow for unquoted status 5.5 (ii)
Share valuations on a past earnings basis are as follows.
P/E ratio Earnings Valuation Number of shares Value per share

'000 '000
(i) 9.167 93 852.5 300,000 2.84
(ii) 5.5 93 511.5 300,000 1.71
Because of the unquoted status of Black Raven Ltd, purchasers would probably apply a lower P/E
ratio, and an offer of about 1.71 per share would be more likely than one of 2.84.
Future earnings might be used. Forecast earnings based on the company's five year plan will be
used.

Expected earnings: Year 1 100,000
Year 2 104,000
Year 3 108,160
Year 4 112,486
Year 5 116,986
Average 108,326.4 (say 108,000)
A share valuation on an expected earnings basis would be as follows.
P/E ratio Average future earnings Valuation Value per share
5.5 108,000 594,000 1.98
It is not clear whether the purchasing company would accept Black Raven's own estimates of
earnings.
(b) A dividend yield basis of valuation with no growth
There seems to have been a general pattern of increase in dividend yields to shareholders in
quoted companies, and it is reasonable to suppose that investors in Black Raven would require at
least the same yield.
An average yield for the recent year for the three quoted companies will be used. This is 12%.
The only reliable dividend figure for Black Raven Ltd is 45,000 a year gross, in spite of the
expected increase in future earnings. A yield basis valuation would therefore be:
45,000
375,000 or 1.25 per share
12%
A purchasing company would, however, be more concerned with earnings than with dividends if it
intended to buy the entire company, and an offer price of 1.25 should be considered too low.
On the other hand, since Black Raven Ltd is an unquoted company, a higher yield than 12% might
be expected.
(c) A dividend yield basis of valuation, with growth
Since earnings are expected to increase by 4% a year, it could be argued that a similar growth rate
in dividends would be expected. We shall assume that the required yield is 17%, rather more than
the 12% for quoted companies because Black Raven Ltd is unquoted. However, in the absence of
information about the expected growth of dividends in the quoted companies, the choice of 12%,
17% or whatever, is not much better than a guess.
D0 (1 g) 45,000(1.04)
P0 360,000 or 1.20 per share
(k g) (0.17 0.04)

(d) The discounted value of future cash flows
The present value of cash inflows from an investment by a purchaser of Black Raven Ltd's shares
would be discounted at either 18% or 14%, depending on the view taken of Black Raven Ltd's
assets. Although the loan of 400,000 is secured on some of the company's property, there are
enough assets against which there are no charges to assume that a purchaser would consider the
investment to be backed by tangible assets.
The present value of the benefits from the investment would be as follows.
Year Cash flow Discount factor PV of cash flow

'000 14% '000
1 120 0.877 105.24
2 120 0.769 92.28
3 140 0.675 94.50
4 70 0.592 41.44
5 120 0.519 62.28
395.74
A valuation per share of 1.32 might therefore be made. This basis of valuation is one which a
purchasing company ought to consider. It might be argued that cash flows beyond Year 5 should
be considered and a higher valuation could be appropriate, but a figure of less than 2 per share
would be offered on a DCF valuation basis.
(e) Summary
Any of the preceding valuations might be made, but since share valuation is largely a subjective
matter, many other prices might be offered. In view of the high asset values of the company an
asset stripping purchaser might come forward.
C
H
A
P
T
E
R

CHAPTER 6
Cost of capital and financial

structuring
Introduction
Topic List
1 Overview of sources of finance
2 Overview of cost of capital, portfolio theory and CAPM
3 Bonds and debt
4 Financial restructuring
5 Refinancing and securitisation
6 Small company finance
7 Working capital management
237
Introduction
Demonstrate and apply detailed knowledge of sources of finance, loan agreement

conditions and raising finance
Demonstrate a detailed understanding and application of cost of capital issues, portfolio
theory and the capital asset pricing model (CAPM)
Demonstrate and apply detailed knowledge and understanding of the use of bonds as a
method of finance
Demonstrate and apply detailed knowledge of bond price, including the flat and gross
redemption yields
Demonstrate and apply detailed knowledge of yield curves, sensitivity to yield and
components of the yield
Demonstrate detailed knowledge and understanding of duration
Demonstrate detailed knowledge and understanding of credit risk and credit spread
Demonstrate a detailed understanding of how financial reconstruction takes place
Demonstrate and apply detailed knowledge of how to carry out a financial reconstruction
Demonstrate and apply detailed knowledge and understanding of the different reasons for
refinancing
Demonstrate and apply detailed knowledge of the workings of, and reasons for,
securitisation
Demonstrate detailed knowledge and understanding of the small- and medium-sized
enterprise financing problem
Demonstrate detailed knowledge and understanding of the various methods of financing
available to small- and medium-sized enterprises
Demonstrate and apply detailed knowledge of working capital management techniques

1 Overview of sources of finance C
H
A
Section overview P
T
In this section we discuss the factors that determine the sources of finance that businesses choose. E
R
Later in this chapter, in Section 6, we review in detail the issues affecting small businesses as they
seek finance.
6
1.1 Equity and debt

You have already covered the different features of equity and debt in your earlier studies, principally in
Financial Management. You may wish to refresh your memory by referring back to this study material.
1.2 Capital structure

Often the decision on the right capital structure will be a complex one. Remember businesses are not
just deciding what the best mix of equity and debt should be. They are also considering the mix of
long-term and short-term debt, the attractiveness of different lenders and the security they wish to offer
amongst other factors. The mix of finance a business should use can be assessed using the suitability,
acceptability and feasibility framework you studied in the Business Strategy syllabus.
1.3 Suitability of capital structure

1.3.1 Stability of company
One determinant of the suitability of the gearing mix is the stability of the company. It may seem
obvious, but it is worth stressing that debt financing will be more appropriate when:
The company is in a healthy competitive position
Cash flows and earnings are stable or rising
Profit margins are reasonable
The bulk of the company's assets are tangible
The liquidity and cash flow position is strong
The debt-equity ratio is low
Share prices are low (unless share prices are low because the company already has high gearing)
1.3.2 Matching assets with funds

As a general rule, assets which yield profits over a long period of time should be financed by long-term
funds.
In this way, the returns made by the asset should be sufficient to pay either the interest cost of the loans
raised to buy it, or dividends on its equity funding.
If, however, a long-term asset is financed by short-term funds, the company cannot be certain that
when the loan becomes repayable, it will have enough cash (from profits) to repay it.
A company would not normally finance all of its short-term assets with short-term liabilities, but instead
finance short-term assets partly with short-term funding and partly with long-term funding (see Section
7).
1.3.3 Long-term capital requirements for replacement and growth

A distinction can be made between long-term capital that is needed to finance the replacement of
worn-out assets, and capital that is needed to finance growth.
Aims Main funding sources
Maintenance of current level of operations Internal sources

Growth External finance
Cost of capital and financial structuring 239

1.3.4 Signalling
Some investors may see the issue of debt capital as a sign that the directors are confident enough of the
future cash flows of the business to be prepared to commit the company to making regular interest
payments to lenders. However this depends on the view that market efficiency is not very high. The
argument would be that an efficient market would have sufficient information to be able to make its
own mind up about the debt issue, without needing to take the directors' views into account.
1.3.5 Clientele effect

When considering whether to change gearing significantly, directors may take into account changes in
the profile of shareholders. If gearing does change significantly, the company may adjust to a new risk-
return trade-off that is unsuitable for many shareholders. These shareholders will look to sell their shares,
whilst other investors, who are now attracted by the new gearing levels, will look to buy shares.
1.3.6 Domestic and international borrowing

If the company is receiving income in a foreign currency or has a long-term investment overseas, it can
try to limit the risk of adverse exchange rate movements by matching. It can take out a long-term loan
and use the foreign currency receipts to repay the loan. Similarly it can try to match its foreign assets
(property, plant etc) by a long-term loan in the foreign currency. However if the asset ultimately
generates home currency receipts, there will be a long-term currency risk.
In addition foreign loans may carry a lower interest rate, but the principle of interest rate parity suggests
that the foreign currency will ultimately strengthen, and hence loan repayments will become more
expensive. Euromarket loans also generally require no security and it may be easier to raise large sums
quickly on overseas markets.
1.3.7 Cost and flexibility

Interest rates on longer-term debt may be higher than interest rates on shorter-term debt. However
issue costs or arrangement fees will be higher for shorter-term debt as it has to be renewed more
frequently.
A business may also find itself locked into longer-term debt, with adverse interest rates and large
penalties if it repays the debt early. Both inflation and uncertainty about future interest rate changes are
reasons why companies are unwilling to borrow long-term at high rates of interest and investors are
unwilling to lend long-term when they think that interest yields might go even higher.
1.3.8 Optimal capital structure and the cost of capital

When we consider the capital structure decision, the question arises of whether there is an optimal mix
of equity and debt that minimises the cost of capital, and which a company should therefore try to
achieve.
One view (the traditional view) is that there is an optimal capital mix at which the average cost of
capital, weighted according to the different forms of capital employed, is minimised. As gearing rises, so
the return demanded by the ordinary shareholders begins to rise in order to compensate them for the
risk resulting from a larger and larger share of profits going to the providers of debt. At very high levels
of gearing the holders of debt too will begin to require higher returns as they become exposed to risk of
inadequate profits.
As you may remember, the alternative view of Modigliani and Miller is that the firm's overall weighted
average cost of capital is not influenced by changes in its capital structure. Their argument is that the
issue of debt causes the cost of equity to rise in such a way that the benefits of debt on returns are
exactly offset. Investors themselves adjust their level of personal gearing and thus the level of corporate
gearing becomes irrelevant. If tax is included in the model, then it is in the company's interests to use
debt finance, because of the tax relief that can be obtained on interest which causes the weighted
average cost to fall as gearing increases.
A further issue is tax exhaustion, that at a certain level of gearing, companies will discover that they
have no taxable income against which to offset interest charges, and they therefore lose the benefit of
the tax relief on the interest.

1.4 Acceptability of capital structure
C
1.4.1 Risk attitudes H
A
The choice of capital structure will not only depend on company circumstances, but the attitudes that P
directors and owners have towards the principal risks. This will include the risks that are specific to the T
business, more general economic risks, and also the risks of raising finance. It could for example E
R
adversely affect the company's reputation if it made a rights issue that was not fully subscribed.
Owner-director attitudes to risk may also differ. Owners will be concerned about the combination of risk
and return. Directors may be concerned with the risk to their income and job security, but on the other 6
hand significant profit incentives in their remuneration packages may encourage them to take more risks
than the owners deem desirable.
At very high levels of gearing, the firm may face costs arising from the possibility, or fear, of bankruptcy.
As firms take on higher levels of gearing, the chances of default on debt repayments, and hence
liquidation ('bankruptcy'), increase. Investors will be concerned over this and sell their holdings, which
will cause the value of the company's securities to fall, with a corresponding increase in its cost of funds.
To optimise capital structure, financial managers must therefore not increase gearing beyond the point
where the cost of investor worries over bankruptcy outweighs the benefits gained from the increased
tax shield on debt.
1.4.2 Loss of control

The directors and shareholders may be unwilling to accept the conditions and the loss of control that
obtaining extra finance will mean. Control may be diminished whether equity or loan funding is sought:
(a) Issuing shares to outsiders may dilute the control of the existing shareholders and directors, and
the company will be subject to greater regulatory control if it obtains a stock market listing.
(b) The price of additional debt finance may be security, restricting disposal of the assets secured and
covenants that limit the company's rights to dispose of assets in general or to pay dividends.
1.4.3 Costs
The directors may consider that the extra interest costs the company is committed to are too high. On
the other hand the effective cost of debt might be cheaper than the cost of equity, particularly if tax
relief can be obtained.
The differing costs of raising finance (zero for retained earnings, much more expensive for equity issues)
may also be important.
1.4.4 Commitments
The interest and repayment schedules that the company is required to meet may be considered too
tight. The collateral loan providers require may also be too much, particularly if the directors are
themselves required to provide personal guarantees.
1.4.5 Present sources of finance

Perhaps it's easy to find reasons why new sources of finance may not be desirable, but equally they may
be considered more acceptable than drawing on current sources. For example shareholders may be
unwilling to contribute further funds in a rights issue. The business may wish to improve its relations
with its suppliers, and one condition may be lessening its reliance on trade credit.
1.5 Feasibility of capital structure

Even if directors and shareholders are happy with the implications of obtaining significant extra finance,
the company may not be able to obtain that finance.
1.5.1 Lenders' attitudes

Whether lenders are prepared to lend the company any money will depend on the company's
circumstances, particularly as they affect the company's ability to generate cash and security for the
loan. Companies with substantial non-current assets may be able to borrow more.

1.5.2 Shareholder willingness to invest
If the stock market is depressed, it may be difficult to raise cash through share issues, so major amounts
will have to be borrowed.
1.5.3 Future trends

Likely future trends of fund availability will be significant if a business is likely to require a number of
injections of funds over the next few years.
1.5.4 Restrictions in loan agreements

Restrictions written into agreements on current loans may prohibit a business from taking out further
loans, or may require that its gearing does not exceed specified limits.
1.5.5 Maturity dates

If a business already has significant debt repayable in a few years' time, because of cash flow restrictions
it may not be able to take out further debt which is repayable around the same time.
1.6 Pecking order theory

Pecking order describes the order in which businesses will use different sources of finance. It contrasts
with the view that businesses will seek an optimal capital structure that minimises their weighted
average cost of capital. The order of preference will be:
Retained earnings*
Straight debt
Convertible debt
Preference shares
Equity shares (rights then new issues)
* Note: A common error in the exam is to refer to retained earnings as a source of finance when there
may be no liquid resources in the business. In the context where retained earnings are referred to as a
source of finance it needs to be made clear that this refers to operating cash flows retained in the
business rather than paid out as dividends.
1.6.1 Reasons for following pecking order

It is easier to use retained earnings than go to the trouble of obtaining external finance and have to
live up to the demands of external finance providers.
There are no issue costs if retained earnings are used, and the issue costs of debt are lower than
those of equity.
Investors prefer safer securities, particularly debt with its guaranteed income and priority on
liquidation.
Some managers believe that debt issues have a better signalling effect than equity issues because
the market believes that managers are better informed about shares' true worth than the market
itself is. Their view is the market will interpret debt issues as a sign of confidence, that businesses
are confident of making sufficient profits to fulfil their obligations on debt and that they believe
that the shares are undervalued.
By contrast the market will interpret equity issues as a measure of last resort, that managers believe
that equity is currently overvalued and hence are trying to achieve high proceeds whilst they can.
The main consequence in this situation will be reinforcing a preference for using retained earnings
first. However debt (particularly less risky, secured debt) will be the next source as the market feels
more confident about valuing it than more risky debt or equity.
1.6.2 Consequences of pecking order theory

Businesses will try to match investment opportunities with internal finance, provided this does not
mean excessive changes in dividend payout ratios.

If it is not possible to match investment opportunities with internal finance, surplus internal funds
will be invested; if there is a deficiency of internal funds, external finance will be issued in the C
pecking order, starting with straight debt. H
A
Establishing an ideal debt-equity mix will be problematic, since internal equity funds will be the P
first source of finance that businesses choose, and external equity funds the last. T
E
R
1.6.3 Limitations of pecking order theory
It fails to take into account taxation, financial distress, agency costs or how the investment
opportunities that are available may influence the choice of finance. 6
Pecking order theory is an explanation of what businesses actually do, rather than what they
should do.
Studies suggest that the businesses that are most likely to follow pecking order theory are those that are
operating profitably in markets where growth prospects are poor. There will thus be limited
opportunities to invest funds, and these businesses will be content to rely on retained earnings for the
limited resources that they need.
1.6.4 Behavioural theories

A number of studies have suggested that businesses pursue rules of thumb or behaviour patterns.
The herd theory states that businesses will stick closely to the industry average capital structure.
Of course the average may hide wide variations that are acceptable to different companies.
However there is evidence to suggest that companies that are significantly more highly geared
than the industry average will have difficulty obtaining further debt finance.
Benchmarking occurs where businesses identify a leader in their market and adopt a similar capital
structure. However the capital structure that is appropriate for the market leader with the
investment opportunities that it faces may not be appropriate for the less successful businesses in
that industry.
Past experience may be an important influence. The argument is that managers are aware of the
advantages and disadvantages of both equity and debt, and choose the source of finance that
experience suggests will cause them few or no problems.
2 Overview of cost of capital, portfolio theory and CAPM
Section overview
The important fundamentals of financial management cost of capital, portfolio theory and the
capital asset pricing model (CAPM) are reviewed here.
These techniques were covered extensively in the Financial Management paper at Professional
stage, therefore you should review earlier study notes to ensure you are familiar with the detail.
Knowledge of all of these topics is essential at the Advanced stage as you will be expected to use
them when developing financial strategies or structures.
2.1 Cost of capital

The importance of cost of capital cannot be emphasised enough in the formulation of financial strategy.
It is used for discounting cash flows of potential projects, determining the type(s) of finance that
companies should be using for investment purposes and so on. If the incorrect cost of capital is used,
then sub-optimal decisions will be made regarding the projects that are undertaken and the way in
which capital is structured.

2.1.1 Pecking order theory
Remember what we said in the last section about pecking order theory and the order of funds being:
Retained earnings
Debt
Equity shares
2.1.2 Cost of equity

The cost of equity (ke) of a company is the same as the returns required by investors and can be
calculated in several different ways: the dividend valuation model (covered in Chapter 5); the Gordon
growth model; and the Capital Asset Pricing Model (CAPM).
(i) Earnings retention model
This model is based on the premise that retained profits are the only source of funds. Growth will
come about from the retention and reinvestment of profits. The model is as follows:
g = rb
Where: g = growth in future dividends
r = the current accounting rate of return
b = the proportion of profits retained
(ii) Capital Asset Pricing Model (CAPM)
The CAPM is based on a comparison of the systematic risk of individual investments with the risks
of all shares in the market and is calculated as follows:
ke = rf + e (rm rf)
where: ke is the cost of equity capital
rf is the risk-free rate of return
rm is the return from the market as a whole
e is the beta factor of the individual security
Interactive question 1: CAPM [Difficulty level: Easy]

Investors have an expected rate of return of 8% from ordinary shares in Algol, which have a beta of 1.2.
The expected returns to the market are 7%.
What will be the expected rate of return from ordinary shares in Rigel, which have a beta of 1.8?
Interactive question 2: Cost of equity [Difficulty level: Easy]

The following data relates to the ordinary shares of Stilton.
Current market price, 31 December 20X1 250 pence
Dividend per share, 20X1 3 pence
Expected growth rate in dividends and earnings 10% pa
Average market return 8%
Risk-free rate of return 5%
Beta factor of Stilton equity shares 1.40
(a) What is the estimated cost of equity using the dividend growth model?
(b) What is the estimated cost of equity using the capital asset pricing model?

Interactive question 3: CAPM and beta factor [Difficulty level: Easy]
C
(a) What does beta measure, and what do betas of 0.5, 1 and 1.5 mean? H
A
(b) What factors determine the level of beta that a company may have? P
See Answer at the end of this chapter. T
E
R
2.1.3 Cost of debt

6
The cost of debt is the return an enterprise must pay to its lenders.
For irredeemable debt, this is the (post-tax) interest as a percentage of the ex interest market value of
the loan stock (or preference shares).
For redeemable debt, the cost is given by the internal rate of return of the cash flows involved.
(i) Irredeemable debt capital
After-tax cost of irredeemable debt capital is:
i(1 T)
kd
P0
where: k d is the cost of debt capital after tax

T is the rate of corporation tax
(ii) Redeemable debt
The procedure is to calculate an internal rate of return on the pre-tax cash flows (the gross
redemption yield). The post-tax cost of debt is then calculated by multiplying the gross redemption
yield by (1 T).
The first step is therefore to calculate the internal rate of return of the following cash flows:
t0 = ex-interest market value
t1 tn = interest
tn = redemption price
(iii) Cost of preference shares

As preference shares usually have a constant dividend the perpetuity valuation formula is used:
D
kp =
P0
where: D = constant annual dividend

P0 = ex-div market value
Remember that, when calculating the weighted average cost of capital, the cost of preference
shares is a separate component and should not be combined with the cost of debt or the cost of
equity.
(iv) Cost of convertible debt
This calculation will depend on whether conversion is likely to happen or not. If conversion is not
expected, then the conversion value is ignored and the bond is treated as redeemable debt. If
conversion is expected, the IRR method for calculating the cost of redeemable debt is used, but the
number of years to redemption is replaced by the number of years to conversion and the
redemption value is replaced by the conversion value (that is, the market value of the shares into
which the debt is to be converted).
Conversion value is calculated as follows.
n
Conversion value = P0 (1 + g) R

where: P0 is the current ex-dividend ordinary share price
g is the expected annual growth of the ordinary share price
n is the number of years to conversion
R is the number of shares received on conversion
Interactive question 4: Cost of debt (no tax) [Difficulty level: Easy]

Allot has in issue 10% loan notes of a nominal value of 100. The market price is 90 ex interest.
Calculate the cost of this capital if the debenture is:
(a) Irredeemable
(b) Redeemable at par after 10 years
Ignore taxation.
Interactive question 5: Cost of debt (with tax) [Difficulty level: Intermediate]

(a) A company has outstanding 660,000 of 8% loan notes on which the interest is payable annually
on 31 December. The debt is due for redemption at par on 1 January 20X6. The market price of
the loan notes at 28 December 20X2 was 103 cum interest. Ignoring taxation, what do you
estimate to be the current cost of debt?
(b) If a new expectation emerged that the cost of debt would rise to 12% during 20X3 and 20X4 what
effect might this have in theory on the market price at 28 December 20X2?
(c) If the effective rate of tax was 23% what would be the after-tax cost of debt of the loan notes in (a)
above?
2.1.4 Weighted average cost of capital (WACC)

WACC is calculated by weighting the costs of the individual sources of finance according to their relative
importance as sources of finance. Two methods of weighting could be used: market value or book
value. The general rule is that market value should always be used if data is available, as the use of
historical book values may result in WACC being understated.
WACC is calculated using the following formula:
E D
WACC = ke + kd
E D E D
Where: ke is the cost of equity
kd is the cost of debt (net of tax)
E is the market value of equity in the firm
D is the market value of debt in the firm

Interactive question 6: Weighted average cost of capital [Difficulty level: Easy]
C
An entity has the following information in its statement of financial position. H
'000 A
Ordinary shares of 50p 2,500 P
Debt (12% irredeemable, nominal value) 1,000 T
E
The ordinary shares are currently quoted at 130 pence each and the loan notes are trading at 72 per R
100 nominal. The ordinary dividend of 15p has just been paid with an expected growth rate of 10%.
Corporation tax is currently 23%.
Calculate the weighted average cost of capital for this entity. 6
2.1.5 Effective interest rates

The effective interest rate is the rate on a loan that has been restated from the nominal interest rate to
one with annual compound interest. It is used to make loans more comparable by converting individual
loans' interest rates into equivalent annual rates.
It is calculated using the following formula:
n
r = (1 + i/n) 1
where: r is the effective interest rate
i is the nominal interest rate
n is the number of compounding periods per year (eg 12 for monthly compounding)
2.1.6 Uses of different costs of capital

It is important to use the appropriate cost of capital in the right calculation.
Cost When used
Cost of equity Discounting earnings after finance costs,

taxation and preference dividends.
Calculating value of a share in a dividend
valuation or earnings valuation model.
Weighted average cost of capital Discounting earnings before finance costs,
taxation and preference dividends.
Calculating the value of an enterprise (ie
total of equity and debt) using an earnings
valuation model.
Appraising investments with similar business
risks where gearing does not change.
Marginal cost of capital Appraising investments in circumstances
where gearing levels or project risks
fluctuate significantly.
Appraising investments where the mix of
additional finance carries a significantly
different level of risks to the existing finance
mix.
Appraising investments where the source of
finance is project-specific.

2.2 Portfolio theory and CAPM
2.2.1 Portfolio theory
Modern portfolio theory is based around the premise that an investor will want to minimise risk and
follows the 'do not put all your eggs in one basket' theory. Rather than holding shares in just one
company and thus being exposed to the risks associated with that company in particular and its
industry in general investors should prefer to hold shares in a combination of different companies in
various industries. In this way, if the investor has invested in companies whose shares move in different
ways in response to economic factors, risk will be reduced.
By holding a portfolio of shares, investors can reduce unsystematic risk (which applies to individual
investments) through diversification. Investors cannot diversify away systematic risk, which is due to
variations in market activity such as macroeconomic factors.
2.2.2 CAPM
We mentioned the CAPM in Section 2.1.2 in relation to calculating the cost of equity. With regard to
portfolio theory, the CAPM is used to calculate the required rate of return for any particular investment
and is based on the assumption that investors require a return in excess of the risk-free rate to
compensate them for systematic risk.
The CAPM formula is given in Section 2.1.2. It makes use of a beta value which measures a share's
volatility in terms of market risk. For a portfolio of shares, the beta value will be the weighted average of
the beta factors of all the securities in the portfolio.
2.2.3 CAPM and cost of capital

CAPM can be used to produce a cost of capital for an investment project, based on the systematic risk of
that investment.
Interactive question 7: CAPM and cost of capital [Difficulty level: Easy]

Panda plc is all-equity financed. It wishes to invest in a project with an estimated beta of 1.5. The
project has significantly different business risk characteristics from Panda's current operations. The
project requires an outlay of 10,000 and will generate expected returns of 12,000.
The market rate of return is 12% and the risk-free rate of return is 6%.
Requirement
Estimate the minimum return that Panda will require from the project and assess whether the project is
worthwhile, based on the figures you are given.
2.2.4 International CAPM

The possibility of international portfolio diversification increases the opportunities available to investors.
If we assume that the international capital market is a fully integrated market like an enlarged
domestic market, then we have an international CAPM formula as follows.
rj = rf + w (rw rf)
where rw is the expected return from the world market portfolio and w is a measure of the world
systematic risk.
This analysis implies that investors can benefit from maximum diversification by investing in the world
market portfolio consisting of all securities in the world economy. New risk and return combinations
may be available.

2.2.5 Arbitrage pricing theory
C
The CAPM specifies that the only risk factor that should be taken into account is the market risk H
premium. Subsequent empirical research has shown that there may be other factors in addition to A
market risk premium that explain differences in asset returns, such as interest rates and industrial P
production. T
E
Unlike the CAPM, which analyses the returns on a share as a function of a single factor the return on R
the market portfolio, the Arbitrage Pricing Theory (APT) assumes that the return on each security is
based on a number of independent factors. The actual return r on any security is shown as:
6
r = E(rj)+ 1F1 + 2F2 ... + e
where E(rj) is the expected return on the security
I is the sensitivity to changes in factor 1
FI is the difference between actual and expected values of factor 1
2 is the sensitivity to changes in factor 2
F2 is the difference between actual and expected values of factor 2
e is a random term
Factor analysis is used to ascertain the factors to which security returns are sensitive. Four key factors
identified by researchers have been:
Unanticipated inflation
Changes in the expected level of industrial production
Changes in the risk premium on bonds (debentures)
Unanticipated changes in the term structure of interest rates
It has been demonstrated that when no further arbitrage opportunities exist, the expected return E(rj)
can be shown as:
E(rj)= rf + 1(r1 rf) + 2(r2 rf) ...
where rf is the risk-free rate of return
r1 is the expected return on a portfolio with unit sensitivity to factor 1 and no sensitivity to any
other factor
r2 is the expected return on a portfolio with unit sensitivity to factor 2 and no sensitivity to any
other factor
Such an approach generalises the CAPM and postulates the following model for the risk premium of a
portfolio:
E(rj)= rf + (E(rA) rf)A + (E(rB) rf)B + .......... +(E(rm) rf)m + .......
Where (E(rA) rf)A is the risk premium on factor A.
(E(rB) rf)B is the risk premium on factor B and so on
The APT model calculates the risk premium by constructing a portfolio with a beta of 1 in relation to
the factor under consideration (such as the interest rate) and a beta of zero in relation to all the other
factors. The risk premium of that specific portfolio is then used as a proxy for the risk premium for the
factor under consideration.
2.2.6 Market-derived capital pricing model

This model uses option pricing model to calculate the equity risk premium from a share's volatility.
Correlation is not a factor in the model, unlike CAPM. MCPM also adds the risk premium to the
estimated yield of a company's debt to calculate its cost of equity.

2.2.7 Three and four factor models
Fama and French identified two factors in addition to the market portfolio that explain company
returns namely size and distress.
The size factor is measured as the difference in return between a portfolio of the smallest stocks and a
portfolio of the largest stocks, whereas the distress factor is proxied by the difference in return between
a portfolio of the highest book to market value stocks and portfolio of the lowest book to market value
stocks.
The Fama and French three factor model is as follows
E(rj) = rf + i,m (E(rm) rf) + i,S SIZE + i,D DIST
where i,m is the stock's beta
i,S is beta with respect to size
i,D is the stock's beta with respect to distress
Carhart, a student of Fama, added a fourth factor to the model, momentum:
E(rj) = rf + i,m (E(rm) rf) + i,S SIZE + i,D DIST + i,M MOM
Where i,m is the stock's beta with respect to momentum
Momentum is the concept that a stock that has performed well recently will continue to perform well.
The theory of momentum appears to be inconsistent with the efficient market hypothesis, that an
increase in share prices should not of itself warrant further increases. The existence of momentum has
been explained by the irrationality of investors who under-react to new information.
3 Bonds and debt
Section overview
Bonds are an important source of finance for companies.
Bonds can be priced at par, at a premium or at a discount.
Returns on bonds can be measured using the flat yield or gross redemption yield.
As interest rates rise, the price of bonds falls.
The yield curve is a graphical representation of the structure of interest rates, where the yield
offered by bonds is plotted against maturity.
The yield on a bond is made up of a number of elements, including credit and default risk,
liquidity and marketability risk, issue specific risk and fiscal risk.
The volatility of a bond is the sensitivity of the bond to movements in the yield/interest rate.
Duration is the weighted average length of time to the receipt of a bond's benefits (coupon and
redemption value), the weights being the present value of the benefits involved.
Credit risk is the risk undertaken by the lender that the borrower will default either on interest
payments or on the repayment of principal on the due date, or on both.
The credit spread is the premium required by an investor in a corporate bond to compensate for
the credit risk of the bond.
A bond also known as loan stock or debenture is debt capital issued by companies, the government
and local authorities.
3.1 Terminology
This terminology should be familiar to you from your earlier studies but it is worthwhile to recap on it
here.

Definitions
C
Face (or par or nominal) value the amount of money the bond holder will receive when the bond H
matures (provided it is not redeemable at a premium or a discount). This is not the market price of the A
bond. If the market price is above par value, the bond is said to be trading at a premium; if price is P
below par value, the bond is trading at a discount. T
E
Coupon rate the amount the bond holder receives as interest payments based upon the par value. R
Maturity the date at which the principal will be repaid. Maturities can range from one day to as long
as 30 years (although it has been known for 100-year bonds to be issued). 6
Issuer the issuer's stability is the bond holder's main assurance for getting repaid. For example, the
Government is much more secure than any company; hence government-issued bonds are known as
risk-free assets and will have lower returns than company-issued bonds.
3.2 Bond pricing

As mentioned in Section 3.1 above, bonds can be priced at par, at a premium or at a discount. When
calculating the price of a bond, you are really determining the maximum price you would want to pay
for it, given the bond's coupon rate compared with the average rate that investors are currently earning
in the bond market. Like shares, the price of a bond will depend on the market forces of supply and
demand.
3.2.1 General method

The price of a bond is the sum of the present values of all expected coupon payments plus the present
value of the redemption value at maturity in other words, all you are doing is discounting the future
cash flows of the bond. The interest rate that is used for discounting purposes is the required yield.
The formula for calculating the price of a bond is as follows.
C C C R
Bond Price= ...
(1 i) (1 i)2 (1 i)n (1 i)n
where: C is the coupon payment

n is the number of payments
i is the interest rate (required yield)
R is the value at maturity (redemption value)
If the coupon payments are the same each time, then you can use the annuity formula:
[1- (1/(1 i)n )] R

Bond Price= C
i (1 i)n
Worked example: Bond pricing

A bond has a par value of 2,500 which is to be redeemed in 15 years' time at par. The coupon rate of
the bond is 8% and there is a required yield of 10%. Coupon payments are made every six months and
the next payment is due in six months' time.
Requirement
What is the price of the bond?

Solution
The first thing we have to do is calculate the number of coupon payments that will be made. As two
payments are made every year for 15 years, there will be 30 payments in total.
What is the value of each coupon payment? As the payments are made twice a year, you should divide
the coupon rate in half which gives a rate of 4%. Each semi-annual coupon payment will be 4% of
2,500 = 100.
Likewise, with the required yield, divide by two, giving a yield of 5%. If we did not reduce the yield, the
bond price would be too low.
We can now use the formula to calculate the bond price:
[1- (1/(1 0.05))30 ] 2,500
Bond price = 100
0.05 (1 0.05)30
= 2,115.69
The bond is trading at a discount the bond price of 2,115.69 is less than the par value of 2,500.
This is because the required yield is greater than the coupon rate. Investors will have to be attracted by
a discount in order to invest in the bonds, as they could earn greater interest elsewhere at the prevailing
rate.
3.2.2 Different frequencies of payments

The Worked example above required preliminary calculations to convert the coupon rate and yield into
semi-annual equivalents. Rather than having to remember to carry out these steps, you can use the
following formula for any payment frequency.
C [1- (1/[1 i /F]nF )] R

Bond price =
F (i /F) (1 [i /F])nF
where: F is the number of times in each year that a coupon payment is made
If you use the data from the previous Worked example in the formula above, you will arrive at the same
bond price.
3.2.3 Zero coupon bonds

The pricing of zero coupon bonds is actually quite straightforward as there is no need to use the annuity
formula. All you have to do is calculate the present value of the redemption value at maturity.
Worked example: Zero coupon bonds

What is the price of a zero coupon bond that matures in 10 years' time, has a required yield of 7% and a
redemption value of 3,200? Assume that coupon payments occur semi-annually.
Solution
As the coupon payments occur semi-annually, this means we have to adjust the yield to its equivalent
semi-annual payment rate. This means that the number of periods for the zero coupon bond will be
doubled from 10 to 20.
The yield will also have to be adjusted in a similar manner to the worked example in Section 3.2.1,
giving a yield of 3.5%.
3,200
Bond price =
(1 0.035)20
= 1,608.21
Zero coupon bonds always trade at a discount, otherwise there would be no chance for the investor to
make any money and thus no incentive to invest in such bonds.

3.3 Flat yield
C
3.3.1 Calculation of the flat yield H
A
The simplest measure of the return used in the market is the flat yield. This is also referred to as the P
running yield or the interest yield. It looks at the cash return generated by an investment over the cash T
price. In simple terms, what is the income that you generate on the money that you invest? E
R
Annual coupon payment
Flat yield 100
Market price
6
Worked example: Flat yield

5% Loan stock
Redemption date five years from now at par
Current market price 97.25
Solution
The flat yield for the above would be:
5
100 = 5.14%
97.25
3.3.2 Limitations of the flat yield

This measure is of some use, particularly in the short term, but it has three important drawbacks for the
investment markets.
With all equities and some bonds (eg floating rate notes), the return in any one period will vary. If
the coupon is not constant, then the measure is only of historic value unless the predicted return is
used.
In addition to the coupon flows, bonds will have return in the form of the redemption monies.
Where the bond has been purchased at a price away from par, this will give rise to potential gains
and losses.
Most importantly, the calculation completely ignores the time value of money. If an investor were
to be offered the choice between the receipt of 10 now or in two years' time, the logical choice
would be to take the 10 now, since the money could then be invested to generate interest.
These limitations combine to make the flat yield of marginal use only.
3.4 Gross redemption yield (yield to maturity)

The gross redemption yield considers the flows of money arising from a bond. Each flow is then
converted into its present value by discounting the future flow.
C1 C2 C3 Cn R
Current price = ...
1 r 1 r 2 1 r 3 1 r n
where C1 = coupon paid at the end of Period 1
Cn = coupon paid at the end of Period n (maturity)
R = principal repaid at the end of Period n
r = gross redemption yield
For each bond, we have the market price and the coupon flows. The GRY is simply the one rate of
interest that, when inserted into the formula, will equate the present values of the coupons with the
current market price.

It can be seen that the GRY is simply the internal rate of return of the bond's flows, where the current
price is treated as an outflow and the future interest and capital repayment flows are treated as inflows.
Worked example: Gross redemption yield

5% loan stock (annual coupon)
Three years to redemption
Current market price 97.25
Solution
The GRY of this bond is 6.03%. This can be demonstrated by calculating the present value of the flows
using a discount rate of 6.03%, as follows.
Cash flow Present value

Time Discount factor

0 (97.25) 1 (97.25)
1
1 5 4.72
1.0603
1
2 5 4.45
1.0603 2
1
3 105 88.08
1.0603 3
Net present value
3.4.1 Problems with the gross redemption yield

We have noted that the yield that has been calculated so far is in effect the internal rate of return (IRR)
of the flows generated by a bond. As a means of appraising an investment project, the IRR is limited
since it ignores the magnitude of the flows.
As a measure of predicted return, the yield is limited, since it assumes that any coupon receipts are
reinvested at the same rate as the current yield. If the investor is only able to reinvest the coupon at a
lower rate, then the overall return generated by the bond will be lower than the yield.
One further criticism of the yield measure is that it ignores reality it discounts all flows in the future by
the same rate when, as we shall see from the yield curve, the rate of return varies for monies of different
maturities.
3.5 The relationship between bond prices and interest rates

One of the fundamental correlations in bond markets is that, as the interest rate rises, the price of a
bond will fall.
This can be demonstrated either through the flat or the gross redemption yield.
Suppose the flat yield was calculated as:
10
100 = 10.283%
97.25
If the market interest rate were to rise to 12% then the holders of the bond would be encouraged to sell
the bond and invest their money into assets yielding 12%. The result of this would be that the supply of

the bond would rise and the demand fall, leading to a fall in the price. As the price falls to 83.33, the
yield rises to 12% thereby removing the incentive to switch out of the bond: C
H
10 = 12% A
83.33 P
T
The GRY can prove the same result. Using our initial GRY formula: E
R
C1 C2 C3 C R
Current price = ... n n
1 r 1 r 1 r
2 3
1 r
6
If the interest rate increases then the flows received in future periods will have a lower present value and
consequently the value of the bond (its price) falls.
3.6 The yield curve

3.6.1 What is the yield curve?
The yield curve is a graphical representation of the structure of interest rates, where the yield offered by
bonds is plotted against maturity. It is often calculated by reference to the gross redemption yield.
3.6.2 The shape of the curve

(a) Liquidity preference
If an investor's money is invested in longer-term (and therefore riskier) debt, then they will require
a greater return a risk premium. Short-term liquid debt carries a lower risk and therefore requires
a lower return. This gives rise to the normal upward sloping yield curve.
(b) Expectations theory
Expectations theory states that the yield curve is a reflection of the market's expectation of future
interest rates. If the market believes that the yield at the long end of the yield curve is high and is
likely to fall, then in order to profit from the increase in prices that this will create, investors will buy
long-dated stocks. As a result, the demand for these stocks will rise and this demand pressure will
force the price to rise. As a consequence, the yield will fall, reflecting the expectation of a fall.
On the other hand, if the market believes that rates will have to rise, then the forces will work in
the opposite direction and this will lead to a fall in the price and a rise in the yield.
The expectations of the market can clearly be seen in an inverted yield curve.

Here, short-term rates are unusually high, but the market anticipates that this cannot last for long.
The longer end of the market has anticipated this change by forcing yields down. This can lead to
the anomalous situation where the long-end of the market remains constant because it has
anticipated change and the short end (which is technically the least volatile) exhibits all of the
movement.
Another key element of the market's expectations will be the expectations of inflation. If the market
believes that inflation will rise in the future then the yields on the longer dated stocks will have to
rise in order to compensate investors for the fall in the real value of their money. The expectation
of inflation is much more of a problem with the long rather than the short end.
(c) Preferred habitat and market segmentation
Certain maturity ranges are appropriate to particular types of investors. In the UK, the short-end of
the market is dominated by the financial sector maintaining a proportion of their assets in liquid
investments, whereas the long-end is dominated by institutional investors such as pension funds.
In effect, this gives rise to two markets and may be reflected in a discontinuity, or hump, in the
yield curve.
(d) Supply-side factors
The availability of debt in certain maturity ranges may lead to either an excess or shortage of debt
and consequently an anomalous yield on some debt.
3.7 Composition of the yield

The yield on any bond is made up of a number of elements.
The real return This is the real rate of return that the investment has to earn. Effectively, it
represents the opportunity cost of saving over immediate consumption.
Inflation premium As inflation rises then the yield on a bond will have to increase in order to
compensate the holder. Inflation is basically negative interest, eroding the value of savings,
whereas interest adds to them.
Together, the real return and the inflation premium form the yield on government bonds and are
therefore said to approximate to the interest rate. In the case of non-government bonds, there are other
risks to consider.
Credit and default risk This is the risk of the issuer defaulting on its obligations to pay coupons
and repay the principal. The ratings issued by commercial rating companies can be used to help
assess this risk.
Liquidity and marketability risk This has to do with the ease with which an issue can be sold in
the market. Smaller issues are particularly subject to this risk. In certain markets the volume of
trading tends to concentrate into the 'benchmark' stocks, thereby rendering most other issues
illiquid. Other bonds become subject to 'seasoning' as the initial liquidity dries up and the bonds
are purchased by investors who wish to hold them to maturity.

Even if an issuer has a triple A credit rating and is therefore perceived as being at least as secure as
the government, it will still have to offer a yield above that offered by the government due to the C
smaller size (normally) and the thinner market in the stocks. H
A
Issue specific risk eg risk of call. If the company has the right to redeem the bond early, then it P
will only be logical for it to do this if it can refinance at a lower cost. What is good for the issuer will T
be bad for the investor and, thus, the yield will have to be higher. E
R
Fiscal risk The risk that withholding taxes will be increased. For foreign bonds, there would also
be the risk of the imposition of capital controls locking your money into the market.
6
Case example: Corporate bonds
As central banks have printed money (quantitative easing) to mitigate the effects of the recession, bond
prices have risen and their yields have fallen. By 2012 the redemption yields of many companies'
corporate bonds were significantly lower than the dividend yields on their shares. Although there is
greater risk attached to shares, if investors believe that the economy and dividends will recover, they
may be more attracted to shares than to fixed interest bonds.
3.8 Sensitivity to yield

3.8.1 Introduction
All of the risks of holding a bond come together in the yield. As we have already seen, there is an inverse
relationship between the price of a bond and its yield. It is possible to define this relationship
mathematically and predict the way in which a selection of bonds will perform. This is sometimes
referred to as the volatility of the bond.
The sensitivity of any bond to movements in the yield/interest rate will be determined by a number of
factors.
3.8.2 Sensitivity to maturity

Longer-dated bonds will be more sensitive to changes in the interest rate than shorter dated stocks.
3.8.3 Sensitivity to coupon

Lower coupon stocks demonstrate the greatest level of sensitivity to the yield. It should be noted that
the relationship between yield and price is not symmetrical. This is a relationship that is known as
convexity.
3.8.4 The impact of the yield

If yields are particularly high, then the flows in the future are worth relatively little and the sensitivity is
diminished. Conversely, if the yield is low then the value of flows in the future is enhanced and the bond
is more sensitive to the changing GRY.
3.8.5 Summary of volatility
High volatility Low volatility
Long dated Short dated

Low coupon High coupon
Low yields High yields
While these simple maxims are good indicators of the likely sensitivity to fluctuations in the rate of
interest, they do not allow for two bonds to be contrasted. For example, which of the following is likely
to be the most sensitive to a rise in interest rates a high-coupon, long-dated stock, or a low-coupon,
short-dated stock? In order to enable two such bonds to be compared, in the 1930s a composite
measure of risk was devised the duration.

3.9 Duration
3.9.1 What is duration?
This calculation gives each bond an overall risk weighting that allows two bonds to be compared. In
simple terms, it is a composite measure of the risk expressed in years.
Duration is the weighted average length of time to the receipt of a bond's benefits (coupon and
redemption value), the weights being the present value of the benefits involved.
3.9.2 Properties of duration

The basic features of sensitivity to interest rate risk will all be mirrored in duration.
Longer-dated bonds will have longer durations.
Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zero-coupon
bond where the duration will be the maturity.
Lower yields will give longer durations. In this case, the present value of flows in the future will rise
if the yield falls, extending the point of balance, therefore lengthening the duration.
The duration of a bond will shorten as the life span of the bond decays. However, the rate of decay will
not be at the same rate. For example a five-year bond might have a duration of 4.157 years. In a year's
time the bond might have a remaining life of four years and a duration based on the same GRY of 3.480
years. The life span has decayed by a full year, but the duration by only 0.677 of a year.
Case example: 100 year bond

In his 2012 Budget,UK Chancellor George Osborne announced a consultation on the issue of 100 year
or perpetual government bonds, to take advantage of low UK interest rates. Average gilt yields were at
th
their lowest during 2012 since the 19 century. The UK Treasury claimed that buyers would be attracted
to the bonds because of their low risk status, with the argument that the UK was a 'safe haven' for
borrowers because it had taken effective steps to reduce government debt.
Reaction to this proposal was generally not very positive. Jonathan Porter, head of the National Institute
of Social and Economic Research, argued that lenders were unlikely to invest in low interest rate bonds
unless they did not expect the economy to grow. If they were confident of growth, they would look for
a higher return investment elsewhere. A 2% return on the bonds would only be a good investment if
inflation was virtually nil, and this would suggest economic stagnation for many years. Joanne Segars,
chief executive of the National Association of Pension Funds, suggested that 100 years would be too
long for most pension funds and would not yield a strong enough return to be attractive. However
pension funds might be compelled to buy these bonds because of regulatory requirements about the
riskiness of their investment portfolios and the lack of risk-free alternatives.
3.10 Credit (default) risk
Definition
Credit risk: also referred to as default risk, is the risk undertaken by the lender that the borrower will
default either on interest payments or on the repayment of principal on the due date, or on both.

3.10.1 Credit risk aspects
C
Credit risk arises from the inability of a party to fulfil its obligation under the terms of a contract. H
Creditors to companies such as corporate bondholders and banks are exposed to credit risk. The credit A
risk of an individual loan or bond is determined by the following two factors: P
T
(a) The probability of default E
R
This is the probability that the borrower or counterparty will default on its contractual obligations
to repay its debt.
(b) The recovery rate 6
This is the fraction of the face value of an obligation that can be recovered once the borrower has
defaulted. When a company defaults, bond holders do not necessarily lose their entire investment.
Part of the investment may be recovered depending on the recovery rate.
Definition
Loss given default (LGD): is the difference between the amount of money owed by the borrower and
the amount of money recovered.
For example, a bond has a face value of 100 and the recovery rate is 80 percent. The loss given
default in this case is:
Loss given default = 100 80 = 20
Definition
Expected loss (EL): from credit risk shows the amount of money the lender should expect to lose
from the investment in a bond or loan with credit risk.
The expected loss (EL) is the product of the loss given default (LGD) and the probability of default
(PD).
EL PD LGD
If the probability of default is, say, 10 per cent, the expected loss from investing in the above bond is:
EL 0.10 20 2
3.10.2 Credit risk measurement

The measurement of credit risk is quite complex. All the approaches concentrate on the estimation of
the default probability and the recovery rate.
The oldest and most common approach is to assess the probability of default using financial and other
information on the borrowers and assign a rating that reflects the expected loss from investing in the
particular bond. This assignment of credit risk ratings is done by credit rating companies such Standard
& Poor's, Moody's Investor Services or Fitch. These ratings are widely accepted as indicators of the credit
risk of a bond. Table 1 shows the credit rating used by the two largest credit rating agencies.

Table 1: Credit risk rating
Standard & Moody's Description of category

Poor's
AAA Aaa Highest quality, lowest default risk

AA Aa High quality
A A Upper medium grade quality
BBB Baa Medium grade quality
BB Ba Lower medium grade quality
B B Speculative
CCC Caa Poor quality (high default risk)
CC Ca Highly speculative
C C Lowest grade quality
Both credit rating agencies estimate default probabilities from the empirical performance of issued
corporate bonds of each category.
3.10.3 Credit migration

There is another aspect of credit risk which should be taken into account when investors are investing in
corporate bonds, beyond the probability of default.
A borrower may not default, but due to changing economic conditions or management actions the
borrower may become more or less risky than at the time the bond was issued and as a result, the bond
issuer will be assigned by the credit agency a different credit rating. This is called credit migration.
The significance of credit migration lies in the fact that the assignment of lower credit rating will
decrease the market value of the corporate bond.
3.10.4 Credit default swaps

A credit default swap is a derivative offering protection to the holder of a bond or basket of bonds. The
buyer of the swap purchases protection against losses on the bonds caused by events such as debt
default, failure to service the debt, insolvency, restructuring or changes in the credit rating on the
bond. The buyer pays a premium to purchase protection, and the seller has to cover losses. Credit
default swaps can be used on a basket of bonds, and to protect against adverse movements on credit
market conditions.
Credit default swaps have also been used for wider trading. Investors can buy or sell protection without
holding any of the debt of the bond issuer this is known as a naked credit default swap. Naked credit
default swaps can be used for speculation on creditworthiness and future debt issues. It has been
estimated that naked credit default swaps constitute up to 80% of the credit default market. They have
also been used for capital structure arbitrage, exploiting market inefficiencies between different parts of
the same company's capital structure.
There is no exchange trading of credit default swaps and a lack of reporting requirements. Regulators
have recently become concerned that the size of the market could pose a major risk to economic
stability. Naked swaps have been criticised by many commentators, blamed by some for contributing to
the Greek financial crisis and also hastening the demise of Lehman Brothers. Supporters claim that
speculation has increased the liquidity of the swap market. They argue that the widening of Lehman's
credit default swap spread, which contributed to the lack of confidence that caused the collapse of the
bank, was itself a symptom that the bank was in trouble for other reasons.

Case example: Santander
C
Banco Santander has been generally regarded as the most stable Spanish bank. However Banco H
Santander has had to set aside almost 3 bn to cover its Spanish property losses. Following the overall A
downgrade to the credit rating of Spain as a whole in April 2012, credit rating agency Standard and P
Poor downgraded the rating of Banco Santander as well as other Spanish banks, and also downgraded T
E
the credit rating of Santander UK. R
As a result many of Santander UK's customers became worried about the safety of their investments,
particularly local authorities who were wary after a number of authorities lost money in the Icelandic
banking crash. 6
However UK rules provide reassurance to investors. Banco Santander owns 100% of the shares of
Santander UK. This means that the only way that the parent company can receive money from the UK
would be by a dividend. However the Financial Services Authority would have to sanction a dividend, in
order to ensure that Santander UK complied with UK capital adequacy rules. In addition Santander
operates a 'firewall' in its markets, which means that money it receives in the UK stays in the UK.
The increased costs Santander faces in the money market, together with its reduced credit rating, is
expected to mean that it will have to offer higher returns for investors over the next few years. It has
also been tightening its lending, reducing the volume it lends and demanding 50% deposits for interest-
only mortgages.
3.11 Credit spreads and the cost of debt capital
Definition
Credit spread: is the premium required by an investor in a corporate bond to compensate for the
credit risk of the bond.
The yield to a government bondholder is the compensation to the investor for forgoing consumption
today and saving. However, corporate bondholders should require compensation not only for forgoing
consumption, but also for the credit risk to which they are exposed. Assuming that a government bond
such as the ones issued by the US or UK governments is free of credit risk, the yield on a corporate
bond will be:
Yield on corporate bond = risk free rate + credit spread
Or in symbols y = r + s
where: y is the yield on the corporate bond
r is the risk-free rate, ie the rate on a government bond with no default risk
s is the credit spread
Since credit spreads reflect the credit risk of a bond, they will be inversely related to the credit quality
of the bond. Low credit quality bonds will be characterised by large spreads and high credit quality
bonds will be characterised by low spreads.
3.11.1 The cost of debt capital

The cost of debt capital for a company will therefore be determined by the following:
Its credit rating
The maturity of the debt
The risk-free rate at the appropriate maturity
The corporate tax rate
Cost of debt capital = (1 tax rate)(risk free rate + credit spread)

Worked example: cost of debt capital
Consider a corporate bond with a maturity of four years and a credit rating of BBB. The four-year risk-
free rate is 5% and the credit spread is 200 basis points. The corporate tax rate is 23 per cent. Find the
cost of debt capital.
Solution
Cost of debt capital = (1 0.23)(5% + 2%) = 5.39%
Case example: Government credit ratings

Credit ratings and credit spreads are not just an issue for companies. They have become a very
important issue in the world economy, reflecting fears that a number of governments may default on
their debt.
Greece's credit rating fell from an A rating in January 2009 to CC in July 2011, using Standard and
Poor's credit ratings. Under this ranking Greece was the lowest-rated country in the world. The
downgrade was a result of what the market viewed as Greek government overspending resulting in
unsustainable long-term debt levels, and lack of confidence in the government's ability to reduce its
fiscal deficit sufficiently.
Standard and Poor's regarded an international bailout deal agreed in July 2011, with a proposed
restructuring of Greek government debt, as a selective default that would result in losses for commercial
creditors. This view was reinforced by markets appearing to price for the risk of a significant default,
with impacts on interest rates on privately-held Greek bonds and prices for credit default swaps.
However a full default was expected over the longer-term. According to Thomson-Reuters the credit
default swap market was pricing in a 71% probability of a default at some time between 2011 and
2016, and an 83% probability over the 2011-2021 period. For shorter periods, the risk that Greece
might default (and the resulting impact) appeared to be a bigger influence on prices and therefore the
yield curve, than beliefs that it would default within two years.
Portugal's credit rating was cut to BBB- with a negative outlook by Standard and Poor's in March 2011,
in the expectation that the country would have to accept a bail-out from the EU. By March 2011
Portugal, like Greece, faced high yields on bonds, with yields on two-year bonds at 7.69% and on 10
year-bonds at 8.2%. Market analysts suggested that any yield above 7% was unsustainable. At times
also during the Spring of 2011 yields on 5 year bonds were above 10 year bonds. This meant that
Portugal had an inverted yield curve, reflecting significant market fears about short-term
creditworthiness.
The Portuguese government accepted a bailout in May 2011 from the European Union and
International Monetary Fund, but this failed to convince the credit rating agencies. Moody's
subsequently downgraded Portugal's long-term rating to Ba2 on the grounds that the bailout was
unlikely to succeed. Moody's felt that the government would fail to meet austerity targets and would
require a second bailout, and private creditors might suffer significant losses.
Ireland's credit rating was cut significantly by Moody's in December 2010 from Aa2 to Baa1, due to the
crystallisation of liabilities relating to the banking sector. Ireland had already accepted a bailout from the
European Union and International Monetary Fund. Moody's also believed that the fiscal adjustment
required to limit its budget deficit could significantly hinder Ireland's recovery from recession. Ireland
also faced an increase in yields on, and problems with finding buyers for, its debt.
In July 2011 Moody's cut Ireland's rating further to Ba1, because of continuing concerns about the Irish
economy, although it acknowledged that the Irish government was delivering its fiscal programme
objectives. The agency was also concerned about shifts in the opinions of other EU governments about
support for distressed countries.
However by the end of July 2011 the market appeared to be re-assessing Ireland's prospects, with
confidence increasing as a result of Ireland's government delivering on its targets and taking effective
moves to deal with the banking crisis. Yields on 10 year bonds fell significantly and trading volumes rose
to over three times their normal levels. However the yields remained some way above the yields that
would mean that Ireland could obtain affordable funding in the commercial markets. Yields on shorter-

term debt remained higher than the 10 year yields, indicating market expectations of a possible debt
restructure and further bailout. Analysts felt that many investors would only regain confidence when the C
yield curve became upward-sloping again. H
A
In August 2011, Standard and Poor's downgraded the United States of America's credit rating for the P
first time from AAA to AA+ with a negative outlook. The reduction was because of concerns about the T
E
adequacy of the government's budget deficit reduction plans and the political process in America, with
R
clashes between the two major parties weakening policymaking. The downgrade appeared to
contribute to the instability on global stock markets during August 2011, along with fears over the
American economy and the Eurozone crisis.
6
Also in August 2011 the yields on government bonds from Spain and Italy rose sharply, as investors
demanded higher returns. In the meantime the yields on Germany's government bonds fell to record
lows. Although the European Central Bank announced that it would buy Italian and Spanish
government bonds to bring down their borrowing costs, in September 2011 Italy's debt rating was cut
by Standard & Poor's from A+ to A.
During Autumn 2011 Eurozone finance ministers approved a bailout loan to Greece and proposed new
budgetary rules for the currency area. However in January 2012 Standard & Poor's downgraded the
ratings of Italy, Spain, Portugal and Cyprus by two notches and the standings of France, Austria, Malta,
Slovakia and Slovenia by one notch each. The cut put Italy onto the same BBB+ rating as Kazakhstan
and downgraded Portugal to junk status. Other countries were put on negative outlook for a possible
further downgrade. Germany was the only country to retain an AAA rating and be viewed as having a
stable outlook. In the markets German 10 year bond futures rose to a record high, while the risk
premium charged on French, Spanish, Italian and Belgian debt widened. Three days after downgrading
the nine countries, Standard & Poor's also downgraded the EU bailout fund, the European Financial
Stability Facility, from AAA to AA+.
In April 2012 Standard & Poor's reduced Spain's rating for a second time in 3 months, lowering it to
BBB+. The agency feared that Spain would have to take on more debt to support its banking sector. It
placed the country on negative outlook with the possibility of further falls. Standard & Poor's made
some positive comments about the measures taken by the Spanish government, but saw the economic
outlook for Spain as adversely affected by a failure to manage the European sovereign debt crisis
effectively and hence give investors confidence. Also in April 2012, Standard & Poor's reaffirmed
Ireland's BBB+ rating, although it put the country on a negative outlook. The agency was impressed
with the measures that the Irish government had taken, but felt that reducing the deficit to 3% by 2015
would be difficult, due to the need to rebalance private sector balance sheets and weaker than expected
growth in Ireland's trading partners.
In July 2012 Spain's 10-year bond yields topped 10%. By contrast yields of German and Austrian 2-year
bonds dropped to below zero. German, Austrian, Belgian and French borrowing costs reached historic
lows as investors sought safety in those countries.
Subsequent measures taken by the EU and ECB resulted in a widespread fall in interest rates. By October
2012 only 3 Eurozone countries (Greece, Portugal and Cyprus) still had long-term interest rates above
6%.
During October 2012, Standard & Poor's reduced Spain's rating to BBB- and Cyprus's to B because of
increasing risks that the countries were judged to face. Greece's rating was B- by the end of 2012, as the
agency took into account the determination of the EU to preserve Greek membership of the Euro.
In February 2013 Moody's downgraded the UK's credit rating from Aaa to Aa1, because it expected
economic growth over the rest of the 2010s to be sluggish. The lack of growth, with the consequent
low tax revenues and higher welfare payments, would make it more difficult to reduce the country's
budget deficit.
There were signs during 2013 that the credit agencies' ratings were coming under greater scrutiny. The
US government launched a lawsuit in 2013 against Standard and Poor's, alleging that the agency gave
excessively high ratings to win business during the boom in mortgage investments. Some
commentators questioned the transparency of the methods the rating agencies used, saying full
transparency of inputs and outputs would enable a worldwide peer review process, which would
promote rapid improvement.

Case example: Credit spreads in Eurozone
In November 2011 the credit spreads of 10 year French government bonds over equivalent German
bonds widened to 195 basis points, a record since the euro was introduced as the common currency for
both countries. The wide spread reflected concerns about large French exposure to problems in the
Greek, Spanish and Italian economies. Around 20% of France's exports go to struggling countries in
Southern Europe and about 50% to the Eurozone. Germany's pattern of exporting is much more
diversified.
3.12 Commercial paper
Definition
Commercial paper is short-term unsecured corporate debt with maturity up to 270 days. The typical
term of this debt is about 30 days.
As commercial paper is unsecured debt, it can only be issued by large organisations with good credit
ratings, normally to fund short-term expenditure on operating expenses or current assets. The debt is
issued at a discount that reflects the prevailing interest rates, but the rates on commercial paper are
typically lower than bank rates.
Commercial paper is a cheaper alternative to bank credit, although the small difference in interest rates
means that the saving on commercial paper is only significant if large sums are being raised. However
many businesses still maintain bank lines of credit even if they use commercial paper. The wide maturity
gives greater flexibility, security does not have to be given and investors can trade their commercial
paper, although the market is less liquid than for bonds. However issues are controlled, and banks that
issue ordinary commercial paper see a reduction in their credit limits.
A sub-sector of the commercial paper market, the asset-backed commercial paper market, is where the
loans are backed by assets such as mortgages or credit card debt. The concern is that asset-backed
commercial paper could be held off-balance sheet in special investment vehicles which use the funds
raised to buy longer-term assets such as mortgage-based securities. As these vehicles are off-balance
sheet, their activities do not affect the banks' ability to lend money for other reasons. However one of
the uses made of the funds raised was to invest in sub-prime mortgage backed assets. When the credit
crunch began, investors lost confidence and refused to continue the loans. As a result some of the
special investment vehicles had to be bailed out by the banks that created them.
3.13 The overnight market

In the overnight market lenders agree to lend borrowers funds on the basis that the borrowers repay the
funds plus interest at the start of business next day. Because of this short time period, banks' overnight
rates are the lowest rates at which they will lend money.
The overnight market is used by banks and financial institutions who firstly establish their customers'
needs over the day. If there is a surplus or deficit between the money the institutions have on hand and
the needs of customers during a day, the institutions will lend or buy on the overnight market at the
start of the business day. During the day, as information about the needs of customers changes, the
institutions will lend or borrow further on this market.
Case example: The impact of low interest rates

The Bank of England reduced its lending rate in the UK to 0.5% in March 2009 and has not raised it
since (ie to September 2013 at the time of writing), in order to help the UK economy recover from
recession. Although the rate of UK inflation was between 4-5% by the summer of 2011, the Bank has
not used increases in interest rates to bring the rate down. By contrast in the early 1990s interest rates
were maintained at much higher levels with the aim of a long-term reduction in inflation, despite other
adverse impacts on the economy. The American Federal Reserve also announced in 2011 that it would
be keeping interest rates near zero until at least the middle of 2013.

Predictions in the summer of 2011 suggested that the Bank's lending rate was unlikely to rise until 2013.
Economic decisions were being made in the context of a situation where significant rises in interest rates C
in the short and medium-term looked very unlikely. H
A
However doubts have been expressed since 2009 about whether low rates have done much to improve P
the economy. Banks wishing to improve their statements of financial position have limited the T
availability of loan finance. UK government measures to reduce the budget deficit appear to have had E
R
an adverse impact on confidence, with many fearing unemployment. Pay increases have also fallen
behind inflation. In April 2011 average pay rose at an annual rate of just 1.8% a year compared with an
increase in the consumer prices index of 4.5%. In the housing market a survey from the Royal
6
Institution of Chartered Surveyors in August 2011 suggested that sales were at their lowest level since
the summer of 2009. Banks have been reluctant to approve new mortgages, with mortgage approvals
in 2011 about half the average in the previous 10 years. Low interest rates appeared to have helped
mortgage holders, with arrears and home repossessions falling during the first half of 2011. However a
survey suggested that almost one-in-four Britons were concerned that they wouldn't be able to afford
their interest payments if mortgage rates did increase.
In the US it has seemed that many consumers and investors have been unwilling to take the kind of risks
that could stimulate economic growth. Many consumers have appeared to be primarily concerned
about paying off existing debt rather than making expensive purchases and taking on new debt.
Companies have appeared to be reluctant to hire workers on a large scale. Many investors have not
speculated on shares and instead have made safer investments, in gold or farmland, a trend that
appeared likely to increase as a result of the significant stock market swings in early August 2011.
The opinions of economic commentators in 2011 about the desirability of low rates for some time have
varied. In June 2011 the Bank for International Settlements (BIS) stated that central banks should start
raising interest rates to curb inflation, and governments act to reduce budget deficits even if economic
growth slowed down as a result. Policymakers should have low expectations of growth because growth
rates prior to 2008 had been unsustainable. The BIS stated that rates needed to increase to facilitate
necessary adjustments in household and bank finance. The BIS was also concerned that low interest
rates in major economies could lead to international distortion and instability, with an undesirable
increase in credit growth without changes in domestic saving.
However the governor of the Bank of England, Sir Mervyn King, remained concerned that an increase in
interest rates could result in a deep recession in the UK. Other commentators stressed the need for low
interest rates to be maintained to encourage consumer spending, even if it meant that savers faced low
income. Charlie Bean, the deputy governor of the Bank of England, pointed out that many older savers
have benefited from large capital gains on their houses, these gains being fuelled by the indebtedness
younger house-buying borrowers took on in the credit expansion prior to 2007. Higher rates would
mean that unemployment would rise, the number of defaults would increase and banks would face
more difficulties.
Figures released in 2012 highlighted problems that final salary pension schemes were facing as a result
of low gilt yields. Falling yields have meant that the discounted value of pension scheme liabilities have
risen, increasing deficits. Pension spokesperson Ros Altmann highlighted the possible existence of a
'death spiral ' for pension schemes. Increasing deficits mean that trustees are trying to reduce risk, but
the obvious risk-free option is to buy gilts. The situation is exacerbated by the fact that schemes are in
competition with the Bank of England, which is implementing quantitative easing by buying gilts. As a
result in the period 20112012 pension deficits have more than doubled, despite companies pumping
millions into their schemes to reduce their pension shortfalls.
We discussed in the last chapter how problems with pension schemes might, for example, impact on
acquisitions. Ros Altmann highlighted the general impact on investment, with firms spending money to
reduce deficits rather than creating jobs and expanding operations. In addition the size of their pension
deficits was making it more difficult for some companies to borrow from banks.

4 Financial restructuring
Section overview
Financial restructuring takes place when firms get into financial difficulty, or as part of an overall
strategy to increase firm value.
A financial reconstruction scheme is where a firm reorganises its capital structure.
The success or otherwise of a financial reconstruction scheme can be assessed by its impact on the
firm's growth rate, its risk and associated rate of return.
Methods of reconstruction include leveraged buy-outs, debt for equity swaps and leveraged
recapitalisations.
Markets tend to respond positively to financial reconstructions.
4.1 Reconstruction schemes

Reconstruction schemes are undertaken when companies have got into difficulties or as part of a
strategy to enhance the value of the firm for its owners.
4.1.1 Reconstruction schemes to prevent business failure

Not all businesses are profitable. Some incur losses in one or more years, but eventually achieve
profitability. Others remain unprofitable, or earn only very small and unsatisfactory profits. Other
companies are profitable, but run out of cash.
A poorly performing company which is unprofitable, but has enough cash to keep going, might
eventually decide to go into liquidation, because it is not worth carrying on in business.
Alternatively, it might become the target of a successful takeover bid.
A company which runs out of cash, even if it is profitable, might be forced into liquidation by
unpaid creditors, who want payment and think that applying to the court to wind up the company
is the best way of getting some or all of their money.
However, a company might be on the brink of going into liquidation, but hold out good promise of
profits in the future. In such a situation, the company might be able to attract fresh capital and to
persuade its creditors to accept some securities in the company as 'payment', and achieve a capital
reconstruction which allows the company to carry on in business.
4.1.2 Reconstruction schemes for value creation

Reconstruction schemes may also be undertaken by companies which are not in difficulties as part of a
strategy to create value for the owners of the company. The management of a company can improve
operations and increase the value of the company by:
Reducing costs through the sale of a poorly performing division or subsidiary.
Increasing revenue or reducing costs through an acquisition to exploit revenue or cost economies.
Improving the financial structure of the company.
4.1.3 Types of reconstruction

Depending on the actions that a company needs to take as part of its reconstruction plans, these
schemes are usually classified in three categories:
Financial reconstruction which involves changing the capital structure of the firm.
Portfolio reconstruction, which involves making additions to or disposals from companies'
businesses eg through acquisitions or spin-offs.
Organisational restructuring, which involves changing the organisational structure of the firm.

4.1.4 Designing reconstructions
C
You can use the following approach to designing reconstructions. H
A
Step 1 Estimate the position of each party if liquidation is to go ahead. This will represent the P
minimum acceptable payment for each group. T
E
Step 2 Assess additional sources of finance, for example selling assets, issuing shares, raising loans. R
The company will most likely need more finance to keep going.
Step 3 Design the reconstruction. Often the question will give you details of how to do it.
6
Step 4 Calculate and assess the new position, and also how each group has fared, and compare
with Step 1 position.
Step 5 Check that the company is financially viable after the reconstruction.
In addition you should remember the following points when designing the reconstruction.
Anyone providing extra finance for an ailing company must be persuaded that the expected return
from the extra finance is attractive. A profit forecast and a cash forecast or a funds flow forecast will
be needed to provide reassurance about the company's future, to creditors and to any financial
institution that is asked to put new capital into the company. The reconstruction must indicate that
the company has a good chance of being financially viable.
The actual reconstruction might involve the creation of new share capital of a different nominal
value than existing share capital, or the cancellation of existing share capital. It can also involve the
conversion of equity to debt, debt to equity, and debt of one type to debt of another.
For a scheme of reconstruction to be acceptable it needs to treat all parties fairly (for example,
preference shareholders must not be treated with disproportionate favour in comparison with
equity shareholders), and it needs to offer creditors a better deal than if the company went into
liquidation. If it did not, the creditors would press for a winding up of the company. A
reconstruction might therefore include an arrangement to pay off the company's existing debts in
full.
4.2 Financial reconstructions

A financial reconstruction scheme is a scheme whereby a company reorganises its capital structure,
including leveraged buyouts, leveraged recapitalisations and debt for equity swaps.
There are many possible reasons why management would wish to restructure a company's finances.
A reconstruction scheme might be agreed when a company is in danger of being put into liquidation,
owing debts that it cannot repay, and so the creditors of the company agree to accept securities in the
company, perhaps including equity shares, in settlement of their debts. On the other hand a company
may be willing to undergo some financial restructuring to better position itself for long-term success.
4.2.1 Leveraged capitalisations

In leveraged recapitalisation a firm replaces the majority of its equity with a package of debt securities
consisting of both senior and subordinated debt. Leveraged capitalisations are employed by firms as
defence mechanisms to protect them from takeovers. The high level of debt in the company
discourages corporate raiders who will not be able to borrow against the assets of the target firm in
order to finance the acquisition.
In order to avoid the possible financial distress arising from the high level of debt, companies that
engage in leveraged capitalisation should be relatively debt free, they should have stable cash flows and
they should not require substantial ongoing capital expenditure in order to retain their competitive
position.
4.2.2 Debt-equity swaps

A second way in which a company may change its capital is to issue a debt/equity or an equity/debt
swap. In the case of an equity/debt swap, all specified shareholders are given the right to exchange their
stock for a predetermined amount of debt (ie bonds) in the same company. A debt/equity swap works
the opposite way: debt is exchanged for a predetermined amount of equity (or stock). The value of the
swap is determined usually at current market rates, but management may offer higher exchange values

to entice share and debtholders to participate in the swap. After the swap takes place, the preceding
asset class is cancelled for the newly acquired asset class.
One possible reason that the company may engage in debt-equity swaps is because the company must
meet certain contractual obligations, such as maintaining a debt/equity ratio below a certain number.
Also a company may issue equity to avoid making coupon and face value payments because they feel
they will be unable to do so in the future.
Worked example: Financing policy

For illustration, assume there is an investor who owns a total of 2,000 in ABC plc shares. ABC has
offered all shareholders the option to swap their shares for debt at a rate of 1.5:1. What is the value of
the debt that the investor will receive?
Solution
The investor would receive, if he elected to take the swap, 3,000 (1.5 2,000) worth of debt, gaining
1,000 for switching asset classes. However, the investor would lose all rights as a shareholder, such as
voting rights, if he swapped his equity for debt.
4.2.3 Leveraged buy-outs

A leveraged buy-out is a transaction in which a group of private investors uses debt financing to
purchase a company or part of a company. In a leveraged buy-out, like a leveraged capitalisation, the
company increases its level of gearing, but unlike the case of leveraged capitalisations, the company no
longer has access to equity markets.
4.2.4 Dividend policy

A company may change its dividend policy as part of financial restructuring and increase retained
earnings and therefore its equity base.
4.3 Financial reconstruction and firm value

The impact of a financial reconstruction scheme on the value of the firm can be assessed in terms of its
effect on the growth rate of the company, its risk and its required rate of return.
4.4 Effect on growth rate

The impact of changes in financial policy on the value of the firm can be assessed through one of the
valuation models that we have considered in previous chapters. For example, the growth rate following
a financial restructuring can be calculated from the formula:
D
g = b ROA + ROA i 1 t
E
where: ROA is the return on the net assets of the company

b is the retention rate
D is the book value of debt
E is the book value of equity
i is the cost of debt
t is the corporate tax rate
Changes in the level of debt will be reflected in the growth rate through its impact on the debt ratio
D/E. Similarly, changes in dividend policy can be reflected in the earnings growth rate. Changes in the
dividend policy will change the value of b. Decreasing dividends (a higher b) will increase the growth
rate, and increasing dividends will decrease the growth rate.

Worked example: Financing policy
C
A firm currently has a debt-equity ratio of 0.12 and a return on assets (ROA) equal to 15 per cent. The H
firm could raise the debt-equity ratio up to 0.30 without increasing the risk of bankruptcy. The firm A
plans to borrow and repurchase equity shares to get to this optimal ratio. The interest rate is expected P
to increase from 7 per cent to 9 per cent. The tax rate is 23 per cent and the retention rate is 50 per T
E
cent. Find the impact of the increase in debt on the growth rate. R
Solution
6
Before the increase in the debt ratio we have:
ROA = 0.15 D/E = 0.12 i = 0.07
B = 0.50 t = 0.23
D
E
g = 0.5(0.15 + 0.12(0.15 0.07(1 0.23))) = 0.0808

After the increase in the debt ratio we have:
ROA = 0.15 D/E = 0.30 i = 0.09
B = 0.50 t = 0.23
D
E
g = 0.5(0.15 + 0.30(0.15 0.09 (1 0.23)) = 0.0871

The increase in the debt-equity ratio will raise the growth rate from 8.08 per cent to 8.71 per cent.
Worked example: Dividend policy

Continuing the previous example suppose that the firm plans to reduce its dividend payout to 30 per
cent and maintain its original debt-equity ratio of 0.12. What is the impact on the growth rate?
Solution
The growth rate before the reduction in the dividend payout ratio is 0.0808. The growth rate after the
decrease in the payout rate (ie increase in b) is:
D
E
g = 0.7(0.15 + 0.12(0.15 0.07 (1 0.23))) = 0.1131

The increase in the retention rate will raise the growth rate from 8.08 per cent to 11.31 per cent, that is
by more than 3 percentage points.
Case example: Low or no dividends

Berkshire Hathaway
At a recent annual general meeting of Berkshire Hathaway Inc, its Chairman and Chief Executive Officer,
American investment guru, Warren Buffett, commented that the value of the corporation's shares would
decline if it declared a dividend. Berkshire had shunned payouts and buybacks, instead using profits to
make acquisitions and buy securities, generating more than a dollar of market value for every dollar
reinvested. However Berkshire's big cash hoards meant it was becoming harder to effectively invest the
profits.

TPK Holding
In China in April 2011, the shares of TPK Holding Co, a touch panel maker, fell in value after the
company declared a low stock dividend of NT$0.50 compared with earnings per share of NT$23.83.
The fall came despite TPK's plans to use the funds it retained for production expansion to meet a boom
in demand, particularly from Apple for whom TPK was a major supplier. However investors had wanted
to reap short-term earnings and had expected a dividend of at least NT$10.
UK dividend payments
In the UK in 2011, UK firms were set to pay out 64.2bn in dividends, up 13.6% on 2010, according to
research by Capita Registrars. An economic forecast from the Ernst and Young Item Club called on
companies to do more to invest spare cash, or release it to shareholders via dividends and share
buybacks.
Trinity Mirror
Some alternative uses of cash have not convinced the market. The share price of the newspaper
publisher Trinity Mirror fell 22% in March 2011, when the company indicated that it would be focusing
on expanding its regional press portfolio and failed to pay a dividend, despite a rise in pre-tax profits.
The group spokesman claimed that economies of scale in regional media could create value for
shareholders. However investors appeared to doubt the potential of the regional newspaper market,
with well-flagged difficulties such as long-term circulation decline, online competition and the
fragmentation of advertising spend.
4.4.1 Effect on systematic risk

The effect of a reconstruction on the systematic risk of a company can be considered by calculating the
revised geared beta using the following formula.
D(1 T)
e = a (1+ )
E
where: a = the asset beta, and

e = the geared beta
A higher level of debt will increase the geared beta of the company, and a lower level of debt will
reduce it.
Worked example: Effect on risk

A firm currently has a debt equity ratio of 0.12 and an asset beta of 0.9. The firm could raise the debt
equity ratio up to 0.30 without increasing the risk of bankruptcy. The firm plans to borrow and
repurchase stock to get to this optimal ratio. The interest rate is expected to increase from 7 per cent to
8 per cent. The tax rate is 23 per cent. Find the impact of the increase in debt on the geared beta.
Solution
Before the increase in the debt ratio we have:
D/E = 0.12
T = 0.23
a = 0.9
e = a(1 + [D(1 T)/E]) = 0.9(1 + 0.12[1 0.23]) = 0.983
After the increase in the debt ratio we have:
D/E = 0.30
T = 0.23
a = 0.9

The new beta following the change in the level of debt will be:
C
e = a(1 + [D(1 T)/E]) = 0.9(1 + 0.30[1 0.23]) = 1.108 H
A
P
T
4.4.2 Leveraged buy-outs (LBOs) E
R
In an LBO a publicly quoted company is acquired by a specialist established private company. The
private company funds the acquisition by substantial borrowing.
6
4.4.3 Procedures for going private
A public company 'goes private' when a small group of individuals, possibly including existing
shareholders and/or managers and with or without support from a financial institution, buys all of the
company's shares. This form of restructuring is relatively common in the USA and may involve the shares
in the company ceasing to be listed on a stock exchange.
4.4.4 Advantages of leveraged buy-outs

The costs of meeting listing requirements can be saved.
The company is protected from volatility in share prices which financial problems may create.
The company will be less vulnerable to hostile takeover bids.
Management can concentrate on the long-term needs of the business rather than the short-term
expectations of shareholders.
Shareholders are likely to be closer to management in a private company, reducing costs arising
from the separation of ownership and control (the 'agency problem').
4.4.5 Disadvantages of leveraged buy-outs

The main disadvantage with leveraged buy outs is that the company loses its ability to have its shares
publicly traded. If a share cannot be traded it may lose some of its value. However, one reason for
seeking private company status is that the company has had difficulties as a quoted company, and the
prices of its shares may be low anyway.
Case example: Going private

One example of going private was Richard Branson's repurchase of shares in the Virgin Company from
the public and from financial institutions. Another example was SAGA the tour operator which changed
status from public to private in 1990. While public, 63% of the company was owned by one family. The
family raised finance to buy all of the shares, to avoid the possibility of hostile takeover bids and to avoid
conflicts between the long-term needs of the business and the short-term expectations which
institutional shareholders in particular are often claimed to have.
More recently, the Matthews family have been considering a management buy-out to buy back the
publicly held shares in their family turkey business, Bernard Matthews. It was held that the company was
being undervalued by the stock market and, after 29 years as a listed company, the Matthews family
wanted it back. Sara Lee, another food producer, made a counter bid but subsequently pulled out.
4.5 Market response to financial reconstruction

The market response to financial reconstruction has been estimated from empirical studies of the
behaviour of share prices.
The empirical evidence shows that the market responds positively to financial restructuring. The
evidence shows that the market reacts positively to firms raising their level of debt up to a certain level,
since the constraint that debt imposes on future cash flows makes companies choosier when selecting
investment opportunities.

A number of studies have dealt with the performance of leveraged buy-outs. Since the company
becomes private as a result of the leveraged buy-out we cannot assess the impact of the equity market
value. However, most studies show that a company does significantly better after the leveraged buy-out.
More specifically leveraged buy-outs result in increases in free cash flow, improved operational efficiency
and a greater focus on the company's core business. The causes of the improvement following financial
restructuring are reportedly benign and cannot be attributed to lay-offs of employees rather the
increased efficiency of operations coupled with improved control of capital expenditure seem to
account for much of the difference.
The empirical evidence also shows that leveraged buy-outs which involve divisions of companies seem
to display larger improvement gains than corporate leveraged buy-outs. On the other hand, the authors
do enter a caveat, as the risk of bankruptcy and financial disaster with leveraged buy-outs seems to be
greater. Moreover, leveraged buy-outs would appear to under-invest in long-term assets where the risk
is greater.
The market reaction to dividend changes has been studied extensively. Most studies show abnormally
high returns for dividend increases and abnormally low returns for dividend decreases around the
announcement days.
4.6 Case study in financial reconstruction

Crosby and Dawson Ltd is a private company that has for many years been making mechanical timing
mechanisms for washing machines. The management was slow to appreciate the impact that new
technology would have and the company is now faced with rapidly falling sales.
In July 20X1, the directors decided that the best way to exploit their company's expertise in the future
was to diversify into the high precision field of control linkages for aircraft, rockets, satellites and space
probes. By January 20X2, some sales had been made to European companies and sufficient progress
had been made to arouse considerable interest from the major aircraft manufacturers and from NASA in
the USA. The cost, however, had been heavy. The company had borrowed 2,500,000 from the Vencap
Merchant Bank plc and a further 500,000 from other sources. Its bank overdraft was at its limit of
750,000 and the dividend on its cumulative preference shares, which was due in December, had been
unpaid for the fourth year in succession. On 1 February 20X2, the company has just lost another two
major customers for its washing machine timers. The financial director presents the following
information.
If the company remains in operation, the expected cash flows for the next five periods are as follows.
9 months Years ending 31 December
to
31.12.X2 20X3 20X4 20X5 20X6
'000 '000 '000 '000 '000
Receipts from sales 8,000 12,000 15,000 20,000 30,000
Payments to suppliers 6,000 6,700 7,500 10,800 18,000
Purchase of equipment 1,000 800 1,600 2,700 2,500
Other expenses 1,800 4,100 4,200 4,600 6,400
Interest charges 800 900 700 400 100
9,600 12,500 14,000 18,500 27,000
Net (1,600) (500) 1,000 1,500 3,000
The above figures are based on the assumption that the present capital structure is maintained by
further borrowings as necessary.

STATEMENTS OF FINANCIAL POSITION
C
31.3.X2
H
31.12.X0 31.12.X1 Projected A
'000 '000 '000 P
Assets employed T
Non-current assets E
R
Freehold property 2,780 2,770 2,760
Plant and machinery 3,070 1,810 1,920
Motor vehicles 250 205 200
6
Deferred development expenditure 700 790
Current assets
Inventories 890 970 1,015
Receivables 780 795 725
1,670 1,765 1,740
Current liabilities
Trade payables 1,220 1,100 1,960
Bank overdraft (unsecured) 650 750 750
1,870 1,850 2,710
(200) (85) (970)

5,900 5,400 4,700
Long-term liabilities
10% debentures 20X8 (secured on
Freehold property) (1,000) (1,000) (1,000)
Other loans (floating charges) (3,000) (3,000)
4,900 1,400 700
Ordinary shares of 1 3,500 3,500 3,500

8% Cumulative preference shares 1,000 1,000 1,000
Accumulated reserves/(accumulated deficit) 400 (3,100) (3,800)
4,900 1,400 700
Other information
1 The freehold property was revalued on 31 December 20X0. It is believed that its net disposal value
at 31 March 20X2 will be about 3,000,000.
2 A substantial quantity of old plant was sold during the second six months of 20X1 to help pay for
the new machinery needed. It is estimated that the break up value of the plant at 31 March 20X2
will be about 1,400,000.
3 The motor vehicles owned at 31 March 20X2 could be sold for 120,000.
4 Much of the work done on the new control linkages has been patented. It is believed that these
patents could be sold for about 800,000, which can be considered as the break-up value of
development expenditure incurred to 31 March 20X2.
5 On liquidation, it is expected that the current assets at 31 March 20X2 would realise 1,050,000.
Liquidation costs would be approximately 300,000.
Requirement
Suggest a scheme of reconstruction that is likely to be acceptable to all the parties involved. The
ordinary shareholders would be prepared to invest a further 1,200,000 if the scheme were considered
by them to be reasonable.
A full solution follows. Complete the first step yourself as a short question.

Interactive question 8: Proceeds from liquidation [Difficulty level: Intermediate]
Ascertain the likely result of Crosby & Dawson Limited (see above) going into liquidation as at 31 March
20X2.
Solution to remainder of the example

If the company was forced into liquidation, the debentures and other loans would be met in full but
after allowing for the expenses of liquidation (300,000) the bank and trade payables would receive a
total of 2,070,000 or 76p per pound. The ordinary and preference shareholders would receive
nothing.
If the company remains in operation, the cash position will at first deteriorate but will improve from
20X4 onwards. By the end of 20X6 net assets will have increased by 12,000,000 before depreciation
(plant 8,600,000 and cash 3,400,000). If the figures can be relied on and the trend of results
continues after 20X6 the company will become reasonably profitable.
In the immediate future, after taking into account the additional amounts raised from the existing
ordinary shareholders, the company will require finance of 400,000 in 20X2 and 500,000 in 20X3.
Vencap might be persuaded to subscribe cash for ordinary shares. It is unlikely that the company's
clearing bank would be prepared to accept any shares, but as they would only receive 76p per pound
on a liquidation they may be prepared to transfer part of the overdraft into a (say) five-year loan while
maintaining the current overdraft limit. It is unlikely that a suitable arrangement can be reached with
the trade creditors as many would be prepared to accept 76p per pound, rather than agree to a
moratorium on the debts or take an equity interest in the company.
A possible scheme might be as follows.
1 The existing ordinary shares to be cancelled and ordinary shareholders to be issued with
1,200,000 new 1 ordinary shares for cash.
2 The existing preference shares to be cancelled and the holders to be issued with 320,000 new
1 ordinary shares at par.
3 The existing debentures to be cancelled and replaced by 800,000 15% secured debentures
with a 15 year term and the holders to be issued with 400,000 of new 1 ordinary shares at par.
4 The loan 'from other sources' to be repaid.
5 The Vencap Bank to receive 2,000,000 15% secured debentures with a 15-year term in part
settlement of the existing loan, to be issued 680,000 new ordinary shares in settlement of the
balance and to subscribe cash for 800,000 of new ordinary shares.
6 The clearing bank to transfer the existing overdraft to a loan account repayable over five years
and to keep the overdraft limit at 750,000. Both the loan and overdraft to be secured by a
floating charge.
Comments
1 Debenture holders
The debentures currently have more than adequate asset backing, and their current nominal
yield is 10%. If the reconstruction is to be acceptable to them, they must have either the same
asset backing or some compensation in terms of increased nominal value and higher nominal
yield. Under the scheme they will receive securities with a total nominal value of 1,200,000 (an
increase of 200,000) and an increase in total yield before any ordinary dividends of 20,000. The
new debentures issued to Vencap can be secured on the freehold property (see below).
2 Loans from other sources
It has been suggested that the 'loans from other sources' should be repaid as, in general, it is easier
to arrange a successful reconstruction that involves fewer parties.

3 Vencap
C
Vencap's existing loan of 2,500,000 will, under the proposed scheme, be changed into
H
2,000,000 of 15% debentures secured on the property and 680,000 of ordinary shares. This A
gives total loans of 2,800,000 secured on property with a net disposal value of 3,000,000. This is P
low asset cover which might increase if property values were to rise. The scheme will increase the T
nominal value of Vencap's interest by 180,000 with an improvement in security on the first E
R
2,000,000 to compensate for the risk involved in holding ordinary shares. It has also been
suggested that Vencap should be asked to subscribe 800,000 for new ordinary shares. From the
company's point of view issuing new equity is to be preferred to loan stock as it will improve the
6
gearing position.
4 The clearing bank
In a liquidation now, the clearing bank would receive approximately 573,000. In return for the
possibility of receiving the full amount owed to them they are being asked under the scheme to
advance a further 750,000. By way of compensation, they are receiving the security of a
floating charge.
5 Preference shares
In a liquidation at the present time, the preference shareholders would receive nothing. The issue
of 320,000 1 ordinary shares should be acceptable as it is equivalent to their current arrears of
dividend.
6 Ordinary shareholders
In a liquidation, the ordinary shareholders would also receive nothing. Under the scheme, they will
lose control of the company but, in exchange for their additional investment, will still hold about
35.3% of the equity in a company which will have sufficient funds to finance the expected future
capital requirements.
7 Cash flow forecast, on reconstruction
'000
Cash for new shares from equity shareholders 1,200
Cash for new shares from Vencap 800
2,000
Repayment of loan from other sources (500)
Cash available 1,500
The overdraft of 750,000 is converted into a long-term loan, leaving the company with a further
750,000 of overdraft facility to use.
8 Adequacy of funds
The statement of assets and liabilities below shows the company's position after the
implementation of the scheme but before any repayments to trade payables.
'000 '000
Non-current assets
Freehold property 2,760
Motor vehicles 200
Deferred development expenditure 790
5,670
Current assets
Inventories 1,015
Receivables 725
Cash 1,500
3,240
Less: Current liabilities: Trade payables 1,960
1,280
6,950
Less: Long-term liabilities
15% debentures (2,800)
Loan from clearing bank (750)
3,400
Ordinary shares of 1 3,400

It would seem likely that the company will have to make a bigger investment in working capital
(ignoring cash) for the following reasons.
(a) Presumably a substantial proportion of the sales will be exports which generally have a longer
collection period than domestic sales.
(b) It is unlikely that the trade payables will accept the current payment position (average credit
takes over two months) in the long term.
9 Will the reconstructed company be financially viable?
Assuming that net current assets excluding cash and any overdraft will, by the end of 20X2, rise
from the projected figure of 220,000 (1,015,000 + 725,000 1,960,000) to 500,000 and
increase in proportion to sales receipts thereafter, that the equipment required in 20X2 and 20X3
will be leased on five-year terms and that the interest charges (including the finance elements in
the lease rentals) will be approximately the same as those given in the question, then the expected
cash flows on implementation could be as shown below.
9 months to
31.12.X2 20X3 20X4 20X5 20X6
'000 '000 '000 '000 '000
Receipts from sales 8,000 12,000 15,000 20,000 30,000
Purchase of equipment 1,600 2,700 2,500
Payments to suppliers 6,000 6,700 7,500 10,800 18,000
Other expenses 1,800 4,100 4,200 4,600 6,400
Interest charges 800 900 700 400 100
Lease rentals (excluding
finance element) (say) 200 360 360 360 360
Bank loan repayment (say) 150 150 150 150 150
Invt. in working capital 720 250 190 310 630
9,670 12,460 14,700 19,320 28,140
Net movement (1,670) (460) 300 680 1,860
Cash balance b/f 1,500 (170) (630) (330) 350
Cash balance c/f (170) (630) (330) 350 2,210
These figures suggest that with an agreed overdraft limit of 750,000 the company will have
sufficient funds to carry it through the next five years, assuming that the figures are reliable and
that no dividends are paid until perhaps 20X4 at the earliest.
This scheme of reconstruction might not be acceptable to all parties, if the future profits of the
company seem unattractive. In particular, Vencap and the clearing bank might be reluctant to
agree to the scheme. In such an event, an alternative scheme of reconstruction must be designed,
perhaps involving another provider of funds (such as another venture capitalist). Otherwise, the
company will be forced into liquidation.
Case example: United Airlines

United Airlines, which went into Chapter 11 bankruptcy in 2002, is a huge restructuring success story.
Its stringent cost cutting exercises, including staff, routes and services offered on board meant that the
airline emerged from Chapter 11 in 2006 a leaner, more competitive company. In February 2007, it
used cash to pay down $972 million of its original $3 billion exit facility and refinanced the remaining
$2 billion. The transaction resulted in significantly lower interest costs, less restrictive covenants and
released approximately $2.5 billion of collateral. This restructuring of the exit facility to a lower rate
reflected an improved financial condition and greater market confidence.
The new credit facility consisted of a $1.8 billion term loan and a $255 million revolving credit line. The
oversubscribed refinancing allowed United to reduce its financing costs by 175 basis points to 200 basis
points over LIBOR. The lower pricing is expected to result in annual net pre-tax savings of
approximately $70 million.
The refinancing allowed United to remove 101 aircraft and the airline's spare parts inventory valued at
approximately $2.5 billion from the collateral pool. There is no restriction on the use of these assets to
secure new financing, providing an additional source of liquidity if required.

Interactive question 9: Financial reconstruction [Difficulty level: Intermediate]
C
Adrian Walsh Ltd produces hand-made furniture. The company is currently facing financial difficulties H
which have been made worse by the recent cancellation of three major orders by important customers. A
P
The company's overdraft limit of 3 million has been reached and the bank has refused to grant any T
further credit. No dividends have been paid on the cumulative preference shares for five years, and the E
shareholders are becoming impatient. R
The company has just completed a projected statement of assets and liabilities.
Projected Statement of Assets and Liabilities at 31 December 20X9 6
'000 '000
Non-current assets
Buildings (freehold) 11,000
Delivery vehicles 800
Deferred development expenditure 3,150
Current assets
Inventory 4,000
Trade receivables 2,900
6,900
Current liabilities
Trade payables 7,750
Bank overdraft 3,000
10,750
Current assets less current liabilities (3,850)

Non-current liabilities
8% loan (20Y5) secured on buildings 4,000
Other loans (floating charges) 12,000
(16,000)
2,850
Ordinary shares of 1 each 14,000

7% cumulative preference shares 4,000
Retained earnings/(deficit) (15,150)
2,850
Other information is available as follows.

The market value of the freehold buildings is estimated at 11,250,000.
Delivery vehicles have a current resale value of 500,000.
Plant and equipment could be sold for approximately 5,000,000.
Approximate liquidation costs are 1,250,000.
The patents to the furniture designs could be sold to a rival company for an estimated 3,125,000. This
is considered to be the break-up value of the development expenditure.
Current assets could be sold for approximately 4,000,000.
The company wants to avoid liquidation as it is due to launch a design and manufacturing service for
wooden gifts, from jewellery boxes to rocking horses, which is expected to be very successful.
A scheme of reconstruction has been suggested as follows.
Cancel existing ordinary shares and issue existing ordinary shareholders with 5,000,000 new 1
ordinary shares for 1 cash each.
Cancel existing preference shares and issue existing holders with 1,250,000 new 1 ordinary shares.
Repay the bank overdraft. Maintain existing overdraft limit but secure it with a floating charge.

Cancel the existing secured loan. Replace it with a 3,125,000 8% secured debenture loan (five year
maturity) and 1,500,000 ordinary shares.
The floating charges loans would be replaced with an 8,000,000 12% loan (secured on the freehold
buildings) and 2,750,000 in 1 new ordinary shares.
The company estimates that, with this restructuring in place, earnings before interest and tax will
increase to 3,600,000.
The current P/E ratio for the industry is 10.8. Tax is charged at 23%.
Requirement
Calculate whether the reconstruction scheme is likely to succeed.
5 Refinancing and securitisation
Section overview
Refinancing is the application for a secured loan to replace an existing loan secured by the same
assets.
Refinancing may take place to reduce interest costs, pay off other debts or reduce risk.
Although refinancing may reduce interest costs, there may be fees related to refinancing a loan
that may outweigh any savings.
Securitisation involves the conversion of illiquid assets into marketable asset-backed securities.
5.1 Refinancing
5.1.1 Refinancing to reduce interest payments
Refinancing can be undertaken at relatively small levels such as individuals refinancing a mortgage or
at a high level involving companies refinancing multi-million pound debts. Whatever the level, the aim
is often to reduce costs, normally interest payments, by switching to a loan with a lower interest rate or
by extending the period of the loan. The money saved might be used to pay off some of the principal
of the loan, which can reduce payments even further.
5.1.2 Refinancing to reduce risk

As well as reducing interest payments, companies may refinance to reduce the risk associated with an
existing loan. For example, rather than having a variable rate loan, companies may switch to a fixed
rate loan, which will eliminate the uncertainty of how much interest will have to be paid in any
particular month. This might be particularly useful for small businesses that are just starting up as they
face a great deal of risk anyway and any opportunities to reduce risk should be welcomed.
5.1.3 Refinancing to pay off debts

Refinancing a loan or a series of loans might help companies to pay off high interest debt and replace it
with lower interest debt. Alternatively debt can be replaced with more flexible debt having perhaps a
longer term to maturity or fewer restrictive covenants. Individuals are often urged to do this via
advertisements urging them to consolidate their debts into one debt. Non-tax deductible debt might
be replaced by tax-deductible debt, thus allowing the borrower to take advantage of tax deductions as
well as potential reductions in interest payments.
5.1.4 Issues to be aware of when thinking about refinancing

Although refinancing may appear to be an attractive option, you should always do your homework
before making a decision. Some loans have penalty clauses that come into play if the loans are paid off
early, whether partially or in full. Some of these penalties can be quite steep, so make sure you read the

small print. In addition, there are usually closing and transaction fees associated with refinancing a loan.
By the time penalty clauses and other fees are taken into consideration, they may actually outweigh the C
savings being made. Therefore, refinancing should only be considered as a source of finance if the H
A
short-term or long-term savings are likely to be substantial.
P
Depending on the type of loan used to refinance existing debt, lower initial payments may give way to T
larger total interest costs over the life of the loan. The borrower might also be exposed to greater risks E
R
than the existing loan. It is therefore vital that any upfront, variable and on-going refinancing costs are
researched thoroughly before deciding whether to refinance existing debt.
6
5.2 Securitisation
Securitisation is the process of converting illiquid assets into marketable securities. These securities are
backed by specific assets and are normally called asset-backed securities (ABS). Securitisation started
with banks converting their long-term loans such as mortgages into securities and selling them to
institutional investors. One of the problems of banks as financial intermediaries is the fundamental
mismatch between the maturities of assets and liabilities. Securitisation of loans and sale to investors
with more long-term liabilities reduces the mismatch problem and a bank's overall risk profile.
The oldest and most common type of asset securitisation is the mortgage-backed bond or security (MBS),
although today one can expect virtually anything that has a cash flow to be a candidate for securitisation,
(eg future season ticket sales for football clubs).
In a typical ABS transaction, the first step is to identify the underlying asset pool that will serve as
collateral for the securities. The assets in this pool should be relatively homogeneous with respect to
credit, maturity, and interest rate risks; common examples of ABS include credit card receivables, trade
receivables, and car loans. Once a suitably large and homogenous asset pool is identified, the pooled
assets are sold to a grantor trust or other bankruptcy-remote, special purpose financing vehicle (SPV).
(Note: the conditions for derecognition of these securities in the financial statements are dealt with in
the Corporate Reporting Study Manual in the section on IAS 39 Financial Instruments: Recognition and
Measurement).
The development of securitisation has led to disintermediation and a reduction in the role of financial
intermediaries as borrowers can reach lenders directly.
Definition
Disintermediation describes a decline in the traditional deposit and lending relationship between banks
and their customers and an increase in direct relationships between the ultimate suppliers and users of
financing.
Cash flows before securitisation
Interest payment
Borrowers Originator
Loans advanced

Cash flows after
securitisation
Borrowers Originator
Interest Sale of Sale

payments assets price
Special purpose
vehicle (SPV)
Sale price Interest and

of principal
securities
Investors
Case examples: English and Scottish football clubs

Manchester United
In 2006, Manchester United football club entered into talks with financial institutions to borrow up to
500 million of more expensive debt used by the US-based Glazer family to fund its 800 million
takeover of the club in 2005. Expected annual revenues were 3 million per match the securitisation
deal would take into account gate receipts as well as associated revenues such as food and drink sales.
In 2006, the Glazers owed 275 million in payment-in-kind notes to US-based hedge funds that
charged interest of up to 20%. The hedge funds had the right to seize the Glazer family's stake if
Manchester United failed to repay the debt by 2010. The club also had a 265 million loan secured
against its assets, including such star players as Wayne Rooney.
Although the club's overall debt under the refinancing scheme rose to 660 million, it was able to
realise this saving by cutting the amount borrowed from the expensive hedge funds mentioned above.
With the scheme, 135 million of in-kind note payments no longer translated into equity, meaning that
the manager Sir Alex Ferguson would have sufficient funds to finance new player signings. This
alteration also released the club from the possibility of being run by bankers.
Arsenal
Arsenal football club had already implemented a similar scheme. It raised 260 million in the first public
sale of asset-based debt by a European football club. The club secured a low interest rate on the bond
of just 5.28%. The money was used to repay a loan that financed its new stadium and the club saved
about 1.2 million in annual interest payments.
The Daily Telegraph, 10 July 2006
Everton
In 2002 Everton football club raised 30 million through a securitisation of Everton's current and future
season ticket receipts. The intention was that the proceeds would be used to repay existing bank debt,
develop training facilities and make transfer funds available.
Since 2002 Everton's board has been considering building a new stadium to try to ensure the club will
be a leading Premiership club. The board has proposed that the finance needed for this new stadium
should be obtained from various sources, including up to 6 million a year through securitisation of the
naming rights to the stadium.
The campaign group Keep Everton in our City has suggested an alternative package, funded by raising
110 million through selling 10% of Everton's future stadium seats to the corporate sector. This plan,
known as Equity Seat Right, allows for life-time purchase of corporate seats.
By 2011 Everton still lacked funding for new players. The club did not buy any footballers during the
summer. Chairman Bill Kenwright stated in August 2011 that 'We've come to a stage with our bank
where we just can't borrow any more...' and that the need was 'to protect the football club and its fans.'
Everton midfielder Mikel Arteta commented: 'We know the situation at the moment: we cannot spend

money like other clubs. That is sensible even if it is not very popular.' Arteta signed for Arsenal in
September 2011. C
H
Financial Fair Play Rules A
P
In the longer-term the use of excessive debt financing by England's top football clubs appears to be T
threatened by UEFA's (the governing body for European football) Financial Fair Play rules. The guidelines E
state that clubs must not run at a loss. Since losses would include financing costs, significant borrowing R
linked to clubs will become problematic. Loans from benefactors or owners to cover wages or transfer
fees would not be allowed, although they would be allowed to fund long-term facilities or stadium
development. Breaches of the rules would lead to clubs being banned from competing in European 6
competitions, potentially a very valuable source of revenue.
The survey by the Guardian newspaper in May 2011 suggested that English Premiership clubs
collectively were a long way from UEFA's desired position. 16 out of the 20 clubs made losses for the
2009-10 season, totalling a record 484 million. These clubs relied on owner funding, mostly to pay
wages and fund transfer fees. The survey noted that only a small proportion of current owner funding
had financed longer-term stadium or facilities expenditure. UEFA's concern to ensure that clubs rely on
income rather than owners in future is inevitably leading to increased ticket prices for fans.
The Guardian's survey in May 2012 revealed that of the 19 Premier league clubs for which data was
available, 8 made between them total profits of 97.4m. However 11 clubs made losses, totalling
458m giving a net loss of 361m, with Manchester City losing 197m, the largest annual loss in the
history of football. Chelsea's loss of 68m was the second greatest, with its owner, Roman Abramovich,
loaning 94m to the club during the 2010/11 season. The Guardian's 2013 survey revealed that 12 out
of 20 clubs made losses, but the net figure had fallen from 361m to 205m, largely due to the
reduction in Manchester City's loss from 197m to 99m.
As well as raising ticket prices, clubs are looking at alternative means of boosting funding. In August
2012 Manchester United launched a $230m flotation of around 10% of shares in New York. However
the price of $14 was below the $16 $20 range announced some months before. Analysts suggested
that making available only 10% of share capital, together with the nil dividend proposed, made the
offer unattractive to institutional investors. This followed the club deciding against pursuing listings on
the Hong Kong and Singapore markets.
Reports suggested that a significant part of the proceeds would go to the Glazers, despite previous
assurances that the monies would be used to reduce the club's debts. The US filing documents also
highlighted that the club's constitution had been altered to include anti-takeover provisions that the
owners could use in the future. Investor concern was focused most on the club's 437m debt at June
2012.
In the summer of 2011 Manchester City sought a sponsorship deal allowing Etihad Airways to take
naming rights for City's stadium. The deal was allegedly worth well in excess of 100 million. UEFA
however was planning to investigate this deal on the grounds that it may not have been at fair value.
The airline is owned by the government of Abu Dhabi whose ruler is the half-brother of City's owner. In
March 2012, the Council of Europe's culture, science, education and media committee described the
sponsorship as an 'improper transaction', although this committee cannot impose any rules.
Glasgow Rangers
In February 2012 Glasgow Rangers entered administration, following a petition for 9m of unpaid taxes
by HMRC. As well as the tax debt, the club faced a 10m deficit in annual running costs.
Rangers also was in dispute with HMRC over its use of Employment Benefit Trusts (EBT) to pay staff over
a ten-year period. Rangers faced a potential liability of 49m. HMRC claimed that the EBT was a tax
dodge. Payments from an EBT should not be made on a contractual basis, as this would make them
part of an employee's salary and subject to tax and National Insurance. There were also allegations that
the scheme was contrary to the Scottish Football Association's registration rules.
In June 2012 the club was forced into liquidation following the rejection of a proposed Company
Voluntary Agreement. The club's assets, including Ibrox stadium, were bought by a new company,
Sevco 5088. The club started the 2012-13 season in Scottish League Division 3.
Although other Scottish clubs voted to exclude Rangers from the Scottish Premier League and to place
the club in Scottish League Division 3, it is possible that their own finances will be adversely affected.
The Premier League clubs will lose a lucrative fixture, no longer benefiting from Rangers' travelling fans.

There were also concerns about the future of existing TV deals, with television companies scaling back
or cancelling commitments and clubs losing vital revenue streams. In the event broadcasters Sky Sports
and ESPN reached agreements with Scottish clubs to continue covering football for the next five years,
including Rangers' matches as the club sought to climb back to the top division. Revenues from the
deals were down by a seven figure sum, according to the chief executive of the Scottish Premier League,
with the value of overseas rights having significantly fallen.
6 Small company finance
Section overview
A major feature of small to medium-sized enterprises is the problems they often have in raising
finance.
Equity financing is more common than debt financing for such organisations, given the lack of
assets required to secure against debt.
There are several sources of finance specifically aimed at smaller enterprises, including venture
capital and business angels.
The UK Government has also put support mechanisms in place to make more finance available to
smaller enterprises and to encourage their growth.
Many small to medium-sized enterprises (SMEs) have excellent business plans that require funding. The
problem these enterprises have is lack of assets to provide as security for conventional loans. Without
special sources of finance, many small businesses would not get off the ground, or their projects would
have to be abandoned.
There are numerous sources of finance available for SMEs. Due to the lack of available assets to offer as
security, most funding will be equity funding rather than debt funding.
6.1 Characteristics of SMEs

SMEs can be defined as having three characteristics:
Firms are likely to be unquoted.
Ownership of the business is restricted to a few individuals, typically a family group.
They are not micro businesses that are normally regarded as those very small businesses that act as
a medium for self-employment of the owners. (Laney)
The characteristics may alter over time, with the enterprise perhaps looking for a listing on the
Alternative Investment Market (AIM) as it expands.
The SME sector accounts for between a third and a half of sales and employment in the UK. The sector
is particularly associated with the service sector and serving niche markets. If market conditions change,
small businesses may be more adaptable. There is however a significant failure rate amongst small firms.
6.2 The problems of financing SMEs

The money for investment that SMEs can obtain comes from the savings individuals make in the
economy. Government policy will have a major influence on the level of funds available.
Tax policy including concessions given to businesses to invest (capital allowances) and taxes on
distributions (higher taxes on dividends mean less income for investors).
Interest rate policy with low interest rates working in different ways borrowing for SMEs
becomes cheaper, but the supply of funds is less as lower rates give less incentive to investors to
save.
SMEs however also face competition for funds. Investors have opportunities to invest in all sizes of
organisation, also overseas and in government debt.

The main handicap that SMEs face in accessing funds is the problem of uncertainty.
C
Whatever the details provided to potential investors, SMEs have neither the business history nor H
larger track record that larger organisations possess. A
P
Larger enterprises are subject by law to more public scrutiny; their accounts have to contain more T
detail and be audited, they receive more press coverage and so on. E
R
Because of the uncertainties involved, banks often use credit scoring systems to control exposure.
Because the information is not available in other ways, SMEs will have to provide it when they seek
finance. They will need to give a business plan, list of the firm's assets, details of the experience of 6
directors and managers and show how they intend to provide security for sums advanced.
Prospective lenders, often banks, will then make a decision based on the information provided. The
terms of the loan (interest rate, term, security, repayment details) will depend on the risk involved, and
the lender will also want to monitor their investment.
A common problem is that banks will often be unwilling to increase loan funding without an increase in
security given (which the owners may be unwilling or unable to give), or an increase in equity funding
(which may be difficult to obtain).
A further problem for SMEs is the maturity gap. It is particularly difficult for SMEs to obtain medium-
term loans due to a mismatching of the maturity of assets and liabilities. Longer-term loans are easier to
obtain than medium-term loans as longer loans can be secured with mortgages against property.
6.3 Sources of finance for SMEs

Potential sources of funding for SMEs include:
Owner financing
Equity finance
Business angel financing
Venture capital
Leasing
Factoring
Bank loans
6.3.1 Owner financing

Finance from the owner(s)' personal resources or those of family connections is generally the initial
source of finance. At this stage because many assets are intangible, external funding may be difficult to
obtain.
6.3.2 Equity finance

Other than investment by owners or business angels (see Section 6.3.3 below), businesses with few
tangible assets will probably have difficulty obtaining equity finance when they are formed (a problem
known as the 'equity gap').
However, once small firms have become established, they do not necessarily need to seek a market
listing to obtain equity financing; shares can be placed privately. Letting external shareholders invest
does not necessarily mean that the original owners have to cede control, particularly if the shares are
held by a number of small investors. However, small companies may find it difficult to obtain large
sums by this means.
As noted above, owners will need to invest a certain amount of capital when the business starts up.
However, owners can subsequently choose whether they withdraw profits from the business or re-invest
them.
A major problem with obtaining equity finance can be the inability of the small firm to offer an easy exit
route for any investors who wish to sell their stake.
The firm can purchase its own shares back from the shareholders, but this involves the use of cash
that could be better employed elsewhere.
The firm can obtain a market listing but not all small firms do.

6.3.3 Business angels
Business angel financing can be an important initial source of business finance. Business angels are
wealthy individuals or groups of individuals who invest directly in small businesses using their own
money. They bring invaluable direct relevant experience, expertise and contacts in an advisory capacity.
Business angels will generally invest between 10,000 and 150,000 in a business.
The main problem with business angel financing is that it is informal in terms of a market and can be
difficult to set up. However, informality can be a strength. There may be less need to provide business
angels with detailed information about the business due to the prior knowledge that they tend to have.
6.3.4 Venture capital

Venture capital is risk capital, normally provided in return for an equity stake. Venture capital
organisations, such as 3i have been operating for many years.
The types of venture that the 3i group might invest in include the following.
Business start-ups. When a business has been set up by someone who has already put time and
money into getting it started, the group may be willing to provide finance to enable it to get off
the ground.
Business development. The group may be willing to provide development capital for a company
that wants to invest in new products or new markets or to make a business acquisition.
Management buyouts. A management buyout is the purchase of all or parts of a business from its
owners by its managers.
Helping a company where one of its owners wants to realise all or part of his investment.
The 3i group may be prepared to buy some of the company's equity.
A survey has indicated that around 75% of requests for venture capital are rejected on an initial
screening, and only about 3% of all requests survive both this screening and further investigation and
result in actual investments.
Venture capital organisations will take account of various factors in deciding whether or not to invest.
The nature of the product (viability of production and selling potential)
Expertise in production (technical ability to produce efficiently)
The market and competition (threat from rival producers or future new entrants)
Future profits (detailed business plan showing profit prospects that compensate for risks)
Board membership (to take account of the venture capital organisation's interests and to ensure it
has a say in future strategies)
Risk borne by existing owners
6.3.5 Leasing
Leasing is a popular source of finance for both large and smaller enterprises. A lease is a contract
between a lessor and lessee for hire of a specific asset selected from a manufacturer or vendor of such
assets by the lessee. The lessor retains ownership of the asset. The lessee has possession and use of the
asset on payment of specified rentals over a period.
Many lessors are financial intermediaries such as banks and insurance companies. The range of assets
leased is wide, including office equipment and computers, cars and commercial vehicles, aircraft, ships
and buildings.
When deciding whether to lease or buy an asset, the SME must make two decisions.
The acquisition decision: is the asset worth having? Test by discounting project cash flows at a
suitable cost of capital.
The financing decision: if the asset should be acquired, compare the cash flows of purchasing with
those of leasing. The cash flows can be discounted at an after-tax cost of borrowing.

SMEs can also consider a sale and leaseback arrangement. If it owns its own premises, for example, the
SME could sell the property to an insurance company or pension fund for immediate cash and rent it C
back, usually for at least 50 years with rent reviews every few years. While such an arrangement usually H
A
realises more cash than a mortgage would, the firm loses ownership of the asset which can reduce its
P
overall borrowing capacity, as the asset can no longer be used as security for a loan. T
E
6.3.6 Debt factoring R
SMEs can make use of debt factoring to release funds quickly. As with leasing, debt factoring was
covered in detail in the Financial Management paper, therefore you should refresh your memory by 6
revising your earlier notes.
Factoring can release funds by 'selling' debts to a factoring organisation that will then chase the debts
on the company's behalf for a fee. At the time of 'sale' the factor will advance a percentage of the debt
in cash to the company, thus helping short-term liquidity. The main problem with this method of
financing is that it could give out adverse signals about the firm's liquidity position.
6.3.7 Bank loans

Bank loans are often used to finance short-term investment or as a 'bridge' to finance the purchase of,
for example, new equipment. Short-term loans might be used to finance a temporary increase in
inventory levels, for example to fulfil a special order. The sale of the goods then provides the finance to
repay the loan.
Longer-term loans are also available, say for five years. These are normally repaid in equal amounts over
the period of the loan, although payments can be delayed until the reason for the loan is up and
running for example, until new machinery is operational and able to generate money-making stock.
This is not often the case for small firms, however.
Short-term loans are usually made at a fixed interest rate, whilst the rates quoted for longer-term loans
tend to be linked to the general rate of interest, such as LIBOR.
6.4 Government aid for SMEs

The UK Government has introduced a number of assistance schemes to help businesses, and several of
these are designed to encourage lenders and investors to make finance available to small and unquoted
businesses.
6.4.1 Enterprise Finance Guarantee

Over the last 30 years the UK government has helped smaller businesses struggling to raise capital by
providing guarantees to lenders.
During 2009 the Enterprise Finance Guarantee supported bank lending, to viable UK businesses with
revenue of up to 25 million. The guarantees provided should help businesses secure loans of between
1,000 and 1 million, with terms of up to 10 years.
The guarantee can be used to:
Support new loans.
Refinance existing loans where the loan is at risk due to deteriorating quality of security.
Allow lenders to restructure a borrower's debt where appropriate.
Allow lenders to convert an existing overdraft into a loan to release capacity to meet working
capital requirements.
The Guarantee was available until 31 March 2011.
6.4.2 Grants
Grants to help with business development are available from a variety of sources, such as Regional
Development Agencies, local authorities and some charitable organisations.

These grants may be linked to business activity or a specific industry sector. Some grants are also linked
to specific geographical areas, such as those in need of economic regeneration.
6.4.3 Enterprise capital funds

Enterprise capital funds (ECFs) are designed to be commercial funds, investing in a combination of
private and public money in small high-growth businesses. They are based on a variant of the Small
Business Investment Company (SBIC) programme that has operated in the United States for the past 45
years. The SBIC programme has supported the early growth of companies such as FedEx, Apple, Intel
and AOL.
Each ECF is able to make equity investments of up to 2 million into eligible SMEs that have genuine
growth potential but whose funding needs are currently not met, based on the evidence that such
businesses struggle to obtain finance of up to 2 million.
6.5 Obtaining finance as an SME

Despite the number of finance options available, SMEs often find it difficult to obtain funding for
projects, owing mainly to the risk involved for the lenders. There is also a great deal of competition for
funds as more and more small businesses are set up. If you are in the position in an exam situation of
trying to obtain funds either for a new start-up or an investment project, you should bear the following
advice in mind.
6.5.1 Small businesses should always aim to raise more money than required
Very often, you only have one chance of raising money with a particular institution. It is always very
difficult, and will appear unprofessional, to go back to the lender to ask for more. As a result, do not be
too conservative with your estimates of funding requirements. Not only will it make you appear
disorganised and lacking knowledge about your business when you have to ask for more money, it may
make the project unfeasible.
6.5.2 There are various ways of raising finance, not just banks
Often banks are not the cheapest method of financing projects. It depends very much on what you
need and for how long. As with larger businesses, short-term cash requirements should be financed by
short-term means and similarly for long-term requirements. If you need money to buy, for example,
vehicles or equipment, you should bear in mind that you don't always have to buy them leasing or
renting may be a cheaper option.
6.5.3 Shop around for the best deal

You may have noticed that there is considerable competition between banks to gain your custom. If
you are about to set up in business, make sure you do your homework and approach several banks
about the types of charges that may apply to your type of business before making a decision. Incentives
such as limited free banking may be tempting, but check on what the charges will be when the period
runs out.
Case example: The Pure Package

The Pure Package, a home delivery meals service tailored to meet clients' individual dietary requirements
and preferences, was set up by Jennifer Irvine in 2004. In its first year, the business delivered 70,000
meals and earned revenue of 200,000. Since then, it has grown into a multi-million pound operation.
When it came to financing, the founder was initially wary of taking on any debt or parting with a stake
in the business. Rather than using these more conventional means to finance growth, she took a
gamble on assuming that clients would be willing to pay for their meals in advance and offered a
discount for paying 90 days early. The gamble worked and she was able to generate the necessary
working capital for sustained growth.

Interactive question 10: SME finance [Difficulty level: Intermediate]
C
DF is a manufacturer of sports equipment. All of the shares of DF are held by the Wong family. H
A
The company has recently won a major three year contract to supply FF with a range of sports P
equipment. FF is a large company with over 100 sports shops. The contract may be renewed after three T
years. E
R
The new contract is expected to double DF's existing total annual sales, but demand from FF will vary
considerably from month to month.
The contract will, however, mean a significant additional investment in both non-current and current 6
assets. A loan from the bank is to be used to finance the additional non-current assets, as the Wong
family is currently unable to supply any further share capital. Also, the Wong family does not wish to
raise new capital by issuing shares to non-family members.
The financing of the additional current assets is yet to be decided. In particular, the contract with FF will
require orders to be delivered within two days. This delivery period gives DF insufficient time to
manufacture items, thus significant inventories need to be held at all times. Also, FF requires 90 days'
credit from its suppliers. This will result in a significant additional investment in accounts receivable by
DF.
If the company borrows from the bank to finance current assets, either using a loan or an overdraft, it
expects to be charged annual interest at 12%. Consequently, DF is considering alternative methods of
financing current assets. These include debt factoring, invoice discounting and offering a 3% cash
discount to FF for settlement within 10 days rather than the normal 90 days.
Requirements
(a) Write a report to the Wong family shareholders explaining the various methods of financing
available to DF to finance the additional current assets arising from the new FF contract. The report
should include the following headings:
Bank loan
Overdraft
Debt factoring
Invoice discounting
(b) Discuss the factors that a venture capital organisation will take into account when deciding
whether to invest in DF.
7 Working capital management
Section overview
All entities need liquid resources to fund working capital needs. Short-term financial strategy
involves planning to ensure enough day-to-day cash flow and is determined by working capital
management. It involves achieving a balance between the requirement to minimise the risk of
insolvency and the requirement to maximise profit.
7.1 Working capital and value creation

Working capital is technically the excess of current assets over current liabilities. In practice it represents
the resources required to run the daily operations of a business. You covered the techniques for
managing working capital in detail in the Management Information syllabus, and may wish to refresh
your memory of the most significant issues.
Working capital ratios
The cash operating cycle

Overtrading
Methods of managing inventory
The Economic Order Quantity (EOQ) model
Using trade credit
Credit control finance and management
Cash management (covered in further detail below)
Cash budgets
This section provides an overview of some of the strategic issues.
The effective management of a company's inventory, customer accounts, cash resources and suppliers'
accounts are a source of competitive advantage and thus corporate and shareholder value.
For example, good control over inventory can be important in ensuring that there are items on hand
when customers want them and they are in good condition. Well handled supplier accounts are part of
good supply chain management and help in the objective of ensuring costs and delivery times are
minimised.
Effective working capital management can also comprise a key element of the value chain. The
management of inventories, supplier relationships and customer relationships are closely related to
operations, supply chain and logistics management.
A lot of working capital management affects the customer interface and deserves a business manager's
attention as it can be a significant source of customer satisfaction.
7.2 Aggressive and conservative working capital management

The volume of working capital required will depend on the nature of the company's business. For
example, a manufacturing company may require more inventories than a company in a service industry.
As the volume of output by a company increases, the volume of current assets required will also
increase.
Even assuming efficient inventory holding, debt collection procedures and cash management, there is
still a certain degree of choice in the total volume of current assets required to meet output
requirements. Policies of low inventory-holding levels, tight credit and minimum cash holdings may be
contrasted with policies of high inventory (to allow for safety or buffer inventory), easier credit and
sizeable cash holdings (for precautionary reasons).
Organisations have to decide what the most important risks are relating to working capital, and
therefore whether to adopt a conservative or aggressive approach.
7.2.1 Conservative working capital management

A conservative working capital management policy aims to reduce the risk of system breakdown by
holding high levels of working capital.
Customers are allowed generous payment terms to stimulate demand, finished goods inventories are
high to ensure availability for customers, and raw materials and work in progress are high to minimise
the risk of running out of inventory and consequent downtime in the manufacturing process. Suppliers
are paid promptly to ensure their goodwill, again to minimise the chance of stock-outs.
However, the cumulative effect on these policies can be that the firm carries a high burden of
unproductive assets, resulting in a financing cost that can destroy profitability. A period of rapid
expansion may also cause severe cash flow problems as working capital requirements outstrip available
finance. Further problems may arise from inventory obsolescence and lack of flexibility to customer
demands.
7.2.2 Aggressive working capital management

An aggressive working capital investment policy aims to reduce this financing cost and increase
profitability by cutting inventories, speeding up collections from customers, and delaying payments to
suppliers.
The potential disadvantage of this policy is an increase in the chances of system breakdown through
running out of inventory or loss of goodwill with customers and suppliers. However, modern

manufacturing techniques encourage inventory and work in progress reductions through just-in-time
policies, flexible production facilities and improved quality management. Improved customer C
satisfaction through quality and effective response to customer demand can also mean that credit H
A
periods are shortened.
P
T
E
7.3 Working capital financing R
There are different ways in which the funding of the current and non-current assets of a business can be
achieved by employing long and short-term sources of funding.
6
Short-term finance is usually cheaper than long-term finance (under a normal yield curve).
The diagram below illustrates three alternative types of policy A, B and C. The dotted lines A, B and C
are the cut-off levels between short-term and long-term financing for each of the policies A, B and C
respectively: assets above the relevant dotted line are financed by short-term funding while assets below
the dotted line are financed by long-term funding.
Fluctuating current assets together with permanent current assets (the core level of investment in
inventory and receivables) form part of the working capital of the business, which may be financed by
either long-term funding (including equity capital) or by current liabilities (short-term funding). This can
be seen in terms of policies A, B and C. Once again a conservative or an aggressive approach can be
followed.
Policy A can be characterised as a conservative approach to financing working capital. All non-
current assets and permanent current assets, as well as part of the fluctuating current assets, are
financed by long-term funding. There is only a need to call upon short-term financing at times
when fluctuations in current assets push total assets above the level of dotted line A. At times when
fluctuating current assets are low and total assets fall below line A, there will be surplus cash which
the company will be able to invest in marketable securities.
Policy B is a more aggressive approach to financing working capital. Not only are fluctuating
current assets all financed out of short-term sources, but so are some of the permanent current
assets. This policy represents an increased risk of liquidity and cash flow problems, although
potential returns will be increased if short-term financing can be obtained more cheaply than long-
term finance. It enables greater flexibility in financing.
A balance between risk and return might be best achieved by the moderate approach of policy C,
a policy of maturity matching in which long-term funds finance permanent assets while short-term
funds finance non-permanent assets.

7.4 Other factors
Overall working capital management will be complicated by the following factors:
7.4.1 Industry norms

These are of particular importance for the management of receivables. It will be difficult to offer a much
shorter payment period than competitors.
7.4.2 Products
The production process, and hence the amount of work in progress is obviously much greater for some
products and in some industries.
7.4.3 Management issues

How working capital is managed may have a significant impact upon the actual length of the working
capital cycle whatever the overall strategy might be. Factors to consider include the degree of
centralisation (which may allow a more aggressive approach to be adopted, depending though on how
efficient the centralised departments actually are).
Differences in the nature of assets also need to be considered. Businesses adopting a more conservative
strategy may well hold permanent safety inventory and cash balances, whereas there is no safety level of
receivables balances.
7.5 Working capital management and the recession

The current credit crunch is impacting upon the finance available to all companies. There are plenty of
examples of well-established companies struggling with funding.
The Financial Times reported in September 2008 that banks were limiting credit facilities, raising interest
rates and pressuring businesses to switch from unsecured overdrafts to secured loans. Companies are
having to draw on their own accumulated funds and look very carefully at their working capital levels. A
significant difference between this recession and previous recession is that the downturn this time has
been driven by a shortage of liquidity.
7.5.1 Inventory levels

Managing inventory has become even more of a balancing act between meeting the demands of
customers and limiting inventory levels. Businesses are looking carefully at slow-moving or surplus items
to see if certain lines can be discontinued. They are also examining re-order levels to see if just-in-time
policies can be introduced.
7.5.2 Credit control

This is another balancing act. Chasing customers too hard at a time when their liquidity is under
pressure may risk customer goodwill. However after some point the finance cost of the outstanding debt
and the collection costs may mean slow payers become uneconomical.
7.5.3 Supplier payments

Using supplier finance to alleviate liquidity problems may be risky. Suppliers may come to regard the
business as a poor credit risk and reduce permitted orders or stop offering credit. New sources of supply,
that do not offer discounts for a long-established relationship, may be significantly more expensive. If
the business is considering changing its supply arrangements, the cost of buying supplies from lower
cost overseas sources will have to be weighed against the increased difficulty of introducing just-in-time
arrangements.
7.5.4 Renegotiate loan finance

Some companies have renegotiated their borrowing so that the loans are over a longer period and are
ultimately more expensive, but have lower payments now. Adding more debt will have long-term
consequences, but refinancing is worth doing if it means companies are able to reach the long-term.

Case example: Managing working capital
C
Deloitte Canada has suggested a ten point process for managing working capital during the current H
credit crunch. A
P
Focus on the cash-to-cash conversion cycle Don't just focus on inventory, but develop a co- T
E
ordinated approach to inventory, receivables and
R
payables.
Think like a chief finance officer Assume inventory management is driven by
financial constraints rather than customer and 6
operational requirements.
Focus on inventory reduction Simple cuts may affect customer service. A
complete overhaul of demand and production
planning and safety inventory levels will lead to
longer-term gains.
Extend supplier credit intelligently Simply delaying payment may lead to worse
supply relationships and may pass on liquidity
problems to suppliers. Agreement with suppliers
may be possible, but payment may have to be
advanced to suppliers in serious trouble.
Manage and expedite receivables The focus should be on specific customers,
highlighting customers who may be changing
their payment practices. Timely and accurate
invoicing helps avoid delays.
Audit receivables and payables transactions Transactions must be settled at the right amounts,
the correct tax paid and the right discounts
allowed and received.
Consider alternate supply chain financing Receivables can be used as collateral for short-term
options credit and early payment discounts for customers
may be necessary.
Ensure framework for managing supply Be aware not only of suppliers who are in trouble,
chain risk is robust but also problems with financial institutions which
may be guaranteeing letters of credit.
Eliminate fixed costs Possible means include sale and leaseback, contract
manufacturing and third party warehousing.
Think beyond four walls Consider the implications of actions to manage
one part of working capital on the rest of the value
chain. Emergency measures may be required to
support important suppliers.
Other possible steps include credit protection insurance and rationalisation of bank accounts to avoid
account and loan charges.
Management information systems will also require review. Possibly cash flow forecasts should be
prepared more frequently, and performance indicators need to be refocused around cash collection and
working capital management.
Case example: Vodafone

Vodafone's focus since 2008 has been to strengthen its free cash flow generation by improving its
working capital position through a structured programme. The programme involves about 100 ideas to
improve performance.
Measures included having customers pay in advance rather than arrears for some aspects of their service.
One particularly important, but challenging, area has been relationships with suppliers. Vodafone does not
wish to abuse its market power and wants to maintain a diversified supplier base. However it has reviewed

contract terms carefully and tightened its internal procedures to eliminate early payments. Operating units
have had stand-alone purchasing functions, but Vodafone is moving towards a standard shared-services
model.
Vodafone has also built achievement of working capital management objectives into its remuneration
packages.
7.5.5 Cash hoarding

Concerns about short-term finance have led some companies to hoard cash.
Case example: Current practices

Ernst and Young's Working Capital Management Report 2012 reported that the leading 2,000 US and
European companies still have up to US$ 1.2 trillion of cash 'unnecessarily' tied up in working capital
equivalent to nearly 7% of their combined sales. Ernst and Young suggested that there were a number
of short-term reasons for this, including unusual and uncertain sales patterns, better cash collection and
billing, a reduction in production and inventory and paying suppliers earlier to achieve discounts.
Ernst and Young noted that the rate of improvement in working capital levels had slowed down
significantly in the period 2009 2011. The report suggested that the most convenient opportunities
for working capital improvements may have already been exploited, or traded off against sales growth
or margin expansion. Ernst and Young suggested that major improvements to performance over the
longer-term would require root and branch reform involving all major aspects of operations,
performance metrics and risk management systems. Many businesses would need to consider lean
manufacturing and supply chain initiatives, greater co-operation with customers and suppliers,
centralisation of procurement and cash management and a fresh approach to financing initiatives.
7.6 Working capital management and exporters

One of the main problems facing exporters is cash flow. In order to win customers, exporters will
normally have to offer credit facilities, but at the same time need liquid funds to finance investment.
There are several finance options available for this purpose. Some of these such as factoring and
documentary credits you will have met before, but we will briefly mention them here.
7.6.1 Factoring
Factoring involves passing debts to an external party (the factor) who will take on the responsibility for
collecting the money due. The factor advances a proportion of the money it is due to collect, meaning
that the exporter will always have sufficient funds to pay suppliers and finance growth. Sometimes the
factor will also take on a percentage of the non-payment risk, which is known as 'non-recourse'
factoring. This means that the factor will not come back to the exporter in the event of default on the
part of the customer.
7.6.2 Documentary credits

A documentary credit (or letter of credit) is a fixed assurance from the customer's bank in the customer's
own country. This basically says that payment will be made for the goods or services provided the
exporter complies with all the terms and conditions established by the credit contract. The exporter's
own bank may be willing to advance a short-term loan for a percentage of the documentary credit prior
to goods being shipped, to cover the temporary shortfall of cash. The bank will then collect the loan
from the proceeds of the transaction.
7.6.3 Forfaiting
Forfaiting or medium term capital goods financing is used for larger projects and involves a bank
buying 100% of the invoice value of an export transaction at a discount. The exporter is then free from
the financial risk of not receiving payment and the resultant liquidity problems the only responsibility
the exporter has and is liable for is the quality of the goods or services being provided.

Three elements make up the price of a forfaiting transaction:
C
The discount rate this is the interest element which is usually quoted as a margin over LIBOR. H
A
Grace days, which are added to the actual number of days to maturity to cover the number of P
days' delay that usually occurs in the transfer of payment. The number of days depends on the T
customer's country. E
R
Commitment fee, which is applied from the date the forfaiter assumes responsibility for the
financing to the date of discounting.
Forfaiting enhances the competitive advantage of the exporter, who will be able to provide financing to 6
customers, thus making the products or services more attractive. By having the assurance of knowing
that they will receive the money owed to them, exporters will also be more willing to do business in
countries whose risks would normally prohibit them from doing so.
7.6.4 Credit insurance

Exporters may also make use of credit insurance facilities to ease liquidity problems. This involves
assigning credit-insured invoices to banks who will offer up to 100% of the insured debt as a loan.
These instruments may also carry the guarantee of the customer's home government.
Case example: Envy Performance Ltd

Envy Performance Ltd exports spare parts for performance cars to customers in more than forty
countries. Overseas trade accounts for approximately 15% of sales revenue and the business sells to
both trade and private customers. One of the main challenges has been protecting the interests of the
business during export transactions.
Gareth Walker, one of the directors, identified transit of goods as being a major issue. On average one
package each month either goes missing or is damaged in transit. This means higher insurance
premiums due to regular claims being made. He finally realised that the current insurance cover was
inadequate for Envy Performance's needs. Solution? The business switched its insurance cover to that
provided by the courier, meaning payment of a flat-rate charge on each consignment shipped rather
than an annual premium. This made budgeting easier and the business also found that dealing with the
courier in the event of any problems was faster than dealing with an external insurer.
Another way in which Envy Performance protected itself was through tighter credit arrangements.
When the business had just started up, it had several credit accounts with overseas customers.
Unfortunately it lost a considerable amount of money when some of the customers went bust. As a
result, it withdrew its account service and almost all transactions are now on a pre-paid basis. The
business is also careful with its credit card transactions and pays a monthly premium for a terminal that
allows address verification to take place on such transactions.

Summary

Self-test
C
1 CRY H
A
The following figures have been extracted from the most recent accounts of CRY plc. P
T
STATEMENT OF FINANCIAL POSITION AS AT 30 JUNE 20X9 E
'000 '000 R
Non-current assets 10,115
Investments 821
Current assets 3,658 6
Less: Current liabilities 1,735
1,923
12,859
Ordinary share capital
Authorised: 4,000,000 shares of 1
Issued: 3,000,000 shares of 1 3,000
Reserves 7,257
Shareholders' funds 10,257
7% Debentures 1,300
Deferred taxation 583
Corporation tax 719
12,859
SUMMARY OF PROFITS AND DIVIDENDS
Year ended 30 June 20X5 20X6 20X7 20X8 20X9
'000 '000 '000 '000 '000
Profit after interest and
before tax 1,737 2,090 1,940 1,866 2,179
Less: Tax 573 690 640 616 719
Profit after interest and tax 1,164 1,400 1,300 1,250 1,460
Less: Dividends 620 680 740 740 810
Added to reserves 544 720 560 510 650
The current (1 July 20X9) market value of CRY plc's ordinary shares is 3.27 per share cum div. An
annual dividend of 810,000 is due for payment shortly. The debentures are redeemable at par in
ten years' time. Their current market value is 77.10 per cent. Annual interest has just been paid on
the debentures. There have been no issues or redemptions of ordinary shares or debentures during
the past five years.
The current rate of corporation tax is 23%. Assume that there have been no changes in the system
or rates of taxation during the last five years.
Requirements
(a) Calculate the cost of capital which CRY plc should use as a discount rate when appraising new
investment opportunities.
(b) Discuss any difficulties and uncertainties in your estimates.
2 Your client is a FTSE-100 company that has not until now considered raising capital by issuing
tradable debt securities. The Board have been looking at the bond statistics and wish to have the
following explained.
(a) The concept of a gross redemption yield.
(b) The volatility of low-coupon, long-dated bonds.
(c) Why the long-dated gilts have lower gross redemption yields than some of the short-dated
gilts, ie an inverse yield curve.
(d) Why a low-coupon gilt like Funding 3.5% 20092014 has a lower gross redemption yield
than comparable high-coupon gilts.

3 (a) Value a corporate bond that has five years to maturity. Its redemption and par value is 1
million and it pays a coupon of 10% annually. The current discount rate applicable to this
class of bonds is 12%.
(b) Discuss the circumstances under which a convertible bond issue might be preferable to both a
straight debt issue and an equity issue.
4 Ella Ltd
Ella Ltd, a small company, is currently considering a major capital investment project for which
additional finance will be required. It is not currently feasible to raise additional equity finance,
consequently debt finance is being considered. The decision has not yet been finalised whether this
debt finance will be short- or long-term and if it is to be at fixed or variable rates. The financial
controller has asked you for your assistance in the preparation of a report for a forthcoming
meeting of the board of directors.
Requirements
Prepare a draft report to the board of directors which identifies and briefly explains:
(a) The main factors to be considered when deciding on the appropriate mix of short-, medium-
or long-term debt finance for Ella Ltd.
(b) The practical considerations which could be factors in restricting the amount of debt which
Ella Ltd could raise.

Answers to Self-test C
H
A
P
T
1 CRY E
R
Tutorial note:
(a) demonstrates the complications that may occur in weighted average cost of capital calculations.
When you calculate the cost of equity, you will need to do more than just plug the figures into the 6
formula. Don't forget to check whether shares are quoted cum or ex div.
With debentures, the most serious mistake you can make is to treat redeemable debentures as
irredeemable. Because the debentures are redeemable, you need to carry out an IRR analysis.
Remember this calculation is done from the viewpoint of the investor. The investor pays the market
price for the debentures at time 0, and then receives the interest and the redemption value in
subsequent years. You must bring tax into your calculation.
Lastly don't forget that the weightings in the WACC calculation are based on market values, not
book values.
(b) demonstrates that the calculation of the weighted average cost of capital is not a purely
mechanical process. It makes assumptions about the shareholders, the proposed investment and
the company's capital structure and future dividend prospects. Given all the assumptions involved,
the result of the calculations may need to be taken with a large pinch of salt!
(a) The post-tax weighted average cost of capital should be calculated first.
(i) Ordinary shares

Market value of shares cum div 3.27
Less: Dividend per share (810 3,000) 0.27
Market value of shares ex div 3.00
The formula for calculating the cost of equity when there is dividend growth is:
D0 (1 g)
ke = g
P0
where: ke = cost of equity

D0 = current dividend
g = rate of growth
P0 = current ex div market value.
In this case we shall estimate the future rate of growth (g) from the average growth in
dividends over the past four years.
4
810 = 620 (1 + g)
810
(1 + g)4 =
620
= 1.3065
(1 + g) = 1.0691
g = 0.0691 = 6.91%
0.27 1.0691
ke = + 0.0691 = 16.53%
3

(ii) 7% Debentures
In order to find the post-tax cost of the debentures, which are redeemable in ten years'
time, it is necessary to find the discount rate (IRR) which will give the future post-tax cash
flows a present value of 77.10.
The relevant cash flows are:
(1) Annual interest payments, pre-tax, which are 1,300,000 7% = 91,000
(for ten years)
(2) A capital repayment of 1,300,000 (in ten years' time)
Try 10%
Present
Value
'000
Current market value of debentures (1,300 at 77.10 per cent) (1,002.3)
Annual interest payments 91 6.145 (10% for ten years) 559.2
Capital repayment 1,300 0.386 (10% in ten years' time) 501.8
NPV 58.7
Try 12%
'000
Current market value of debentures (1,002.3)
Annual interest payments 91 5.650 514.2
Capital repayment 1,300 0.322 418.6
NPV (69.5)
58.7
(12 10)
IRR = 10% + 58.7 69.5 % = 10.92%

Post-tax cost of debt = 10.92% (1 0.23) = 8.41%

(iii) The weighted average cost of capital
Market
value Cost Product
'000 % '000
Equity 9,000 16.53 1,488
7% Debentures 1,002 8.41 84
10,002 1,572
1,572
WACC = 100 = 15.72%
10,002
The above calculations suggest that a discount rate in the region of 16% might be
appropriate for the appraisal of new investment opportunities.
(b) Difficulties and uncertainties in the above estimates arise in a number of areas.
(i) The cost of equity. The above calculation assumes that all shareholders have the same
marginal cost of capital and the same dividend expectations, which is unrealistic. In
addition, it is assumed that dividend growth has been and will be at a constant rate of
6.9%. In fact, actual growth in the years 20X5/6 and 20X8/9 was in excess of 9%, while
in the year 20X7/8 there was no dividend growth. 6.9% is merely the average rate of
growth for the past four years. The rate of future growth will depend more on the return
from future projects undertaken than on the past dividend record.
(ii) The use of the weighted average cost of capital. Use of the weighted average cost of
capital as a discount rate is only justified where the company in question has achieved
what it believes to be the optimal capital structure (the mix of debt and equity) and
where it intends to maintain this structure in the long term.
(iii) The projects themselves. The weighted average cost of capital makes no allowance for
the business risk of individual projects. In practice, some companies, having calculated

the WACC, then add a premium for risk. In this case, for example, if one used a risk
premium of 5% the final discount rate would be 21%. Ideally the risk premium should C
vary from project to project, since not all projects are equally risky. In general, the riskier H
A
the project the higher the discount rate which should be used.
P
2 (a) The gross redemption yield is the discount rate which, when applied to the cash flows on a T
E
bond, give a net present value of zero. It is the internal rate of return of the cash flows on the
R
bond.
Alternatively, it may described as the annual yield to the maturity on a bond which an investor
can earn by investing in the bond, provided that any intervening cash receipts (such as 6
interest payments) are reinvested at the given yield to maturity.
(b) Volatility of bonds refers to the sensitivity of the bond's price to changes in interest rates.
Generally speaking, when interest rates rise, a fixed rate bond price will fall and vice versa.
Long-dated, low-coupon bond prices have a high sensitivity to changes in interest rates.
Hence the bonds are described as being very volatile compared to short-dated and high-
coupon bonds. This is because the present value of more distant cash flows is more sensitive
to changes in the discount rate used to value the flows.
(c) An inverse yield curve is caused primarily by interest rate expectations. When investors expect
interest rates to fall, they will invest in longer-dated bonds to lock into higher available yields
compared to expected future short-term rates. This buying pressure increases the prices of
long bonds and hence reduces their yields, causing a downward sloping yield curve.
An additional reason is convexity bias. Other things being equal, investors value convexity in a
bond. Since longer-dated bonds tend to have higher convexity, their prices will be biased
upwards slightly, giving a bias to lower yields.
(d) The low coupon means that the price of the bond is below par and part of the gross
redemption yield consists of a capital gain. This gives rise to a lower overall yield than higher
coupon bonds.
The capital gain will be tax-free for private investors, meaning that they will find the low
coupon bond a more attractive investment. This will increase demand and increase price,
reducing yield.
3 (a) The market value will be given by the present value of the future cash flows. The answer
assumes that the 12% discount rate is a pre-tax required rate of return or that all investors are
tax free.
Cash flow Present value

Time Narrative 12% Factor
'000 '000
15 Interest 100 3.60 360

5 Redemption 1,000 1/1.125 567
927
The market value of the bond is 927,000.

WORKING
Discount factor = 1/r {1 1/ (1 + r)n} = 1/0.12 (1 1/1.125) = 3.60
(b) The following factors would be relevant in making the decision as to whether or not
convertibles are the preferred option.
Business and financing strategy
Funding of the business should match the business's strategic aims and not just be an
opportunistic decision. For example, a business may need to raise a substantial amount of
new funds to invest in new projects with very good prospects. It cannot withstand a high
interest charge due to low profits at present and a currently low share price makes a share
issue an unattractive option. A convertible issue will reduce the interest costs and dilution will

only occur later when the new project is fully developed, avoiding significant dilution of
existing shareholder interests.
Supply and demand
Where convertibles are in demand by investors then the company will be able to issue at very
attractive prices. Demand may arise when equity becomes unattractive due to dividend cuts
in a recession. Income-seeking investors will turn to convertibles as a more secure form of
income but nevertheless with a possibility of upside.
The danger is that, particularly with overseas investors, the investors may take the income,
convert into shares and then, because of their emphasis towards secure income, sell the shares
back into the home market. This flowback will reduce the market value of the shares in
subsequent years and needs to be managed.
Cheap funding
The convertible offers a cheap coupon for a number of years before converting into equity.
This may give a short-term gain to the company and also achieve the desired long-term aim
of increasing the equity financing base. Even if a put option is incorporated into the
convertible giving the investor some downside protection, the company can still achieve a
very competitive form of finance.
The cheap coupon can be further emphasised by the use of deep discount convertibles (or
'liquid yield option notes') where if conversion takes place then minimal interest or no interest
at all may be paid on the debt.
Accounting and tax issues
Convertibles have been structured in such ways as to enable the company and its investors to
get advantageous tax treatments. In the past, advantageous accounting treatments have also
been adopted by companies, meaning that although the convertible is debt for tax and legal
purposes (and offers all the advantages of a debt instrument), it is treated as equity for
accounting purposes. Such companies were therefore getting the best of all worlds, although
this advantage is likely to disappear as new accounting rules are introduced.
Pre-emption rights
Convertible issues may be a way of avoiding pre-emption rights for existing shareholders,
although the institutional investors are wary about allowing companies too much scope in this
area.
Second, the falling yield curve means that longer-dated spot rates are lower than shorter-
dated spot rates. Since a greater proportion of the flows are longer-dated for a low coupon
bond, there will be a greater weighting within the gross redemption yield to the lower long-
dated spot rates compared to a higher-coupon bond. This will also give a lower gross
redemption yield.

4 Ella Ltd
C
(a) To: Board H
A
From: Accountant
P
Date: 8 January 20X7 T
E
Re: Debt finance R
Factors to be considered when deciding on the appropriate mix of finance are as follows:
The term of the assets being acquired 6
The term should be appropriate to the asset being acquired. As a general rule, long-term
assets should be financed from long-term finance sources. Cheaper short-term funds should
finance short-term requirements, such as fluctuations in the level of working capital.
Flexibility
Short-term debt is a more flexible source of finance; there may be penalties for repaying
long-term debt early. If the company takes out long-term debt and interest rates fall, it will
find itself locked into unfavourable terms.
Repayment terms
The company must have sufficient funds to be able to meet repayment schedules laid
down in loan agreements, and to cover interest costs. Although there may be no specific
terms of repayment laid down for short-term debt, it may possibly be repayable on demand,
so it may be risky to finance long-term capital investments in this way.
Costs
Interest on short-term debt is usually less than on long-term debt. However, if short-term
debt has to be renewed frequently, issue expenses may raise its cost significantly.
Availability
It may be difficult to renew short-term finance in the future if the company's position or
economic conditions change adversely.
Effect on gearing
Certain types of short-term debt (such as bank overdrafts and increased credit from suppliers)
will not be included in gearing calculations. If a company is seen as too highly geared,
lenders may be unwilling to lend money, or judge that the high risk of default must be
compensated by higher interest rates or restrictive covenants.
(b) The following factors may restrict the amount of debt that the company could raise.
Previous record of company
If the company (or possibly its directors or even shareholders) has a low credit rating with
credit reference agencies, investors may be unwilling to subscribe for debentures. Banks may
be influenced by this, and also by their own experiences of the company as customer
(especially if the company exceeded overdraft limits in the past on a regular basis).
Restrictions in Memorandum and Articles
The company should examine the legal documents carefully to see if they place any
restrictions on what the company can borrow, and for what purposes.
Restrictions of current borrowing
The terms of any loans to the company that are currently outstanding may contain
restrictions about further borrowing that can be taken out.
Uncertainty over project
The project is a significant one, and presumably the interest and ultimately repayment that
lenders obtain may be very dependent on the success of the project. If the results are
uncertain, lenders may not be willing to take the risk.

Security
The company may be unwilling to provide the security that lenders require, particularly if it
is faced with restrictions on what it can do with the assets secured.
Alternatively it may have insufficient assets to provide the necessary security.

Answers to Interactive questions C
H
A
P
T
Answer to Interactive question 1 E
R
Algol: ke = rf + e (rm rf)
8 = rf + 1.2(7 rf)
6
8 = rf + 8.4 1.2 rf
0.2 rf = 0.4
rf =2
Rigel: ke = 2 + (7 2) 1.8
=11%

d0 (1 g)
(a) ke = +g
P0
3(1.10)
= + 0.10
250
= 0.1132 or 11.32%
(b) ke = 5 + 1.40 (8 5) = 9.2%

(a) Beta measures the systematic risk of a risky investment, such as a share in a company, and
financial risk. The total risk of the share can be sub-divided into two parts, known as systematic (or
market) risk and unsystematic (or unique) risk. The systematic risk depends on the sensitivity of
the return of the share to general economic and market factors such as periods of boom and
recession. The capital asset pricing model shows how the return which investors expect from shares
should depend only on systematic risk, not on unsystematic risk, which can be eliminated by
holding a well-diversified portfolio.
Beta is calibrated such that the average risk of stock market investments has a beta of 1. Thus
shares with betas of 0.5 or 1.5 would have half or 1 times the average sensitivity to market
variations respectively.
This is reflected by higher volatility of share prices for shares with a beta of 1.5 than for those with
a beta of 0.5. For example, a 10% increase in general stock market prices would be expected to be
reflected as a 5% increase for a share with a beta of 0.5 and a 15% increase for a share with a beta
of 1.5, with a similar effect for price reductions.
(b) The beta of a company will be the weighted average of the beta of its shares and the beta of its
debt. The beta of debt is very low, but not zero, because corporate debt bears default risk, which in
turn is dependent on the volatility of the company's cash flows.
Factors determining the beta of a company's equity shares include:
(i) Sensitivity of the company's cash flows to economic factors, as stated above. For example,
sales of new cars are more sensitive than sales of basic foods and necessities.
(ii) The company's operating gearing. A high level of fixed costs in the company's cost structure
will cause high variations in operating profit compared with variations in sales.
(iii) The company's financial gearing. High borrowing and interest costs will cause high variations
in equity earnings compared with variations in operating profit, increasing the equity beta as
equity returns become more variable in relation to the market as a whole. This effect will be
countered by the low beta of debt when computing the weighted average beta of the whole
company.

i 10
(a) The cost of irredeemable debt capital is 100% = 11.1%
P0 90
(b) The cost of redeemable debt capital. The capital profit that will be made from now to the date of
redemption is 10 (100 90). This profit will be made over a period of ten years which gives an
annualised profit of 1 which is about 1% of current market value. We will try 12% as a trial and
error figure.
Year Cash Discount Discount
flow factor PV factor PV
12% 11%
0 Market value (90) 1.000 (90.00) 1.000 (90.00)
110 Interest 10 5.650 56.50 5.889 58.89
10 Capital repayment 100 0.322 32.20 0.352 35.20
(1.30) +4.09
The approximate cost of redeemable debt capital is, therefore:
4.09
kd = (11 + 1) = 11.76%
(4.09 - -1.30)

(a) The current cost of debt is found by calculating the internal rate of return of the cash flows shown
in the table below. We must subtract the current interest (of 8% per 100 of stock) from the
current market price, and use this 'ex interest' market value. A discount rate of 10% is chosen for a
trial-and-error start to the calculation.
Disct Present
Item and date Year Cash flow factor value
10%
Market value (ex 28.12.X2 0 (95) 1.000 (95.0)
int)
Interest 31.12.X3 X5 13 8 2.487 19.9
Redemption 1.1.X6 3 100 0.751 75.1
NPV 0.0
By coincidence, the cost of debt is 10% since the NPV of the cash flows above is zero.
(b) If the cost of debt is expected to rise in 20X3 and 20X4 it is probable that the market price in
December 20X2 will fall to reflect the new rates obtainable. The probable market price would be
the discounted value of all future cash flows up to 20X6, at a discount rate of 12%.
Discount Present
Item and date Year Cash flow factor value
12%
Interest 31.12.X2 0 8 1.000 8.0
Interest 31.12.X3 X5 13 8 2.402 19.2
Redemption 1.1.X6 3 100 0.712 71.2
NPV 98.4
The estimated market price would be 98.40 per cent cum interest.
(c) Again we must deduct the current interest payable and use ex interest figures.
Item and date Year Cash flow PV 10%

Market value (ex int) 0 (95.0) (95.0)
Interest 31.12.X35 13 8.0 19.9
Redemption 1.1.X6 3 100.0 75.1
NPV 0
The estimated after-tax cost of debt is: 10% (1 0.23) = 7.7%

C
Market values: H
'000 A
P
Equity (E): 2,500 6,500 T
1.30
0.5 E
Loan notes (D): 1,000 0.72 720 R
E+D 7,220
Cost of equity:
6
d 1 g
0.15 1 0.1
ke 0 g 0.1 0.2269 22.69%
P0 1.3
Cost of loan stock:
i(1- T) 0.12(1- 0.23)

kd = = = 0.1283 = 12.83%
P0 0.72
Weighted average cost of capital:
E D
WACC = ke + kd
E D E D
6,500 720
WACC = 22.69% + 12.83% = 20.43% + 1.28% = 21.71%
7,220 7,220

We do not need to know Panda's weighted average cost of capital, as the new project has different
business characteristics from its current operations. Instead we use the capital asset pricing model so
that:
Required return = 6 + 1.5(12 6) = 15%
12,000 10,000
Expected return = = 20%
10,000
Thus the project is worthwhile, as expected return exceeds required return.

Break-up values of assets at 31 March 20X2 '000
Freehold 3,000
Motor vehicles 120
Patents 800
Current assets 1,050
6,370
Total liabilities at 31 March 20X2 '000

Debentures 1,000
Other loans 3,000
Bank overdraft 750
Trade payables 1,960
6,710
Thus liabilities exceed assets, and on a liquidation the shareholders would receive
nothing.

Break-up values of assets at 31 December 20X9
'000
Freehold buildings 11,250
Liquidation costs (1,250)
Secured loan (4,000)
6,000
Delivery vehicles 500
Sale of patents 3,125
Current assets 4,000
18,625
Other loans (12,000)
6,625
Trade payables and bank overdraft 10,750
Comment
The secured loan, other loans and liquidation costs would be paid in full in the event of liquidation.
However there would only be 6,625,000 left to pay trade payables and the bank overdraft.
Approximately 61.6% of these obligations would be met. There would be nothing left for the
preference and ordinary shareholders.
Reconstruction scheme
'000
Earnings before interest and tax 3,600
Interest (8% 3,125,000 + 12% 8,000,000) 1,210
Earnings before tax 2,390
Tax at 23% 550
Earnings after interest and tax 1,840
P/E ratio (average) 10.8
Share price = (1,840,000 10.8) / Number of shares (10,500,000) = 1.89

Comments
Secured loan
Under the proposed scheme, the loan provider will receive securities of 5,375,000 (3,125,000 +
1,500,000 shares at, say, 1.50 each). This is more than they had previously and the yield on the loan
remains the same (8%). If the company went into liquidation they would receive the full amount of the
money owing to them.
Other loans
The loan provider will receive 8,000,000 secured loan plus 4,125,000 worth of shares (1.50 x
2,750,000). This is more than they had previously. This means that a total of 11,125,000 (including
the secured loan above) is secured on freehold buildings with a disposal value of 11,250,000. This
does not give good asset coverage, although this could change if the value of the buildings was to
increase. The loan provider's risk has increased as a result of being granted ordinary shares (last in the
pecking order if the company went into liquidation).
Ordinary shareholders
Under the scheme the current ordinary shareholders would lose control of the company due to the
shares granted to loan providers and preference shareholders. In the event of liquidation they would
receive nothing.
Preference shareholders
The preference shareholders have received no dividends for five years. However the granting of
1,250,000 ordinary shares more than covers the arrears.

Cash flow forecast if reconstruction took place
C
'000
H
Cash from new share issue to equity holders 5,000 A
Repayment of overdraft 3,000 P
Available cash 2,000 T
E
The reconstruction scheme may not be acceptable to all interested parties. In particular the providers of R
the 'other loans' may be reluctant, given their increased risk. This will be a concern for the company as
the funds from the 'other loans' are necessary to finance the business. If the reconstruction scheme is
not acceptable, the company may have to seek funds elsewhere, otherwise liquidation may be 6
unavoidable.

Tutorial note:
Part (a) covers alternative sources of finance. Various criteria can be used to consider them:
Costs (including costs saved)
Flexibility (a company knows when and how much interest and principal it has to pay on a loan
but still has to pay it; by contrast an overdraft facility only has interest charged on it if it is used,
but it is repayable on demand)
Commitment (security that has to be given, how much the company is tied into the
arrangement)
Appearances (effect on gearing, effect on accounts receivable if factor organisation is employed)
Although the question directs you towards discussing certain sources of finance, it does not confine you
to those sources. Therefore, although the bulk of your answer to (a) should discuss the sources listed, a
section briefly mentioning other sources should also be included.
Don't forget also in (a) to bear in mind the likely level of financial knowledge of the recipients of your
report; don't assume a high level of understanding.
(b) is a summary list of the key factors venture capitalists will take into account. As well as the company's
market prospects, venture capitalists are also interested in the involvement of management (level of
commitment and expertise).
(a) REPORT
To: Shareholders in DF
From: Accountant
Date: 11 December 20X1
Subject: Alternative methods of financing current assets
Introduction
The contract to supply FF means that DF will need to make a significant additional permanent
investment in current assets (in the form of additional inventories and higher accounts
receivable). There will also be an additional temporary element which fluctuates with the level of
sales. This will increase the amount of money needed by the company to finance these assets.
There are a number of different sources of finance that could be considered.
Bank loan
A bank loan would normally be for a fixed amount of money for a fixed term and at a fixed rate of
interest. It is not clear whether or not the company has any existing debt finance. However, it has
already been decided to use a bank loan to fund the purchase of the additional non-current assets.
The size of this loan and the quality of security available will be key factors in determining
whether the bank is willing to make a further advance to cover the investment in current assets.
Assuming that a further loan is forthcoming, the company will need to evaluate the effect of this in
terms of cost and the effect on the capital structure.

Advantages of bank loan
(i) Bank finance is cheaper than the cost of allowing a 3% settlement discount, and is also
likely to be cheaper than using debt factoring or invoice discounting.
(ii) The loan can be negotiated for a fixed term and a fixed amount, and this is less risky than,
for example, using an overdraft, which is repayable on demand.
Disadvantages of bank loan
(i) The company will have to pay interest on the full amount of the loan for the entire period.
This could make it more expensive in absolute terms than using an alternative source of
finance where interest is only payable on the amount outstanding.
(ii) The loan will increase the level of the company's financial gearing. This means that there
could be greater volatility in the returns attributable to the ordinary shareholders.
(iii) The bank is likely to require security. If there are questions as to the quality of the asset base,
the bank may also require personal guarantees or additional security from the directors or
shareholders.
Overdraft
An overdraft is a form of lending that is repayable on demand. The bank grants the customer a
facility up to a certain limit, and the customer can take advantage of this as necessary. Overdrafts
are essentially short-term finance, but are renewable and may become a near-permanent source.
Advantages of overdraft
The attraction of using an overdraft to finance current assets is that interest is only payable on the
amount of the facility actually in use at any one time. This means that the effective cost of the
overdraft will be lower than that of the bank loan. This is particularly attractive for a company
such as DF, where demand is expected to fluctuate significantly from month to month, and
consequently there are likely to be large variations in the level of working capital. It is also likely to
be cheaper than the other alternatives being considered.
Disadvantages of overdraft
The main drawback to using an overdraft is that it will be repayable on demand, and therefore
the company is in a more vulnerable position than it would be if a bank loan were used instead. A
long-term overdraft may be included in the gearing calculations, and the bank may require
security.
Debt factoring
Factoring is an arrangement to have debts collected by a factor company, which advances a
proportion of the money it is due to collect. Services offered by the factor would normally include
the following.
(i) Administration of the client's invoicing, sales accounting and debt collection service.
(ii) Credit protection for the client's debts, whereby the factor takes over the risk of loss from
bad debts and so 'insures' the client against such losses.
(iii) Making advance payments to the client before the debts are collected.
Benefits of factoring
(i) Growth is effectively financed through sales, which provide the security to the factor. DF
would not have to provide the additional security that might be required by the bank.
(ii) The managers of the business will not have to spend time on the problem of slow paying
accounts receivable.
(iii) Administration costs will be reduced since the company will not have to run its own sales
ledger department.

Disadvantages of factoring
C
(i) The level of finance is geared to the level of sales; in other words, finance lags sales. In H
practice, DF will need finance ahead of sales in order to build up sufficient inventories to meet A
demand. P
T
(ii) Factoring may be more expensive than bank finance. Service charges are generally around E
2% of total invoice value, in addition to finance charges at levels comparable to bank R
overdraft rates.
(iii) The fact that accounts receivable will be making payments direct to the factor may present a
6
negative picture of the firm.
Invoice discounting
Invoice discounting is related to factoring and many factors will provide an invoice discounting
service. Invoice discounting is the purchase of a selection of invoices, at a discount. The
discounter does not take over the administration of the client's sales ledger, and the arrangement
is purely for the advance of cash.
Advantages of discounting
The arrangement is thus a purely financial transaction that can be used to release working
capital, and therefore shares some of the benefits of factoring in that further security is not
required. The discounter will make an assessment of the risk involved, and only good quality
invoices will be purchased, but this should not be a problem to DF since FF is a large well
established company.
Disadvantage of discounting
The main disadvantage is that invoice discounting is likely to be more expensive than any of the
other alternatives. It is normally only used to cover a temporary cash shortage, and not for the
routine provision of working capital.
Other options
(i) Finance can be obtained by delaying payment to accounts payable. In theory this is
potentially a cheap source of finance. The main disadvantage may be a loss of supplier
goodwill, at a time when the company needs supplier co-operation to fulfil the new order.
(ii) Other methods of loan finance, notably debenture issue, are not appropriate as they are
essentially long-term, and the debenture holders may require security that the company is
unable to give.
(iii) Although we are told that increased inventory levels will be needed to fulfil FF's
requirements, there may be scope for reducing the inventory levels necessary to fulfil other
customers' requirements.
Conclusions
Of the options considered, factoring or some form of bank finance is likely to be the most
appropriate. The final decision must take into account the full cost implications, and not just the
relative rates of interest on the finance. DF must also consider the effect of the type of finance
selected on the statement of financial position, and the type of security that will be required. This
could also impact on the ability of the company to raise further finance in the future.
(b) A venture capital organisation (below, 'VC') is likely to take the following factors into account
when deciding whether or not to invest in DF.
The nature of the company's product
The VC will consider whether the good or service can be produced viably and has potential to sell,
in the light of any market research which the company has carried out.
Expertise in production
The VC will want to be sure that the company has the necessary technical ability to implement
production plans with efficiency.

Expertise in management
Venture capitalists pay much attention to the quality of management, since they believe that this is
crucial to the success of the enterprise. Not only should the management team be committed to
the enterprise; they should also have appropriate skills and experience.
The market and competition
The nature of the market for the product will be considered, including the threat which rival
producers or future new entrants to the market may present.
Future prospects
The VC will want to be sure that the possible prospects of profits in the future compensate for the
risks involved in the enterprise. The VC will expect the company to have prepared a detailed
business plan detailing its future strategy.
Board membership
The VC is likely to require a place on the board of directors. Board representation will ensure that
the VC's interests will be taken account of, and that the VC has a say in matters relating to the
future strategy of the business.
Risk borne by the existing owners
The VC is likely to wish to ensure that the existing owners of the business bear a significant part of
the investment risk relating to the expansion. If they are owner-managers, bearing part of the risk
will provide an incentive for them to ensure the success of the venture. Although the VC may be
providing most of the investment, the amounts provided by the owners should be significant in
relation to their overall personal wealth.
Exit routes
The means by which the VC can eventually realise its investment are called 'exit routes'. Ideally, the
VC will try to ensure that there are a number of exit routes.

CHAPTER 7
Financial engineering
Introduction
Topic List
1 Overview of derivatives and valuation of options
2 Caps, collars and floors
3 Valuation of options
4 Interest rate hedging strategies
5 Foreign exchange risk management strategies
6 Financing projects and assets
7 Treasury functions
311
Introduction
Demonstrate a detailed understanding and application of the financial instruments

available for hedging against interest rate and foreign exchange rate risk, including swaps,
collars and floors
Demonstrate knowledge and understanding of nature and operation of the financial
instruments underlying the disclosure, recognition and measurement requirements of
IAS 32 and 39, and IFRS 7 and IFRS 9
Demonstrate and apply detailed knowledge and understanding of how to formulate
interest rate hedging strategies and foreign currency risk management strategies
Demonstrate and apply knowledge and understanding of the financing alternatives
available for projects and assets, and be able to make informed choices as to which
alternative is the most compatible with the overall financial strategy of the firm

1 Overview of derivatives and valuation of options
Section overview
This section reviews the derivatives covered in the Professional stage Financial Management paper
that are used for hedging against interest rate and foreign currency exchange rate exposure,
including forward contracts, futures, options and swaps.
A sound knowledge and application of derivatives are required at the Advanced Stage. You
should review these techniques thoroughly to ensure you are comfortable with how and when to
use them.
C
1.1 Interest rate hedging H
A
1.1.1 Futures P
T
An interest rate futures contract is a contract that either has a debt security as an underlying or is based E
on an interbank deposit. The price of futures contracts is quoted as 100 minus the interest rate for the R
contract period expressed in annual terms (the interest rate used is the LIBOR). Futures contract prices
move in 'ticks', with the tick size for interest rate futures usually being one basis point or 0.01% interest
rate movement in the underlying market. Futures contracts require an initial margin deposit and also 7
subsequent maintenance margin deposits.
Interactive question 1: Profit from futures trading [Difficulty level: Easy]

A three-month sterling interest rate futures contract (contract size 500,000) is quoted on a recognised
investment exchange. Its delivery date is 20 December 20X6.
On 22 November the future is trading at 94.63, implying that the market believes three-month LIBOR
will be 5.37% (100 94.63) on 20 December.
On 24 November 20X6 the future is quoted at 94.53. If you sell the future on 22 November at 94.63
and buy on 24 November at 94.53, how much profit will you make?
1.1.2 Options
An interest rate option is an instrument sold by an option writer to an option purchaser, for a price
known as a premium. The specified rate of interest for borrowing or lending is the strike price of the
option. The option holder has the right, but not the obligation, to exercise the option on or before a
specified expiry date.
A call option gives the holder the right to buy an underlying instrument at the strike price and obliges
the option writer to buy the instrument at that price if and when the option is exercised.
A put option gives its holder the right to sell an underlying instrument at the strike price and obliges the
option writer to sell the instrument at that price if and when the option is exercised.
The strike price of an OTC (over-the-counter) option is for a benchmark or reference interest rate such as
three month LIBOR. (Note: an over-the-counter option is one that is tailor-made to the individual
client's precise requirements.)
An option is said to be 'in-the-money' if its strike price is more favourable than the current market rate,
'out of the money' if the strike price is less favourable than current market rate, and 'at-the-money' if the
strike price and current market rate are the same.
1.1.3 Forward rate agreements (FRAs)

A forward rate agreement is a cash-settled forward contract on a short-term loan. FRAs are over-the-
counter instruments whose terms can be set according to the end user's requirements, but tend to be
Financial engineering 313

illiquid as they can only be sold back to the issuing investment bank. A 2 v 5 FRA, for example, is a two-
month forward on a three-month loan.
There are several important dates when dealing with FRAs. The trade date is the date on which the FRA
is dealt. The spot date is usually two business days after the traded date. The fixing date is the date
on which the reference rate used for the settlement is determined. FRAs settle with a single cash
payment made on the first day of the underlying loan this date is the settlement date. Finally, the
date on which the notional loan or deposit expires is known as the maturity date.
The settlement amount for a FRA is calculated using the following formula:
ND
rREF - rFRA
S= L DY
ND
1 rREF
DY
where: L = The notional amount of the loan

S = Settlement amount
rREF = The reference rate, typically a LIBOR rate or EURIBOR
ND = The number of days the loan is for, and
DY = The day count basis applicable to money market transactions in the currency of
the loan
Interactive question 2: FRA settlement value [Difficulty level: Intermediate]

Suppose a 4 v 10 US$10 million FRA is transacted with a FRA rate of 3.5%. The four-month forward
period starts on the spot date and extends to the settlement date. For this FRA, the reference rate is six-
month US$ LIBOR. Suppose the reference rate is 3.8% on the fixing date. What is the settlement
amount? (Remember that the US$ money market uses a 360-day basis.)
1.1.4 Swaps
An interest rate swap is a contract between two parties. The two parties agree to exchange a stream of
payments at one interest rate for a stream of payments at a different rate, normally at regular intervals
for a period of several years. The two parties to a swap agreement can come to an arrangement
whereby both will reduce their costs of borrowing. The most popular type of swap is a fixed-for-floating
arrangement where cash flows of a fixed rate loan are exchanged for those of a floating rate loan.
1.2 Foreign currency hedging

1.2.1 Forward contracts
A forward contract allows importers and exporters to hedge the risk of foreign currency rates moving
against them. Companies can arrange for a bank to buy or sell foreign currency at a future date, at a
rate of exchange determined when the contract is made. Remember that the current spot price is
irrelevant to the outcome of a forward contract these contracts must be exercised regardless of
whether the spot rate is more favourable than the agreed forward rate. Such contracts are used to limit
potential losses on exchange, but prevent any exchange gains being made.

1.2.2 Currency futures
It is useful to contrast how currency forward contracts work with how currency futures work.
A currency future is a contract to buy or sell a standardised amount of a currency for notional delivery at
a set date in the future. For example, the Chicago Mercantile Exchange (CME) trades sterling futures
contracts with a standard size of 62,500. Only whole number multiples of this amount can be bought
or sold. They can also only be delivered on certain dates eg sterling futures have contract dates of
March, June, September or December.
Futures contracts seldom go to maturity. The ease of liquidating positions in the futures market makes a
futures contract attractive for hedging and speculation. The high degree of standardisation in the
futures market means that traders need only discuss the number of contracts and the price, and
transactions can be arranged quickly and efficiently.
C
Forward contracts are generally intended for delivery, and many market participants may need more H
flexibility in setting delivery dates than is provided by the foreign exchange futures market. Transactions A
are typically for much larger amounts in the forward market while most standardised futures contracts P
are each set at about $100,000 or less, though a single market participant can buy or sell multiple T
E
contracts. Also, forward contracts are not limited to the currencies traded on the futures exchanges. R
The foreign currency futures market provides an alternative to the forward market, but it also
complements that market. Like the forward market, the currency futures market provides a mechanism
whereby users can alter portfolio positions. It can be used on a highly geared basis for both hedging 7
and speculation. It thus facilitates the transfer of risk from hedgers to speculators, or from speculators
to other speculators.
1.2.3 Money market hedge

Money market hedges can be set up to cover future foreign currency payments or future foreign
currency receipts. They can be used instead of forward contracts and have exactly the same effects. If
you are required to make a payment in Japanese yen in the future, you can set up a hedge as follows.
Borrow appropriate amount in pounds sterling now.
Convert pounds sterling to Japanese yen now.
Put yen on deposit in a Japanese yen bank account.
When payment becomes due, pay the creditor out of the yen bank account and repay the pounds
sterling loan.
Interactive question 3: Money market hedge [Difficulty level: Intermediate]

A UK company owes a Danish supplier Kr3,500,000, payable in three months' time. The spot exchange
rate is Kr/ 7.5509 7.5548. The company can borrow in sterling for three months at 8.60% per
annum and can deposit kroners for three months at 10% per annum. What is the cost in pounds
sterling with a money market hedge and what effective forward rate would this represent?
1.2.4 Currency options

A currency option is an agreement involving a right, but not an obligation, to buy or sell a certain
amount of currency at a stated rate of exchange (the exercise price) on or before some specified time
in the future. Currency options involve the payment of a premium, which is the most the buyer of the
option can lose. An option reduces the risk of losses due to currency movements but allows currency
gains to be made. The premium cost means that if the currency movement is adverse, the option will be
exercised, but the hedge will not normally be quite as good as that of the forward or futures contract.
However if the currency movement is favourable, the option will not be exercised, and the result will
normally be better than that of the forward or futures contract; this is because the option allows the
holder to profit from the improved exchange rate.

Interactive question 4: Crabtree plc [Difficulty level: Intermediate]
Crabtree plc is expecting to receive 20 million South African rand (R) in one month's time. The current
spot rate is R/ 19.3383 19.3582. Compare the results of the following actions.
(a) The receipt is hedged using a forward contract at the rate 19.3048.
(b) The receipt is hedged by buying an over-the-counter (OTC) option from the bank, exercise price
R/ 19.3000, premium cost 12 pence per 100 rand.
(c) The receipt is not hedged.
In each case compute the results if, in one month, the exchange rate moves to:
(a) 21.0000
(b) 17.6000
1.2.5 Currency swaps

A currency swap (or cross currency swap) is an interest rate swap with cash flows in different currencies.
It is an agreement to make a loan in one currency and to receive a loan in another currency. With the
currency swap there are three sets of cash flows. Initially, the underlying principals are exchanged when
the swap starts; interest payments are then made over the life of the swap; and finally the underlying
principal amounts are re-exchanged. Liability on the main debt (the principal) is not transferred and the
parties are liable to counterparty risk: if the other party defaults on the agreement to pay interest, the
original borrower remains liable to the lender. This can present complicated legal problems, and some
borrowers are unwilling to get involved in swap transactions for this reason.
A currency swap could also be interpreted as issuing a bond in one currency (and paying interest on this
bond) whilst investing in a bond in another currency (and receiving interest on this bond).
Worked example: Currency swaps 1

A simple example would be one in which a UK company agrees with a US company to swap capital
amounts at an agreed rate of exchange. Suppose a UK company is selling satellite equipment to NASA
in the USA but will not be paid (in US dollars) for two years. The UK company could agree with another
company to swap capital at an agreed rate of exchange in two years' time. The UK company will give
the counterparty US dollars and receive the sterling in return.
Worked example: Currency swaps 2

Consider a UK company X with a subsidiary in France which owns vineyards. Assume a spot rate of 1 =
1.2000 euros. Suppose the parent company wishes to raise a loan of 1.2 million euros for the purpose of
buying another French wine company. At the same time, the French subsidiary Y wishes to raise 1
million to pay for new up-to-date capital equipment imported from the UK. The UK parent company X
could borrow the 1 million sterling and the French subsidiary Y could borrow the 1.2 million euros,
each effectively borrowing on the other's behalf. This is known as a back-to-back loan.
1.2.6 FX swaps
An FX swap is a spot currency transaction coupled with an agreement that it will be reversed at a pre-
specified date by an offsetting forward transaction.
An FX swap is useful for hedging as it allows companies to shift temporarily into or out of one currency
in exchange for a second currency without incurring exchange rate risk. This avoids a change in
currency exposure which is the role of the forward contract.

Interactive question 5: El Dorado part 1 [Difficulty level: Intermediate]
El Dorado plc, an engineering company based in the UK, has won a contract to build a theme park ride
in Sri Lanka. This project will require an initial investment of 500 million Sri Lankan rupees and will be
sold for 900 million rupees to the Sri Lankan government in one year's time. As the Sri Lankan
government will pay in rupees, El Dorado is exposed to movements in the /rupee exchange rate.
Requirement
Construct a forex (FX) swap that will help to hedge the exchange rate risk.
C
Interactive question 6: El Dorado part 2 [Difficulty level: Intermediate]
H
Look again at El Dorado part 1. A
P
Assume that the currency spot rate is 100 rupees/ and the Sri Lankan government has offered a forex T
swap at that rate. The estimated spot rate in one year's time (when the government will pay for the E
R
theme park ride) is 180 rupees/. The current UK borrowing rate is 8%.
Requirement
7
Should El Dorado hedge the exposure using the swap or should it just do nothing? Show all workings
to support your answer.
1.3 REPOs
Definition
A repurchase agreement (repo) is an agreement between two counterparties under which one
counterparty agrees to sell an instrument to the other on an agreed date for an agreed price, and
simultaneously agrees to buy back the instrument from the counterparty at a later date for an agreed
price.
A repo is a loan secured by a marketable instrument, usually a treasury bill or a bond. The typical term is
1180 days. A repo is an attractive instrument because it can accommodate a wide spectrum of
maturities. The flows in a repo are shown in the following diagram.
Security
Flows at Repo
Lender
initiation dealer
Money lent
Security
Flows at Repo
maturity Lender
dealer
Money lent + interest
A repo is in effect a cash transaction combined with a forward contract. Repos can be:
Overnight (one-day maturity transactions)
Term (specified end date)
Open (no end date)
A reverse repurchase agreement (reverse repo) is an agreement for the purchase of an instrument with the
simultaneous agreement to resell the instrument at an agreed future date and agreed price. In a reverse

repo, the dealer purchases the security initially and then sells it on maturity. Because the two parties in a
repo agreement act as a buyer and a seller of the security, a repo to one party is a reverse repo to the other.
1.3.1 Use of repos

Repos give buyers the chance to invest cash for a limited period of time, on a transaction where they
receive collateral as security. Market liquidity and rates are generally good. Traders use repos to cover
their positions and benefit from lower funding costs. The repo market is an important component of
the overnight market that we discussed in Chapter 6.
Case example: Repo 105

Repo 105 is an accounting dodge where a short-term loan is treated as a sale of assets. The cash
obtained pays off other debt and the company appears to reduce its leverage on its published statement
of financial position. After the statement is published, the company borrows cash and buys back its
original assets. This contrasts with a normal repo arrangement where the assets remain in the statement
of financial position, as the transaction is treated as financing.
The justification for using Repo 105 has been that under US accounting rules, the sale could be
recognised as the assets sold were valued at more than 105% of cash received. However the
arrangement is contrary to the principle of substance over form. Repo 105 does not have a business
purpose. It is undertaken to manipulate financial information.
Lehman Brothers used Repo 105, having obtained the opinion of its legal advisers Linklaters that the
arrangement was a true sale under UK law. It then applied US accounting standards to make it effective.
In the second quarter of 2008 it employed Repo 105 to appear to demonstrate better leverage and
liquidity, and mitigate the disclosure of its losses.
1.4 Macro hedging

Macro hedging, also known as portfolio hedging, is a technique where financial instruments with similar
risks are grouped together and the risks of the portfolio are hedged together. Often this is done on a net
basis with assets and liabilities included in the same portfolio. For example, instead of using interest rate
swaps to hedge interest rate exposure on a loan-by-loan basis, banks hedge the risk of their entire loan
book or specific portions of the loan book.
In practice however macro hedging is difficult, as it may be hard to find an asset that offsets the risk of a
broader portfolio.
1.5 Cash flow and fair value hedges

An important distinction when accounting for derivatives is the distinction between cash flow and fair
value hedging.
1.5.1 Cash flow hedges

A cash flow hedge is a hedge of the variability in an organisation's cash flows. The variability should be
attributable to a particular risk associated with:
A recognised asset or liability; or
A highly probable forecast transaction
and could affect profit or loss.
An interest rate swap changing floating rate debt into fixed rate debt is an example of a cash flow
hedge. The organisation is hedging the risk of variability in future interest payments which may arise, for
instance from changes in market interest rates. The fixed rate protects against this cash flow variability.

1.5.2 Fair value hedges
A fair value hedge is a hedge of an organisation's exposure to changes in fair value of a recognised asset
or liability or an unrecognised firm commitment, that is attributable to a particular risk and could affect
profit or loss.
A forward contract hedging against the future purchase of raw materials in a foreign currency is an
example of a fair value hedge. The contract protects against the market risk of depreciation of the local
currency and increase in the cost of the materials.
1.6 Accounting issues

Accounting for derivatives under IASs 32 and 39, and IFRSs 7 and 9 is covered in Chapters 57 of the
Advanced level Corporate Reporting text. These accounting standards have placed significant demands C
on organisations that use derivatives regularly. Organisations will need to H
A
Value derivatives P
Produce documentation of hedging strategies T
E
Test hedging effectiveness and manage hedging relationships
R
Generate the information necessary to fulfil accounting requirements
The following areas may cause particular problems for organisations.
7
1.6.1 Initial recognition of derivatives
When an organisation enters into a derivative transaction involving a contract that is recognised under
IFRS 9 as a financial instrument, it should be recognised when the organisation enters into the contract,
not when the transaction occurs that was stipulated by the derivative contract.
1.6.2 Valuation of derivatives

Establishing a fair value for non-traded derivatives may be problematic. Their value will be very
dependent on the assumptions used, particularly those relating to the timing and size of future cash
flows.
1.6.3 Hedge accounting

Establishing whether a hedge is effective as defined by accounting standards may be difficult.
Remember that under accounting standards, hedge accounting is only permitted if both at inception
and during the life of the hedging relationship, hedge effectiveness falls between 80% and 125%.
1.6.4 Risk disclosures

IFRS 7 requires qualitative and quantitative disclosures about market, credit and liquidity risks associated
with derivatives. These disclosures will be more detailed than those for other types of risk that the
organisation faces.
1.7 Limitations of using derivatives

It is easy to assume that derivatives should always be used to hedge interest rate and foreign exchange
rate risk. In many instances organisations could have perfectly legitimate reasons for not using
derivatives.
1.7.1 Cost
Many organisations will be deterred from using derivatives by the costs, including transaction costs and
possibly brokerage fees. Companies may feel that the maximum losses if derivatives are not used are too
small to justify incurring the costs of derivatives, either because the size of transactions at risk is not
particularly large, or because the risks of large movements in interest or exchange rates is felt to be very
small. Using natural hedging methods, such as matching receipts and payments in the same currency as
far as possible, avoids the costs of derivatives. Matching may be particularly important for countries
trading in Europe with countries using the euro.

1.7.2 Attitudes to risk
The desirability of hedging must also be seen in the wider context of the organisation's strategy and its
appetite for taking risks. For example directors may be reluctant to pass up the chance of making
exchange gains through favourable exchange rate movements. They may therefore choose the riskier
course of not hedging, rather than fixing the exchange rate through a forward contract and eliminating
the possibility of profits through speculation.
1.7.3 Uncertainty over payments and receipts

There may not only be uncertainties over movements in rates. Uncertainties may also affect the amount
and timing of settlement of the transactions being hedged. Uncertainties over timing may be
particularly significant if the hedging transaction has to be settled on a specific date, for example an
exporter having to fulfil a forward contract with a bank even if its customer has not paid.
1.7.4 Lack of expertise

If a business is making a lot of use of derivatives, or using complex derivatives, the potential losses from
poor decision-making due to lack of expertise may be unacceptably high. These must be weighed
against the costs of obtaining specialist external advice or maintaining an in-house treasury function, in
order to reduce the risks of poor management of hedging.
1.7.5 Accountancy and tax complications

The accounting complications of using hedging instruments, described in 1.6 above, may be significant.
Case example: UBS

In September 2011, Kweku Adoboli, a trader at the Swiss bank UBS was arrested after allegedly having
lost the bank 1.5 billion. The frauds that Adoboli was charged with took place between October 2008
and September 2011 and involved reporting fictitious hedges against legitimate derivative transactions.
Adoboli worked for UBS's global synthetic equities division, buying and selling exchange traded funds
which track different types of stocks or commodities such as precious metals. In November 2012 he was
sentenced to seven years in prison.
Later in September 2011 UBS announced plans to scale back its investment banking activities to reduce
its risks and chief executive, Oswald Gruebel, resigned. In November 2010 Mr Gruebel had reportedly
justified the bank's decision at that time to increase its risk appetite with these words: 'Risk is our
business. I can assure you, as long as I'm here, as long as my colleagues are here, we do know about
risk. (If things go wrong) you won't hear us saying we didn't know it.'
Case example: JP Morgan

The hedging activities of the banking sector in general were put under the media spotlight in May 2012
when JP Morgan announced that a trading desk in London had lost more than $2bn. JP Morgan had
had a reputation for being one of the better managed and cautious banks. However the chief executive,
Jamie Dimon, blamed 'errors, sloppiness and bad judgement' for the losses.
Initial reports suggested the transactions were not unauthorised or carried out by a rogue trader, but
were the result of a change in hedging strategy. This change made the strategy more complex and
more risky, when hedge funds took advantage of the volatility stemming from JP Morgan's trades.
According to an executive at the bank, Dimon wasn't immediately told about the shift in strategy and
didn't know the magnitude of the losses until after the company reported earnings on 13 April.
However Dimon had reportedly previously encouraged the trading desk to make bigger and riskier
speculative trades.
It was reported that the desk had taken positions so large that even JP Morgan, the largest and most
profitable US bank, couldn't unwind them at all easily.

Dimon had called previous news coverage in April 2012 about the positions that the bank was taking as
a 'complete tempest in a teacup'. Days before the announcement of the loss he had led bank chief
executives in a meeting to lobby the American Federal Reserve to soften proposed banking reforms.
JP Morgan's share price fell by 9% on the day the losses were announced. The share price of other banks
also suffered.
2 Caps, collars and floors
Section overview
C
Caps set a ceiling to the interest rate. H
A
Floors set a lower limit for the interest rate. P
T
Collars are a combination of caps and floors, keeping the interest rate within a particular range. E
R
Caps set a ceiling to the interest rate; a floor sets a lower limit. Using a collar arrangement, the
borrower can buy an interest rate cap and at the same time sell an interest rate floor which fixes the cost
for the company within a range. 7
The cost of a collar is lower than for a cap alone. However, the borrowing company forgoes the benefit
of movements in interest rates below the floor limit in exchange for this cost reduction.
Worked example: Caps and collars

Suppose the prevailing interest rate for a company's variable rate borrowing is 10%. The company
treasurer considers that a rise in rates above 12% will cause serious financial difficulties for the company.
How can the treasurer make use of a 'cap and collar' arrangement?
Solution
The company can buy an interest rate cap from the bank. The bank will reimburse the company for the
effects of a rise in rates above 12%. As part of the arrangements with the bank, the company can agree
that it will pay at least 9%, say, as a 'floor' rate. The bank will pay the company for agreeing this. In
other words, the company has sold the floor to the bank, which partly offsets the costs of the cap. The
bank benefits if rates fall below the floor level.
2.1 Traded caps, floors and collars

2.1.1 Traded caps
Say you are a borrower and have bought a put option (a right to sell a future). The exercise price is
93.00, reflecting an interest rate of 7%.
Interest rate rises
If the interest rate you have to pay rises to 8%, the price of the future will fall to 92.00.
You will buy the future at 92.00 and exercise your right to sell it at 93.00.
The profit you make on buying and then selling the future can be set against the 8% interest you
have to pay, to give an effective interest rate of 7%.
Interest rate falls
If the interest rate falls to 6%, you don't exercise the option, therefore don't worry about buying
and selling the future, and just pay interest at 6%.

2.1.2 Traded floors
In order to set a floor if you are investing/lending, you have to buy a call option a right to buy a
future. Say the exercise price is 95.00, corresponding to an interest rate of 5%.
Interest rate falls
If the interest rate falls to 4%, the price of the future will rise to 96.00.
You will only receive interest at 4%.
However you will exercise your option to buy the future at 95.00 and then you will sell it on at
96.00.
The profit you make on the future will be added to the 4% interest you receive to give an effective
net interest rate of 5%.
Interest rate rises
If the interest rate rises to 6%, you will not exercise the option, and you will receive interest at 6%.
2.1.3 Traded collars

With collars, if you are a borrower, you are buying a put and selling a call. Say the exercise price is
96.00, corresponding to an interest rate of 4%.
Buying a put as above.
Selling a call means that you are selling someone else the right to buy a future from you.
Interest rate falls
If the interest rate falls to 3%, the price of the future will rise to 97.00.
You will pay interest at 3%.
However, the holder of the call option will wish to exercise the option to buy the future at 96.00.
You, therefore, have to buy the future yourself at 97.00 and sell it to the option holder at 96.00,
thus incurring a loss.
The loss you incur will be added to the 3% interest you have to pay to give an effective net
interest rate of 4%.
If interest rates fall further, you will pay a lower interest rate but incur a larger loss on the option,
netting out always at an interest rate of 4%.
Interest rate rises
If the interest rate rises above 4%, the option holder will not exercise the option.
You will pay interest at more than 4%, but be able to offset against this a profit on selling the
future, to give an effective interest rate of 4%.
3 Valuation of options
Section overview
Various factors affect the value of options, including the current share price, the option's exercise
price and the volatility of the share price. These factors were covered in the Professional stage
Financial Management paper and are reviewed in this section.
The value of an option is made up of intrinsic value and time value.
The Black-Scholes model is frequently used for valuing options, with Monte Carlo simulation being
another useful valuation technique.

3.1 Factors affecting option value
The value of a call option depends upon:
Current share price. If the share price rises, the value of a call option will increase. For currency
options, the relevant 'price' is the spot exchange rate.
Exercise price of the option. The higher the exercise price, the lower is the value of a call option.
Share price volatility or standard deviation of return on underlying share. The higher the
standard deviation of the return, the higher is the value of a call option, because there is more
likelihood that the share price will rise above the option price.
Time to expiry of the option. The longer the period to expiry, the higher is the value of a call
option because there is more time for the share price to rise above the option price.
C
Risk-free rate of interest. The higher the risk-free rate of interest, the higher is the value of a call
H
option. As the exercise price will be paid in the future, its present value diminishes as interest rates A
rise. This reduces the cost of exercising and thus adds value to the option. P
T
The widespread use of derivatives involving options has resulted in much attention being paid to the
E
valuation of options. The share option is a common form of option, giving the right but not the R
obligation to buy or to sell a quantity of a company's shares at a specified price within a specified
period.
7
3.1.1 Intrinsic value and time value
The value of a share option is made up of:
'Intrinsic value'
'Time value'
The intrinsic value of an option depends upon:
Share price
Exercise price
The time value of an option is affected by:
Time period to expiry
Volatility of the underlying security
General level of interest rates
3.1.2 Summary of determinants of option prices
Summary of determinants of option prices
in Call price Put price

Share price
Exercise price
Volatility
Time to expiry
Risk-free rate of return
3.2 The Black-Scholes model

The Black-Scholes model for the valuation of European call options was developed in 1973. (European
options are options that can only be exercised on the expiry date, as opposed to American options,
which can be exercised on any date up till the expiry date.) The model is based on the principle that the
equivalent of an investment in a call option can be set up by combining an investment in shares with
borrowing the present value of the option exercise price.

The model requires an estimate to be made of the volatility in return on the shares. One way of making
such an estimate is to measure the volatility in the share price in the recent past and to make the
assumption that this volatility will apply during the life of the option.
3.2.1 Assumptions of the model
In order to incorporate volatility and the probabilities of option prices into the model, the following
assumptions are needed.
Returns are normally distributed.
Share price changes are lognormally distributed.
Potential price changes follow a random model.
Volatility is constant over the life of the option.
The Black-Scholes formula is also based on the following other important assumptions.
Traders can trade continuously.
Financial markets are perfectly liquid.
Borrowing is possible at the risk-free rate.
There are no transaction costs.
Investors are risk-neutral.
3.2.2 Using the Black-Scholes model to value share options

The factors affecting option values in general were covered in Section 3.1 above.
3.3 Monte Carlo simulation model

The Monte Carlo simulation model is widely used in situations involving uncertainty. The method
amounts to adopting a particular probability distribution for the uncertain (random) variables that affect
the option price and then using simulations to generate values of the random variables.
To deal with uncertainty the Monte Carlo method assumes that the uncertain parameters or variables
follow a specific probability distribution.
The basic idea is to generate through simulation thousands of values for the parameters or variables of
interest and use these variables to derive the option price for each possible simulated outcome. From
the resulting values we can derive the distribution of the option price.
The Monte Carlo simulation model is particularly relevant for IFRS 2 Share-based payment. This
Standard requires that share-based transactions are recognised in the financial statements at their fair
value at the grant date.
One of the major challenges of this statement is measuring the value of the equity instruments (such as
share options). The statement requires such instruments to be included in the financial statements at
fair value, which should be based on market prices if available. If market prices are not available, the
Monte Carlo simulation model is often used to estimate the fair value of the instruments.
4 Interest rate hedging strategies
Section overview
When deciding which techniques to use to hedge against interest rate risk, issues such as cost,
flexibility, expectations and ability to benefit from favourable interest rate movements should be
considered.
Financial instruments should not be chosen in isolation their impact on the overall financial
strategy of the company should also be considered.

While it is essential to know about the different financial instruments that are available to reduce interest
rate risk, it is also very important to be able to determine which instrument(s) should be used in
particular circumstances or when devising strategies.
If you have to discuss which instrument should be used to hedge interest rate risk, consider cost,
flexibility, expectations and ability to benefit from favourable interest rate movements.
Different hedging instruments often offer alternative ways of managing risk in a specific situation. In the
following example, we consider the different ways in which a company can hedge interest rate risk.
Worked example: Hedging strategies

It is 31 December. Octavo needs to borrow 6 million in three months' time for a period of six months.
For the type of loan finance which Octavo would use, the rate of interest is currently 13% per year and
the corporate treasurer is unwilling to pay a higher rate. C
H
The treasurer is concerned about possible future fluctuations in interest rates, and is considering the A
following possibilities: P
T
Forward rate agreements (FRAs) E
Interest rate futures R
Interest rate guarantees or short-term interest rate caps
Requirement 7
Explain briefly how each of these three alternatives might be useful to Octavo.
Solution
Forward rate agreements (FRAs)
Entering into an FRA with a bank will allow the treasurer of Octavo to effectively lock in an interest
rate for the six months of the loan. This agreement is independent of the loan itself, upon which the
prevailing rate will be paid. If the FRA were negotiated to be at a rate of 13%, and the actual interest
rate paid on the loan were higher than this, the bank will pay the difference between the rate paid and
13% to Octavo. Conversely, if the interest paid by Octavo turned out to be lower than 13%, they would
have to pay the difference to the bank. Thus the cost to Octavo will be 13% regardless of movements in
actual interest rates.
Interest rate futures
Interest rate futures have the same effect as FRAs, in effectively locking in an interest rate, but they are
standardised in terms of size, duration and terms. They can be traded on an exchange (such as LIFFE in
London), and they will generally be closed out before the maturity date, yielding a profit or loss that
is offset against the loss or profit on the money transaction that is being hedged. So, for example, as
Octavo is concerned about rises in interest rates, the treasurer can sell future contracts now; if that rate
does rise, their value will fall, and they can then be bought at a lower price, yielding a profit which will
compensate for the increase in Octavo's loan interest cost. If interest rates fall, the lower interest cost of
the loan will be offset by a loss on their futures contracts.
There may not be an exact match between the loan and the future contract (100% hedge), due to
the standardised nature of the contracts, and margin payments may be required while the futures are
still held.
Interest rate guarantees
Interest rate guarantees (or short-term interest rate options) give Octavo the opportunity to benefit
from favourable interest rate movements as well as protecting them from the effects of adverse
movements. They give the holder the right but not the obligation to deal at an agreed interest rate at a
future maturity date. This means that if interest rates rise, the treasurer would exercise the option, and
'lock in' to the predetermined borrowing rate. If, however, interest rates fall, then the option would
simply lapse, and Octavo would feel the benefit of lower interest rates.
The main disadvantage of options is that a premium will be payable to the seller of the option, whether
or not it is exercised. This will therefore add to the interest cost. The treasurer of Octavo will need to

consider whether this cost, which can be quite expensive, is justified by the potential benefits to be
gained from favourable interest rate movements.
When considering interest rate or currency risk hedging, don't discuss every possible technique that you
can recall. Marks will only be awarded for techniques that are appropriate to the circumstances
described in the question.
5 Foreign exchange risk management strategies
Section overview
Similar issues to those taken into consideration for interest rate hedging strategies apply to foreign
exchange risk management strategies. Some of these issues have already been covered in the
Professional stage Financial Management paper.
Internal methods such as matching and leading and lagging can also be used as part of the overall
strategy.
5.1 Causes of exchange rate fluctuations

5.1.1 Currency supply and demand
The exchange rate between two currencies that is the buying and selling rates, both 'spot' and
forward is determined primarily by supply and demand in the foreign exchange markets, which are
influenced by such factors as the relative rates of inflation, relative interest rates, speculators and
government policy.
5.1.2 Interest rate parity

The difference between spot and forward rates reflects differences in interest rates. If this was not the
case then investors holding the currency with the lower interest rates would switch to the other
currency for (say) three months, ensuring that they would not lose on returning to the original currency
by fixing the exchange rate in advance at the forward rate. If enough investors acted in this way
(known as arbitrage), forces of supply and demand would lead to a change in the forward rate to
prevent such risk-free profit making.
The principle of interest rate parity can be stated as follows:
(1 ic )
F0 = S0
(1 ib )
where: F0 = expected future spot rate

S0 = current spot rate
ic = interest rate in country c
ib = interest rate in country b
Interactive question 7: Northland and Southland [Difficulty level: Intermediate]

Exchange rates between two currencies, the Northland florin (NF) and the Southland dollar ($S) are
listed in the financial press as follows.
Spot rates 4.7250 NF/$S
0.21164 $S/NF
90-day rates 4.7506 NF/$S
0.21050 $S/NF
The money market interest rate for 90-day deposits in Northland florins is 7.5% annualised. What is
implied about interest rates in Southland?

Assume a 365-day year.
(Note: In practice, foreign currency interest rates are often calculated on an alternative 360-day basis,
one month being treated as 30 days.)
5.1.3 Purchasing power parity

Purchasing power parity theory predicts that the exchange value of foreign currency depends on the
relative purchasing power of each currency in its own country and that spot exchange rates will vary
over time according to relative price changes.
Formally, purchasing power parity can be expressed in the following formula. C
H
A
(1 hc ) P
S1 = S 0
(1 hb ) T
E
where S1 = expected spot rate R
S0 = current spot rate

hc = expected inflation rate in country c 7
hb = expected inflation rate in country b
Note that the expected future spot rate will not necessarily coincide with the 'forward exchange rate'
currently quoted.
Worked example: Forecasting exchange rates
The spot exchange rate between UK sterling and the Danish kroner is 1 = 8.00 kroners. Assuming that
there is now purchasing parity, an amount of a commodity costing 110 in the UK will cost 880 kroners
in Denmark. Over the next year, price inflation in Denmark is expected to be 5% while inflation in the
UK is expected to be 8%. What is the 'expected spot exchange rate' at the end of the year?
Using the formula above:
1.05
Future (forward) rate, S1 = 8
1.08
= 7.78
This is the same figure as we get if we compare the inflated prices for the commodity. At the end of the
year:
UK price = 110 1.08 = 118.80
Denmark price = Kr880 1.05 = Kr924
S1 = 924 118.80 = 7.78
In the real world, exchange rates move towards purchasing power parity only over the long term.
However, the theory is sometimes used to predict future exchange rates in investment appraisal
problems where forecasts of relative inflation rates are available.

Interactive question 8: Forecasting exchange rates [Difficulty level: Easy]
Assume that the $/ exchange rate is currently $1.7/, expected inflation in the UK is 4 per cent and the
expected inflation rate in the US is 5 per cent. What is the expected exchange rate in one year's time
according to the PPP?
Case example: Purchasing power parity

An amusing example of purchasing power parity is The Economist's Big Mac index. Under PPP
movements in countries' exchange rates should in the long-term mean that the prices of an identical
basket of goods or services are equalised. The McDonald's Big Mac represents the basket.
The index compares local Big Mac prices with the price of Big Macs in America. This comparison is used
to forecast what exchange rates should be, and this is then compared with the actual exchange rates to
decide which currencies are over- and under-valued.
5.1.4 International Fisher effect

The International Fisher effect states that currencies with high interest rates are expected to depreciate
relative to currencies with low interest rates.
For the UK the Fisher equation can be expressed as:
(1 + i) = (1 + r) (1 + h)
where: i = the nominal return h = the expected inflation rate
r = the real return
Countries with relatively high rates of inflation will generally have high nominal rates of interest, partly
because high interest rates are a mechanism for reducing inflation, and partly because of the Fisher
effect: higher nominal interest rates serve to allow investors to obtain a high enough real rate of return
where inflation is relatively high.
According to the International Fisher effect, interest rate differentials between countries provide an
unbiased predictor of future changes in spot exchange rates. The currency of countries with relatively
high interest rates is expected to depreciate against currencies with lower interest rates, because the
higher interest rates are considered necessary to compensate for the anticipated currency depreciation.
Given free movement of capital internationally, this idea suggests that the real rate of return in different
countries will equalise as a result of adjustments to spot exchange rates.
The international Fisher effect can be expressed as:
1 i c 1 hc

1 i b 1 hb
where ic is the nominal interest rate in country c

ib is the nominal interest rate in country b
hc is the inflation rate in country c
hb is the inflation rate in country b

Interactive question 9: International Fisher effect 1 [Difficulty level: Easy]
Suppose that the nominal interest rate in the UK is 6 per cent and the expected rate of inflation is
4 per cent. If the expected rate of inflation in the US is 5 per cent what is the nominal interest rate in the
US? What is the real interest rate in each country?
Interactive question 10: International Fisher effect 2 [Difficulty level: Easy]

Suppose that the nominal interest rate in the UK is 6 per cent and the nominal interest rate in the US is
7 per cent. What is the expected change in the dollar/sterling exchange rate over a year?
C
H
A
P
T
Worked example: International Fisher effect E
R
Refer back to Worked example Overseas Investment Appraisal in Chapter 4 Investment Appraisal.
We can now use the International Fisher effect to find the cost of capital in the host country that takes
account of the UK discount rate (10%) and the rate at which the exchange rate is expected to decrease 7
(5%). We can then use this rate to discount the euro cash flows.
The required return in euros can be calculated as:
e1
1 r (1 r )
e0
Or
1.52
1 r 1.10 1.045
1.6
Thus the euro discount rate is 4.5% and discounting the euro flows at this rate produces a NPV in euros
of NPV = 1,238.78m (as shown in the workings below).
0 1 2 3 4 5 6
Euro flows (m)
Capital 1,750 500
Net cash flows 800 800 800 800 800
Depreciation 250 250 250 250 250
Tax 220 220 220 220 220
Net cash flows 1,750 800 580 580 580 1,080 220
Discount factor 1 0.957 0.916 0.876 0.839 0.802 0.768
PV 1,750.00 765.6 531.28 508.08 486.62 866.16 168.96
NPV in euros 1,238.78m
Translating this present value at the spot rate gives:
NPV = 1,238.78m/1.6 = 774.24m
The difference between the figure above and the NPV of 774.37m using the alternative method in
Chapter 4 is due to rounding.
5.2 Foreign exchange risk management

As with interest rate risk management, you should consider cost, flexibility, expectations and ability to
benefit from favourable movements in rates when trying to determine how to hedge against foreign
currency risk.

As well as the derivatives mentioned in Section 1.2 above, it is possible to use internal hedging
techniques to protect against foreign currency risk. Basic methods include matching receipts and
payments, invoicing in your own currency and leading and lagging the times that cash is received and
paid. These were covered in detail in the Application Level paper Financial Management and are
reviewed briefly below.
Case example: Exchange rate movements

2008 demonstrated that exchange rates could be volatile in both directions within a short space of time,
as a consequence of uncertain economic conditions. For example the value of the Australian dollar
varied significantly over the year. The dollar appreciated rapidly in the first half of 2008, before falling
back against a number of other major currencies. By the end of 2008 the Australian dollar had, over the
twelve months, fallen 21% against the US dollar, 18% against the Euro and 26% against the Chinese
Yuan. However the Australian dollar had appreciated by 8% against the British pound and 5% against
the New Zealand dollar.
5.3 Currency of invoice

An exporting company can avoid currency risk by invoicing customers in its own home currency; an
importing company can make arrangements to be invoiced in its own currency by overseas suppliers.
This transfers all the currency risk to the other party. However, this is unlikely to continue in the long
term as the overseas customers and suppliers are unlikely to be willing to bear the entire currency risk
exposure burden.
5.4 Matching receipts and payments

A company can reduce or eliminate its foreign exchange transaction exposure by matching receipts and
payments. Wherever possible, a company that expects to make payments and have receipts in the same
foreign currency should plan to offset its payments against its receipts in the currency. Since the
company will be setting off foreign currency receipts against foreign currency payments, it does not
matter whether the currency strengthens or weakens against the company's 'domestic' currency because
there will be no purchase or sale of the currency.
The process of matching is made simpler by having foreign currency accounts with a bank. Receipts of
foreign currency can be credited to the account pending subsequent payments in the currency.
(Alternatively, a company might invest its foreign currency income in the country of the currency for
example, it might have a bank deposit account abroad and make payments with these overseas
assets/deposits.)
5.5 Matching assets and liabilities

This is particularly popular with multinational companies with substantial long-term investments
overseas. To avoid losses arising due to currency movements, multinationals try to finance overseas
investments with loans in the local currency. Similarly, if a company expects to receive a considerable
sum in a foreign currency, this can be hedged by borrowing in the foreign currency and using the
foreign currency income to repay the loan.
5.6 Leading and lagging

Lead payments are payments made in advance, whilst lagged payments are those that are delayed.
This tactic is often used to take advantage of movements in exchange rates.
5.7 Netting
As the name suggests, netting involves setting off inter-company balances before payment is arranged.
This is common in multinational groups where a significant amount of intra-group trading takes place.

5.8 Hedging of net investment
As well as hedging transactions, an organisation may hedge an investment overseas.
In a hedge of a net investment in a foreign operation the hedged item is the amount of the reporting
organisation's interest in the net assets of that operation.
The amount that an entity may designate as a hedge of a net investment may be all or a proportion of
its net investment at the commencement of the reporting period. This is because the exchange rate
differences reported in equity on consolidation which form part of a hedging relationship relate only to
the retranslation of the opening net assets. Profits or losses arising during the period cannot be hedged
in the current period. However they can be hedged in the following periods, because they will then
form part of the net assets which are subject to translation risk.
An obvious means of hedging a net investment is foreign currency borrowing, which will offset the C
translation exposure on the investment. H
A
P
5.9 Devising a foreign currency hedging strategy T
E
Given the wide range of financial instruments (both internal and external) available to companies that R
are exposed to foreign currency risk, how can an appropriate strategy be devised that will achieve the
objective of reduced exposure whilst at the same time keeping costs at an acceptable level and not
damaging the company's relationship with its customers and suppliers? 7
There is no individual best way of devising a suitable hedging strategy each situation must be
approached on its own merits. Unless you are told otherwise, it should be assumed that the company
will be wanting to minimise its risk exposure it is up to you to come up with the most appropriate way
of doing so. You should be prepared to justify your choice of strategy.
The following worked example will give you an idea of how to put together a suitable strategy while
justifying your choice of doing so.
Worked example: Foreign currency hedging

IOU Inc is a large company based in the USA that trades mainly within the USA and with the UK. It has a
significant amount of borrowing in sterling. Debt interest of 725,000 is due to be paid on 31 October
and a further 530,000 on 31 December. IOU Inc's policy is to hedge the risks involved in all foreign
currency transactions.
Assume it is now 30 September. The company's bank quotes the following rates of exchange, US$ per
:
1 month forward 3 months forward
Spot
(mid rate) (mid rate)
1.5584 1.5590 1.5601 1.5655
Prices for a /US$ option on a US stock exchange (cents per , payable on purchase of the option,
contract size 31,250) are:
Strike price Calls Puts
(US$/) October December October December
1.56 2.02 3.00 1.00 2.16
1.57 1.32 n/a n/a n/a
1.58 0.84 2.12 2.18 3.14
The treasurer is considering two methods of hedging the risk, forward or option contracts. Market
expectations, based on current published economic forecasts, are that sterling will appreciate against
the US$ over the next three months. The treasurer thinks the might weaken or at least remain stable
against the $. He suggests that if options are to be used, one-month options should be bought at a
strike price of 1.57 and three-month options at a strike price of 1.58.
Ignore transaction costs.
Requirements
(a) Recommend, with reasons, the most appropriate method for IOU Inc to hedge its foreign
exchange risk on the two interest payments due in one and three months' time. Your answer

should include appropriate calculations, using the figures in the question, to support your
recommendation and a discussion of the factors to consider when choosing between the two
hedging mechanisms.
Assume you are a financial manager with the nationally-owned postal and telecommunications
company in Zorro, a country in Asia. In organisations such as this, periodic settlements are made
between local and foreign operators. Net receipts or payments are in US$.
(b) Explain the main types of foreign exchange risk exposure that are likely to affect the organisation
and advise the company on policies it could consider to reduce exposure to these risks.
Solution
(a) Spot market position
The company expects to pay 1,255,000. At today's spot rate this would be converted to $ at
$1.5590, giving 1,255,000 1.5590 = $1,956,545.
Forward contracts
Forward contracts remove the risk from future short-term currency fluctuations by fixing an
exchange rate in advance. If forward contracts are used, the following dollar costs will be incurred:
One month: 725,000 1.5601 = $1,131,073
Three months: 530,000 1.5655 = $829,715
Total payment:1,131,073 + 829,715 = $1,960,788
A forward contract will mean that the interest payment is of a predictable amount and the possibility
of exchange losses is eliminated. However, IOU will not be able to participate in exchange gains if the
pound weakens.
Options
Options can be used to put a 'ceiling' (or 'cap') on the amount payable while allowing the user to
take advantage of favourable exchange rate movements.
Option set-up October payment
(i) Contract date
October
(ii) Option type
Call option; buy with $
(iii) Strike price
Choose $1.57 as recommended by the treasurer
(iv) Number of contracts
725,000
= 23.2 contracts. Say 23 contracts hedging 31,250 23 = 718,750, leaving
31,250
6,250 to be hedged on forward market.
(v) Premium
Premium = 23 31,250 $0.0132
= $9,488
Outcome
Option will be exercised if dollar weakens to more than $1.57 in .
Exercise 23 contracts @ $1.57

$
Option outcome 1.57 23 31,250 1,128,438
Option premium 9,488
Unhedged amount covered by forward contract 6,250 1.5601 9,751
1,147,677
Option set-up December payment
(i) Contract date
December contract
(ii) Option type
Call option
(iii) Strike price C
H
Choose $1.58 A
P
(iv) Number of contracts
T
530,000 E
= 16.96 contracts, say 17 contracts hedging 31,250 17 = 531,250, with R
31,250
difference taken to forward market (531,250 530,000 = 1,250)
(v) Premium 7
Premium = 17 31,250 $0.0212

= $11,263
Outcome
Option will be exercised if dollar weakens to more than $1.58 in .
$
Option outcome 1.58 17 31,250 839,375
Option premium 11,263
Forward contract receipt 1,250 1.5655 (1,957)
Net payment 848,681
Breakeven rate
The disadvantage of options is that they can be expensive to buy because of the premium. The
breakeven rate, the rate below which options will give a more favourable outcome than a forward
contract, can be calculated as follows, ignoring the issue of whole contracts.
(Breakeven rate Amount hedged) + Premium = Forward contract payment
1,131,073 9,488
For October breakeven rate =
725,000
= $1.5470
829,715 11,263
For December breakeven rate =
530,000
= $1.5442
Recommendation
Options should only be used if it is thought to be a good chance that the pound will weaken (but
protection is still required against its strengthening). If, as the market believes, the pound is likely
to strengthen, forward contracts will offer better value.
(b) Exchange risks in Zorro
Transactions exposure
This is the risk that the exchange rate moves unfavourably between the date of agreement of a
contract price and the date of cash settlement.

Economic exposure
This is the risk of an adverse change in the present value of the organisation's future cash flows as
a result of longer-term exchange rate movements.
Netting off
The Zorro postal and telecommunications company will receive domestic income in its local
currency but will make settlements (net receipts or payments) with foreign operators in US dollars.
It may appear that most of the currency risk is hedged because dollar payments are balanced
against dollar receipts before settlement. However, although this is a good way of reducing
currency transaction costs, it does not remove currency risk.
Residual risk
Although the foreign transactions are denominated in dollars, the exchange risk involves all the
currencies of the countries with which the company deals. For example, if money is owed to
Germany and the euro has strengthened against the dollar, then the dollar cost of the transaction
has increased. Also, although all of these transactions are short term, their combined effect is to
expose the company to continuous exchange risk on many currencies. The company needs a
strategy to manage this form of economic exposure.
Management of currency risk
One way to manage currency risk in this situation is to attempt to match assets and liabilities in
each currency as follows.
(i) The company needs to examine each country with which it deals and, having selected those
with which it has a material volume of transactions, determine in each case whether there is
a net receipt or net payment with that country and the average amount of this net
receipt/payment.
(ii) If for a given country there is normally a net receipt, currency risk can be hedged by
borrowing an amount in that currency equal to the expected net receipt for the period for
which hedging is required, and converting this amount to the home currency.
(iii) For countries where there is normally a net payment, a deposit account in this currency
should be maintained.
Recommendation
This strategy will go some way towards hedging currency risk in the various countries involved, but
will involve increased currency transaction costs and possibly increased interest costs. It is
therefore probably only feasible for major currencies (eg dollar, euro, yen) and for currencies of
Asian countries with which there are major transaction volumes.
Interactive question 11: Hedging strategies [Difficulty level: Intermediate]

(a) Discuss briefly four techniques a company might use to hedge against the foreign exchange risk
involved in foreign trade.
(b) Fidden plc is a medium-sized UK company with export and import trade with the USA. The
following transactions are due within the next six months. Transactions are in the currency
specified.
Purchases of components, cash payment due in three months: 116,000
Sale of finished goods, cash receipt due in three months: $197,000
Purchase of finished goods for resale, cash payment due in six months: $447,000
Sale of finished goods, cash receipt due in six months: $154,000

Exchange rates (London market)
$/
Spot 1.71061.7140
Three months forward 0.820.77 cents premium
Six months forward 1.391.34 cents premium
Interest rates
Three months or six months Borrowing Lending
Sterling 12.5% 9.5%
Dollars 9% 6%
Foreign currency option prices (New York market)
Prices are cents per , contract size 12,500
C
Calls Puts H
Exercise price ($) March June Sept March June Sept A
1.60 15.20 2.75 P
1.70 5.65 7.75 3.45 6.40 T
E
1.80 1.70 3.60 7.90 9.32 15.35
R
Assume that it is now December with three months to the expiry of March contracts and that the
option price is not payable until the end of the option period, or when the option is exercised.
7
Requirements
(i) Calculate the net sterling receipts and payments that Fidden might expect for both its three-
and six-month transactions if the company hedges foreign exchange risk on:
1 The forward foreign exchange market
2 The money market
(ii) If the actual spot rate in six months' time turned out to be exactly the present six-month
forward rate, calculate whether Fidden would have done better to have hedged through
foreign currency options rather than the forward market or the money market.
(iii) Explain briefly what you consider to be the main advantage of foreign currency options.
6 Financing projects and assets
Section overview
There are numerous ways in which projects and assets can be financed the main challenge is
deciding which method is most suitable to your company's overall strategy.
Non-recourse debt is a loan secured on collateral (normally property) for which the borrower has
no personal liability.
Leasing is a common method of financing a large asset such as buildings.
Sale and leaseback is becoming a very popular way of maintaining use of an asset without the
overall responsibility of its ownership.
6.1 Non-recourse debt

Non-recourse debt is a loan secured on collateral (usually property) but for which the borrower is not
otherwise liable. If the borrower defaults, the lender can seize the collateral but the borrower's liability is
limited to the loss of that collateral. In the situation where the value of the collateral is insufficient to
cover the loan (if property prices dropped for example) then the lender would suffer the loss.

Non-recourse debt is commonly used to finance commercial property and other high value projects
with long loan periods and uncertain revenue streams. It usually appears on the company statement of
financial position as a liability and the collateral as an asset.
6.2 Leasing
Rather than buying an asset outright, using either available cash resources or borrowed funds, a business
may lease an asset. This method of financing is extremely popular with airlines who typically lease their
aircraft and companies with car pools.
6.2.1 Operating leases

An operating lease is a lease where the lessor retains most of the risks and rewards of ownership.
The lessor supplies the equipment to the lessee.
The lessor is responsible for servicing and maintaining the leased equipment.
The period of the lease is fairly short, less than the economic life of the asset. At the end of one
lease agreement, the lessor can either lease the same equipment to someone else and obtain a
good rent for it, or sell the equipment second-hand.
Most of the growth in the UK leasing business has been in operating leases.
6.2.2 Finance leases

A finance lease is a lease that transfers substantially all of the risks and rewards of ownership of an asset
to the lessee. It is an agreement between the lessee and the lessor for most or all of the asset's expected
useful life.
There are other important characteristics of a finance lease.
The lessee is responsible for the upkeep, servicing and maintenance of the asset.
The lease has a primary period covering all or most of the useful economic life of the asset. At the
end of this period, the lessor would not be able to lease the asset to someone else, because the
asset would be worn out. The lessor must therefore ensure that the lease payments during the
primary period pay for the full cost of the asset as well as providing the lessor with a suitable return
on his investment.
At the end of the primary period the lessee can normally continue to lease the asset for an
indefinite secondary period, in return for a very low nominal rent, sometimes called a 'peppercorn
rent'. Alternatively, the lessee might be allowed to sell the asset on a lessor's behalf (since the lessor
is the owner) and perhaps to keep most of the sale proceeds.
6.2.3 Sale and leaseback

Sale and leaseback is when a business that owns an asset agrees to sell the asset to a financial institution
and lease it back on terms specified in the sale and leaseback agreement. The business retains use of the
asset but has the funds from the sale, whilst having to pay rent. It is particularly appropriate for highly
specialised assets that may have a low realisable value and therefore would be poor security for a more
traditional loan.
Case example: Tesco

Tesco is one of the biggest corporate owners of property in the UK. In 2005, the company completed
two significant sale and leaseback transactions with an aggregate value of 636 million. The first
transaction, worth 366 million, resulted in the sale and leaseback of twelve stores and two distribution
centres. Tesco used the funds to help finance its expansion plan, whilst at the same time retaining a
high level of operational control over the properties, including rights to make significant alterations.
The funds from the second transaction (270 million) were applied to Tesco's CAPEX programme.

6.2.4 Attractions of leasing
Attractions include the following:
The supplier of the equipment is paid in full at the beginning. The equipment is sold to the lessor,
and other than guarantees, the supplier has no further financial concern about the asset.
The lessor invests finance by purchasing assets from suppliers and makes a return out of the lease
payments from the lessee. The lessor will also get capital allowances on his purchase of the
equipment.
Leasing may have advantages for the lessee:
The lessee may not have enough cash to pay for the asset, and would have difficulty obtaining
a bank loan to buy it. If so the lessee has to rent the asset to obtain use of it at all.
C
Finance leasing may be cheaper than a bank loan. H
A
The lessee may find the tax relief available advantageous. P
T
Operating leases have further advantages. E
R
The leased equipment and the related obligation do not have to be shown in the lessee's published
statement of financial position, and so the lessee's statement of financial position shows no increase
in its gearing ratio.
7
The equipment is leased for a shorter period than its expected useful life. In the case of high-
technology equipment, if the equipment becomes out-of-date before the end of its expected life,
the lessee does not have to keep on using it. The lessor will bear the risk of having to sell obsolete
equipment secondhand.
A major growth area in operating leasing in the UK has been in computers and office equipment (such
as photocopiers and fax machines) where technology is continually improving.
6.2.5 Lease or buy?

The decision whether to lease or buy an asset involves two steps.
The acquisition decision: is the asset worth having? Test by discounting project cash flows at a
suitable cost of capital.
The financing decision: if the asset should be acquired, compare the cash flows of purchasing and
leasing or HP arrangements. The cash flows can be discounted at an after-tax cost of borrowing.
The traditional method is complicated by the need to choose a discount rate for each stage of the
decision. In the case of a non-taxpaying organisation, the method is applied as follows.
Step 1
The cost of capital that should be applied to the cash flows for the acquisition decision is the cost of
capital that the organisation would normally apply to its project evaluations.
Step 2
The cost of capital that should be applied to the (differential) cash flows for the financing decision is the
cost of borrowing.
We assume that if the organisation decided to purchase the equipment, it would finance the
purchase by borrowing funds.
We therefore compare the cost of borrowing with the cost of leasing (or hire purchase) by
applying this cost of borrowing to the financing cash flows.
In the case of a tax-paying organisation, taxation should be allowed for in the cash flows, so that the
traditional method would recommend:
Step 1
Discount the cash flows of the acquisition decision at the firm's after-tax cost of capital.

Step 2
Discount the cash flows of the financing decision at the after-tax cost of borrowing.
Worked example: Lease or buy decisions 1

Mallen and Mullins Co has decided to install a new milling machine. The machine costs 20,000 and it
would have a useful life of five years with a trade-in value of 4,000 at the end of the fifth year.
Additional net cash generated from the machine would be 8,000 a year for five years. A decision has
now to be taken on the method of financing the project. Two methods of finance are being considered.
The company could purchase the machine for cash, using bank loan facilities on which the current
rate of interest is 13% before tax.
The company could lease the machine under an agreement which would entail payment of 4,800
at the end of each year for the next five years.
The company's weighted average cost of capital, normally used for evaluating projects, is 12% after tax.
The rate of corporation tax is 23%. If the machine is purchased, the company will be able to claim an
annual tax depreciation allowance of 20% of the reducing balance.
Requirement
Advise the management on whether to acquire the machine, on the most economical method of
finance, and on any other matter which should be considered before finally deciding which method of
finance should be adopted.
Solution
The traditional method begins with the acquisition decision. The cash flows of the project should be
discounted at 12%. The first writing down allowance is assumed to be claimed in the first year resulting
in a saving of tax at Year 2.
Tax depreciation
Year

1 20% of 20,000 4,000
2 20% of (20,000 4,000) 3,200
3 20% of (16,000 3,200) 2,560
4 20% of (12,800 2,560) 2,048
11,808
5 (20,000 11,808 4,000) 4,192
16,000
Taxable profits and tax liability
Tax
Cash allowable Taxable
Year profits depreciation profits Tax at 23%

1 8,000 4,000 4,000 920
2 8,000 3,200 4,800 1,104
3 8,000 2,560 5,440 1,251
4 8,000 2,048 5,952 1,369
5 8,000 4,192 3,808 876
NPV calculation for the acquisition decision
Cash Net cash Discount Present
Year Equipment profits Tax flow factor value

0 (20,000) (20,000) 1.000 (20,000)
1 8,000 8,000 0.893 7,144
2 8,000 (920) 7,080 0.797 5,643
3 8,000 (1,104) 6,896 0.712 4,910
4 8,000 (1,251) 6,749 0.636 4,292
5 4,000 8,000 (1,369) 10,631 0.567 6,028
6 (876) (876) 0.507 (444)
NPV 7,573

Conclusion
The net present value (NPV) is positive, and the machine should be acquired, regardless of the method
used to finance the acquisition.
The second stage is the financing decision, and cash flows are discounted at the after-tax cost of
borrowing, which is at 13% 77% = 10%. The only cash flows that we need to consider are those
which will be affected by the choice of the method of financing. The operating savings of 8,000 a year,
and the tax on these savings, can be ignored.
The present value (PV) of purchase costs
Cash Discount
Year Item flow factor 10% PV

0 Equipment cost (20,000) 1.000 (20,000) C
H
5 Trade-in value 4,000 0.621 2,484 A
Tax savings, from allowances P
2 23% 4,000 920 0.826 760 T
E
3 23% 3,200 736 0.751 553
R
4 23% 2,560 589 0.683 402
5 23% 2,048 471 0.621 292
23% 4,192 964 0.564 544 7
6
NPV of purchase (14,965)
The PV of leasing costs

It is assumed that the lease payments are fully tax-allowable.
Lease Savings Discount
Year payment in tax factor 10% PV
(23%)

15 (4,800) pa 3.791 (18,197)
26 1,104 pa 3.446 3,804
NPV of leasing (14,393)
The cheaper option would be to lease the machine. However, other matters should be considered.
Running expenses
The calculations assume that the running costs are the same under each alternative. However
expenses like maintenance, consumable stores, insurance and so on may differ between the
alternatives.
The effect on cash flow
Purchasing requires an immediate outflow of 20,000 compared to nothing for leasing. This effect
should be considered in relation to the company's liquidity position, which in turn will affect its
ability to discharge its debts and to pay dividends.
Alternative uses of funds
The proposed outlay of 20,000 for purchase should be considered in relation to alternative
investments.
The trade-in value
The net present value of purchase is materially affected by the trade-in value of 4,000 in the fifth
year. This figure could be very inaccurate.

6.2.6 Other issues
Once a company has made the decision to acquire an asset, the comparison of lease vs buy only needs
to include the costs that differ; the costs that are common to each option need not be included.
A disadvantage of the traditional approach to making a lease or buy decision is that if there is a negative
NPV when the operational cash flows of the project are discounted at the firm's cost of capital, the
investment will be rejected out of hand. However, the costs of leasing might be so low that the project
would be worthwhile provided the leasing option were selected. This suggests that an investment
opportunity should not be rejected without first giving some thought to its financing costs.
Other methods of making lease or buy decisions are as follows.
Make the financing decision first. Compare the cost of leasing with the cost of purchase, and
select the cheaper method of financing; then calculate the NPV of the project on the assumption
that the cheaper method of financing is used.
Combine the acquisition and financing decisions together into a single-stage decision.
Calculate an NPV for the project if the machine is purchased, and secondly if the machine is
leased. Select the method of financing which gives the higher NPV, provided that the project has a
positive NPV.
Worked example: Lease or buy decisions 2

In the case of Mallen and Mullins Co, the NPV with purchase would be + 7,573. This was calculated
above. The NPV with leasing would be as follows. A discount rate of 12% is used here.
Profit less Tax Net cash Discount
Year leasing cost at 23% flow Factor 12% PV

1 3,200 3,200 0.893 2,858
25 3,200 (736) 2,464 2.712 6,682
6 (736) (736) 0.507 (373)
NPV = 9,167
Using this method, leasing is preferable, because the NPV is 1,594 higher.
Since operating leases are a form of renting, the only cash flows to consider for this type of leasing are
the lease payments and the tax saved. Operating lease payments are allowable expenses for tax
purposes.
Remember that the decisions made by companies are not solely made according to the results of
calculations like these. Other factors (short-term cash flow advantages, flexibility, and use of different
costs of capital) may be significant.
Interactive question 12: Lease or buy decisions [Difficulty level: Intermediate]

The management of a company has decided to acquire Machine X which costs 63,000 and has an
operational life of four years. The expected scrap value would be zero. Tax is payable at 23% on
operating cash flows one year in arrears. Tax allowable depreciation is available at 20% a year on a
reducing balance basis.
Suppose that the company has the opportunity either to purchase the machine or to lease it under a
finance lease arrangement, at an annual rent of 20,000 for four years, payable at the end of each year.
The company can borrow to finance the acquisition at 10%. Should the company lease or buy the
machine?

7 Treasury functions
Section overview
Treasury management in a modern enterprise covers a number of areas including liquidity
management, funding management, currency management and corporate finance.
Centralising the treasury management function allows businesses to employ experts, deal in bulk
cash flows and hence take advantage of lower bank charges and avoid a mix of surpluses and
deficits. Decentralised cash management can be more responsive to local needs however.
The treasury department is usually run as a cost centre if its main focus is to keep costs within
budgeted spending targets. It may be run as a profit centre if there is a high level of foreign
C
exchange transactions, or the business wishes to make speculative profits. H
A
Globalisation, information technology and pressures to add value are significant catalysts for P
changes in the role of the treasury function. T
E
R
7.1 Treasury policy
All treasury departments should have a formal statement of treasury policy and detailed guidance on 7
treasury procedures. The aims of a treasury policy are to enable managers to establish direction, specify
parameters and exercise control, and also provide a clear framework and guidelines for decisions.
The guidance needs to cover the roles and responsibilities of the treasury function, the risks requiring
management, authorisation and dealing limits.
Guidance on risks should cover:
Identification and assessment methodology
Criteria including tolerable and unacceptable levels of risk
Management guidelines, covering risk elimination, risk control, risk retention and risk transfer
Reporting guidelines
7.2 Advantages of a separate treasury department

Advantages of having a treasury function which is separate from the financial control function are as
follows.
Centralised liquidity management avoids mixing cash surpluses and overdrafts in different localised
bank accounts.
Bulk cash flows allow lower bank charges to be negotiated.
Larger volumes of cash can be invested, giving better short-term investment opportunities.
Borrowing can be agreed in bulk, probably at lower interest rates than for smaller borrowings.
Currency risk management should be improved, through matching of cash flows in different
subsidiaries. There should be less need to use expensive hedging instruments such as option
contracts.
A specialist department can employ staff with a greater level of expertise than would be possible in
a local, more broadly based, finance department.
The company will be able to benefit from the use of specialised cash management software.
Access to treasury expertise should improve the quality of strategic planning and decision making.

Case example: Argyll and Bute council
Treasury management can be a very significant function within public bodies such as local authorities.
Scotland's Argyll and Bute Council treasury strategy for 2004 highlighted the following areas.
Treasury limits in force limiting the treasury risk and activities of the council; 40 million short-term
borrowing and 25% maximum proportion of interest on borrowing subject to variable rate
interest.
Borrowings strategy: because of expected favourable and stable short-term rates, the Council will
borrow as much as possible short-term at variable rates to minimise borrowing costs or make short-
term savings in order to meet budgetary constraints.
Investments strategy: the basic principles are security of principal and access to funds as needed.
Surplus cash flows are generally lodged with bankers. Substantial surpluses might be placed in
short-term business deposit accounts with approved institutions, subject to liaison with the
Council's treasury advisers.
Extent of debt repayment opportunities. Debt repayment would occur when fixed interest rates are
anticipated to be at their peak, or when there appear to be anomalies with the yield curve. The aim
will be to enhance the balance of the long-term portfolio.
Retention of set aside capital receipts. Scottish Councils are required to set aside 75% of receipts
generated by the Housing Revenue Account for either the redemption of external debt or to use
monies to finance new capital expenditure as an alternative to new borrowing.
Extraordinary activities. The treasury department was also involved in a feasibility study for housing
stock transfer and negotiations over the financing of a public-private partnership school buildings
project.
7.3 Outsourcing
Because of the specialist nature of treasury management, a number of businesses outsource the function
to specialist institutions. The company receives the benefit of the expertise of the staff of the institution,
which may be able to fill resource or skills gaps from which the internal team is suffering. Outsourcing
operational functions may enable the internal team to concentrate on strategic functions. It may also
give the organisation access to better systems solutions. The specialists can deal on a large scale and
pass some of the benefit on in the form of fees that are lower than the cost of setting up an internal
function would be.
However, whether the same level of service could be guaranteed from the external institution as from an
internal department is perhaps questionable. The external institution may not have as much knowledge
of the needs of the business as an internal department.
If treasury activities are to be outsourced, contract documentation needs to be clear and management
and reporting procedures must be established.
Other mechanisms may achieve the cost savings of outsourcing, but be more responsive to an
organisation's needs. These include shared service centres (separate legal entities owned by the
organisation and acting as independent service providers), which can be used to obtain economies of
scale by concentrating dispersed units into one location. These may not necessarily be located near
head office; in fact many are located where they can obtain tax advantages.
7.4 Centralised or decentralised cash management?

7.4.1 The centralisation decision
A large company may have a number of subsidiaries and divisions. In the case of a multinational, these
will be located in different countries. It will be necessary to decide whether the treasury function should
be centralised.

With centralised cash management, the central treasury department effectively acts as the bank to the
group. The central treasury has the job of ensuring that individual operating units have all the funds
they need at the right time.
7.4.2 Advantages of a specialist centralised treasury department

Centralised liquidity management avoids having a mix of cash surpluses and overdrafts in different
local bank accounts and facilitates bulk cash flows, so that lower bank charges can be negotiated.
Larger volumes of cash are available to invest, giving better short-term investment opportunities
(for example, money market deposits, high interest accounts and Certificates of Deposit).
Any borrowing can be arranged in bulk, at lower interest rates than for smaller borrowings, and
perhaps on the eurocurrency or eurobond markets.
C
Foreign currency risk management is likely to be improved in a group of companies. A central H
treasury department can match foreign currency income earned by one subsidiary with A
P
expenditure in the same currency by another subsidiary. In this way, the risk of losses on adverse
T
exchange rate changes can be avoided without the expense of forward exchange contracts or E
other 'hedging' (risk-reducing) methods. R
A specialist treasury department will employ experts with knowledge of dealing in futures,
eurocurrency markets, taxation, transfer prices and so on. Localised departments would not have
7
such expertise.
The centralised pool of funds required for precautionary purposes will be smaller than the sum of
separate precautionary balances which would need to be held under decentralised treasury
arrangements.
Through having a separate profit centre, attention will be focused on the contribution to group
profit performance that can be achieved by good cash, funding, investment and foreign currency
management.
Centralisation provides a means of exercising better control through use of standardised
procedures and risk monitoring. Standardised practices and performance measures can also create
productivity benefits.
7.4.3 Possible advantages of decentralised cash management

Sources of finance can be diversified and can be matched with local assets.
Greater autonomy can be given to subsidiaries and divisions because of the closer relationships
they will have with the decentralised cash management function.
The decentralised treasury function may be able to be more responsive to the needs of individual
operating units.
However, since cash balances will not be aggregated at group level, there will be more limited
opportunities to invest such balances on a short-term basis.
7.4.4 Centralised cash management in the multinational firm

If cash management within a multinational firm is centralised, each subsidiary holds only the minimum
cash balance required for transaction purposes. All excess funds will be remitted to the central treasury
department.
Funds held in the central pool of funds can be returned quickly to the local subsidiary by telegraphic
transfer or by means of worldwide bank credit facilities. The firm's bank can instruct its branch office in
the country in which the subsidiary is located to advance funds to the subsidiary.

Interactive question 13: Treasury centralisation [Difficulty level: Intermediate]
Touten is a US registered multinational company with subsidiaries in 14 countries in Europe, Asia and
Africa. The subsidiaries have traditionally been allowed a large amount of autonomy, but Touten is now
proposing to centralise most of the group treasury management operations.
Requirements
Acting as a consultant to Touten prepare a memo suitable for distribution from the group finance
director to the senior management of each of the subsidiaries explaining:
(a) The potential benefits of treasury centralisation; and
(b) How the company proposes to minimise any potential problems for the subsidiaries that might
arise as a result of treasury centralisation.
7.5 The treasury department as cost centre or profit centre

7.5.1 Treasury department as cost centre
A treasury department might be managed either as a cost centre or as a profit centre. For a group of
companies, this decision may need to be made for treasury departments in separate subsidiaries as well
as for the central corporate treasury department.
In a cost centre, managers have an incentive only to keep the costs of the department within budgeted
spending targets. The cost centre approach implies that the treasury is there to perform a service of a
certain standard to other departments in the enterprise. The treasury is treated much like any other
service department.
7.5.2 Treasury department as profit centre

However, some companies (including BP, for example) are able to make significant profits from their
treasury activities. Treating the treasury department as a profit centre recognises the fact that treasury
activities such as speculation may earn revenues for the company, and may as a result make treasury
staff more motivated. It also means that treasury departments have to operate with a greater degree of
commercial awareness, in for example the management of working capital.
Interactive question 14: Profit centre [Difficulty level: Intermediate]

Suppose that your company is considering plans to establish its treasury function as a profit centre.
Before reading the next paragraph, see if you can think of how the following issues are of potential
importance to these plans.
(a) How can we ensure that high quality treasury staff can be recruited?
(b) How might costly errors and overexposure to risk be prevented?
(c) Why will the treasury team need extensive market information to be successful?
(d) Could there be a danger that attitudes to risk in the treasury team will differ from those of the
board? If so, how?
(e) What is the relevance of internal charges?
(f) What problems could there be in evaluating performance of the treasury team?

7.6 Current developments in the treasury function
7.6.1 The changing role of the treasury function
A predictable consequence of the wide-ranging scope of the treasurer's role is that it is constantly
evolving. Partly this is in response to changes in the financial world such as the development of different
types of capital instruments. It is also due to a changing emphasis on the relative importance of different
aspects of the treasury role.
7.6.2 Globalisation
Globalisation requires treasury to monitor continuously market conditions, currency rates and political
conditions.
Globalisation is a clear impetus towards further centralisation and concentration on control frameworks, C
decision support and improved business performance. However, its implications need to be considered H
carefully. A
P
Involvement of regional and local personnel has to be built into the system, drawing on their knowledge T
E
of local financial management requirements and operations. Regional personnel may be used for
R
operational tasks such as credit control or payroll, but they will be subject to liquidity management
guidelines decided centrally.
The needs of the regions also need to be considered when banking relationships are assessed. Businesses 7
will be concerned about whether their banks have the ability to provide global treasury services.
However, the services of the global bank(s) chosen need to be matched with regional needs.
7.6.3 Risk prevention

We have already stressed that risk control is an integral part of the treasury management function. More
accurate forecasting techniques are being used to help other departments mitigate and avoid risks.
7.6.4 Working capital management

Many businesses are placing increased emphasis on constant working capital improvement to minimise
funding requirements. This means greater treasury involvement in supplier and inventory management.
7.6.5 Tax management

Consequences of global developments such as European Union harmonisation need to be considered
carefully. However in many businesses limitation of tax liabilities must be seen in the context of
optimum liquidity management.
7.6.6 Information and technology management

Careful management is needed of all the information sources that are relevant for the business including
the internet, wire services and mass communication media. Optimum use of technology is a key part of
information management and as well as choosing the right supplier, treasury departments need to
monitor technological developments that could enhance their operations.
Technology can also be used to provide a common information base that the service providers to the
treasury function can use.
7.6.7 Relationship management

The wider scope of treasury's role implies strengthening of relations with other functions, and co-
operation in tasks such as establishment of terms and payment methods for customers.
7.6.8 Co-operation between treasuries

Treasury functions of different organisations sometimes pass aspects of their operations to a single
independent supplier. This enables the organisations to share processes, information and knowledge.
Treasury functions also co-operate together in payment systems harmonisation, supplying information
to rating agencies, and presenting a common front to suppliers and regulators.

Summary

Self-test
1 Prices (premiums) on 1 June for sterling traded currency options on the Philadelphia Stock
Exchange are shown in the following table:
Sterling option contracts of 31,250 contracts (cents per )
Exercise price Calls Puts
$/ September December September December
1.5000 5.55 7.95 0.42 1.95
1.5500 2.75 3.85 4.15 6.30
1.6000 0.25 1.00 9.40 11.20
Prices are quoted in cents per . On the same date, the September sterling futures contract
(contract size 62,500) is trading at $/ 1.5390 and the current spot exchange rate is $1.5404 C
$1.5425. Stark Inc, a US company, is due to receive sterling 3.75 million from a customer in four H
A
months' time at the end of September. The treasurer decides to hedge this receipt using either P
September traded options or September futures. T
E
Requirements R
Compute the results of using
(a) Futures 7
(b) Options hedges
(illustrating the results with all three possible option exercise prices) if by the end of September the
spot exchange rate moves to (i) 1.4800; (ii) 1.5700; (iii) 1.6200. Assume that the futures price
moves by the same amount as the spot rate and that by the end of September the options
contracts are on the last day before expiry.
2 (a) Briefly discuss the problems of using futures contracts to hedge exchange rate risks.
(b) Identify and explain the key reasons why small versus large companies may differ in terms of
both the extent of foreign exchange and interest rate hedging that is undertaken, and the
tools used by management for such purposes.
3 Kilber plc
Kilber plc is a mining company with exclusive rights to the mining of kilbe in Wales. Kilbe is a new
metal that is used in the construction industry. The demand for kilbe is highly dependent on the
state of the housing market and the price is volatile. Kilber would like to hedge its exposure but
there are no traded derivatives for kilbe. The treasurer of Kilber has approached a number of banks
but has found the OTC market is expensive, as kilbe is considered to be too risky, and the company
is therefore reluctant to use forward contracts for hedging. One of the bankers they have sought
advice from, suggested that they should use futures contracts on copper. She explained that the
price of kilbe is highly correlated with the price of copper and therefore copper futures contracts
are good substitutes.
(a) Explain why the company should care about hedging its risks and comment on the risks that
Kilber plc may face if it adopts the recommendation and uses copper futures contracts as a
hedging instrument.
(b) Discuss briefly the advantages and disadvantages of OTC derivatives.
(c) The management of Kilber is currently reviewing its funding strategies. All its borrowing is at
variable rate and there are strong indications that interest rates will increase.
Requirement
Advise the management of Kilber on how they might reduce the impact of higher rates on the
company's interest payments.

4 Assume that you are the financial manager of a UK company which currently trades only with
major European countries. Your managing director has strongly advocated that the UK should
adopt the euro, which will result in significant savings in transactions costs, and will eliminate all
foreign exchange exposure for your company.
Discuss whether or not the managing director is correct in his comments.
5 AGD plc
AGD plc is a profitable company which is considering the purchase of a machine costing 320,000.
If purchased, AGD plc would incur annual maintenance costs of 25,000. The machine would be
used for three years and at the end of this period would be sold for 50,000. Alternatively, the
machine could be obtained under an operating lease for an annual lease rental of 120,000 per
year, payable in advance.
AGD plc can claim capital allowances on a 20% reducing balance basis. The company pays tax on
profits at an annual rate of 23% and all tax liabilities are paid one year in arrears. AGD plc has an
accounting year that ends on 31 December. If the machine is purchased, payment will be made in
January of the first year of operation. If leased, annual lease rentals will be paid in January of each
year of operation.
Requirements
(a) Using an after-tax borrowing rate of 7%, evaluate whether AGD plc should purchase or lease
the new machine.
(b) Explain and discuss the key differences between an operating lease and a finance lease.

1 The target receipt is 3,750,000 1.5404* = $5,776,500.

*The American company gets the lower number of dollars for selling sterling.
A receipt of 3.75 million will represent 3,750,000/62,500 = 60 futures contracts or
3,750,000/31,250 = 120 option contracts. The value of a one-tick movement will be $6.25 on the
futures contract (tick size of 0.0001 futures contract size of 62,500) and $3.125 on the options
contract (although this figure will not be needed in the calculation).
(a) If we make the assumption that the futures price moves by the same amount as the spot rate, C
there will be no basis risk and the future will give a perfect hedge. H
A
On 1 June, 60 sterling futures contracts are sold for $1.5390 (a price which is $0.0014 below P
T
the spot rate). The results of this hedge are as follows.
E
Scenario (i) (ii) (iii) R
Spot rate, 30 Sept 1.4800 1.5700 1.6200
Sell 60 at 1.5390 1.5390 1.5390
Buy 60 at (spot 0.0014) 1.4786 1.5686 1.6186 7
Gain/(loss) in ticks 604 (296) (796)
$ $ $
Value of gain/(loss) 226,500 (111,000) (298,500)
3.75 million sold at spot for 5,550,000 5,887,500 6,075,000
Total net receipt 5,776,500 5,776,500 5,776,500
(b) Using options, the treasurer will purchase 120 September put options. The premium cost will
vary with the exercise price as follows.
Exercise price Cost $
1.5000 120 0.42/100 31,250 = $15,750
1.5500 120 4.15/100 31,250 = $155,625
1.6000 120 9.40/100 31,250 = $352,500
Scenario 1
Spot rate moves to 1.4800.
In all cases, exercise the option and sell 3.75 million at the exercise price.
Exercise price Cash received Premium cost Net
$/ $ $ $
1.5000 5,625,000 (15,750) 5,609,250
1.5500 5,812,500 (155,625) 5,656,875 Best result
1.6000 6,000,000 (352,500) 5,647,500
Scenario 2
Exercise Exercise Exchange Cash Premium
price option? rate used received cost Net
$ $ $
1.5000 No 1.57 5,887,500 (15,750) 5,871,750 Best result
1.5500 No 1.57 5,887,500 (155,625) 5,731,875
1.6000 Yes 1.60 6,000,000 (352,500) 5,647,500
Scenario 3
In all cases, abandon the option.
Cash received = $6,075,000

Exercise price Cash Premium Net
received cost
$/ $ $ $
1.5000 6,075,000 (15,750) 6,059,250 Best result
1.5500 6,075,000 (155,625) 5,919,375
1.6000 6,075,000 (352,500) 5,722,500
Summary. The futures hedge achieves the target exactly. The options give a range of possible
results around the target. When the option is exercised, it does not give as good a result as
the future. However, when the option is allowed to lapse because of a favourable movement
in the exchange rate, it allows the company to make a gain over target.
2 (a) Tailoring of contracts
The contracts cannot be tailored to the user's exact requirements. Futures are dealt with on
currency exchanges using standard contract sizes and the amount to be hedged may not be
an amount that can be hedged using a whole number of contracts. In addition, futures are
only available for standard delivery dates that may not correspond to when the company is
receiving or paying currency. This means that the company will have to eliminate its
commitments under the futures contracts by closing out; undertaking a second futures
transaction that reverses the effect of the first one.
Hedge inefficiencies
Having to deal in a whole number of contracts means that there may be an amount that is
not hedged by futures, or the futures hedge a larger amount than required. The company can
leave the difference unhedged and exposed to currency risk, or use a forward contract to
hedge the difference at a different rate. Hedge inefficiencies are also caused by basis risk; the
risk that the futures contract price will move by a different amount from the price of the
underlying currency.
Limited availability
Only a limited number of currencies are the subject of futures contracts (although the
number of currencies is growing).
Conversion between two currencies
The procedure for converting between two currencies neither of which is the US dollar is
complex, as contracts are priced in dollars. The company has to sell contracts of one type and buy
contracts of the other type.
Potential losses
Volatile trading conditions on the futures markets mean that the potential loss can be high.
(b) Objectives and risk appetites
The strategic objectives and hence the risk appetites of small and large companies are likely to
differ significantly. Small companies are likely to concentrate on fewer products and markets
and hedging may only be appropriate in limited circumstances. The key aim is most likely to
be using hedging instruments as a means of minimising exchange transaction risks.
However, the risks involved in using some hedging instruments may be considered excessive,
for example futures or swaps with significant counterparty risks. Small companies may also
wish to avoid the accounting and tax complications of more complex hedging instruments.
Larger companies by contrast are more likely to achieve their objects by diversification, and
are likely to tolerate varying levels of risk and return from different activities. This may mean
that they are more concerned with being able to take advantage of possible profits from
derivative usage, for example by using an option so if rates move in a favourable direction the
option is not exercised and the companies can take advantage of a favourable rate.
Ultimately, large companies may choose to speculate in derivatives or deal in derivatives as a
profit-making activity without any link to other underlying transactions.
Incurring exchange risks
Small companies may incur currency risk on a limited number of significant transactions in a
few currencies. Directors may therefore feel it is worthwhile to hedge all significant

transactions. To minimise risk, forward contracts may well be used as these guarantee the
exchange rate at which the company will receive or pay monies.
For larger companies, hedging all significant transactions may be unnecessarily expensive.
Directors will take account of the currency portfolio of their transactions. Currency losses
through significant payments in a particular currency may be offset by significant receipts in
the same currency. If the company is undertaking transactions in several major currencies,
there is a greater chance that exchange losses on transactions in one currency will be
balanced by exchange gains on transactions in another currency.
Incurring interest rate risks
Small companies will be most concerned with the interest rate sensitivities of the debt they
need to take out, and their gearing structure is unlikely to be complex. Again, they are most
likely to be concerned with guaranteeing a borrowing rate on particular sums that they have C
to borrow and use forward rate agreements for that purpose. However, they may also want H
A
to use interest rate swaps as a means of obtaining finance on better terms.
P
Larger companies will be concerned with their overall portfolio, with the interest rate T
E
sensitivities and term structure of their debt and also their investments. This may mean that R
a variety of instruments are used to hedge different types of finance.
Risk management methods
7
Smaller companies may not be able to use all the risk management methods available to
larger companies. They may not be able to match receipts and payments in the same
currency for example, or match investments and borrowings. The commitment required
may be excessive; over-the-counter contracts are often of a minimum size that may be too
large. The costs of certain techniques, for example option premiums, may be considered too
high.
Large companies may be able to employ specialist treasury personnel who have a greater
level of expertise in using derivatives than would be found in a smaller general finance
function. They are also more likely to have directors or senior managers with sufficient
expertise to be able to monitor treasury activity effectively.
3 Kilber plc
(a) The management of risk is one of the most important aspects of the treasury function.
Excessive volatility in the cash flows of the company, caused by changing business conditions,
changes in exchange rates or interest rates will affect adversely the value of the firm. Hedging
is in general considered to enhance the value of the company.
The most serious risk that Kilber faces is the falling kilbe prices. Since kilbe prices are highly
correlated with copper prices, it is reasonable to use copper futures contracts to lock into
certain future value. Suppose that Kilber has sold a sufficient number of copper futures
contracts maturing in three months. Suppose further that during this period, the price of both
kilbe and copper have fallen. On expiry of the contract, the company will have a loss due to
the fall in the price of the kilbe but a gain on the copper futures contracts.
Whether the gain in the futures contract will offset the loss due to the fall in the price of the
kilbe will depend on whether the price of copper has fallen by the same percentage as the
price of kilbe. If it has fallen by the same percentage then the price of copper will be behaving
exactly like the price of kilbe, so the copper futures contract will be the exact equivalent of a
kilbe futures contract.
However, when the price of kilbe and copper is not perfectly correlated, then the copper
futures contract is an imperfect hedge.
The remaining risk is called basis risk and arises from the imperfect correlation between the
hedging instrument and the hedged asset.
(b) The main benefit of OTC derivatives is that they can be tailored to the needs of the two
parties; their major drawback is that they pose a higher risk of default than do exchange-
traded derivatives. Some very specialised agreements may also be illiquid.

(c) Kilber could use a variety of instruments to hedge interest rate risk depending on its time
horizon. For short-term protection the company could use forward rate agreements, short-
term interest rate futures and interest rate options. For long-term protection, it could use
interest rate swaps to convert the variable interest rate debt to fixed rate.
Note that forward rate agreements, futures and swaps lock into a particular borrowing rate
and the company does not benefit from a fall in interest rate. Interest rate options on the
other hand set a ceiling on the interest rate to be paid but allow the company to benefit from
a fall in interest rates.
4 Foreign exchange exposure
The managing director is certainly correct in saying that the foreign exchange exposure in
dealing with other EMU countries will be eliminated. However, foreign exchange exposure will still
affect trade with countries that are not members of EMU.
Transaction costs
Similarly transaction costs involved in trade with other EMU members will disappear, and this
could represent a considerable saving. However, there will still be transaction costs when trading
with other countries who are not EMU members.
Economic exposure
In addition the company would still face economic exposure even if it only traded with other
countries within EMU. If the euro is over-valued with respect to non-members' currencies,
companies from non-member countries may gain sales at the expense of the UK company because
they can charge cheaper prices. The company may also face indirect economic exposure if it buys
products from other EMU members who buy their raw materials from non-EMU members. Any
adverse exchange movements meaning raw material prices increases would be passed on through
the value chain.
5 AGD plc
(a) (i) Net present value of purchasing machine
'000 '000 '000 '000 '000
Cash outflows
Capital costs (320)
Annual
maintenance costs (25) (25) (25)
(320) (25) (25) (25) 0
Cash inflows
Disposal proceeds 50
Taxation (at 23% in
following year) 6 6 6
Writing down
allowances (W1) 15 12 36
21 68 42
Net cash flows (320) (25) (4) 43 42
Discount at 7% 1.000 0.935 0.873 0.816 0.763
PV of cash flow (320) (23) (3) 35 32
NPV of cash outflow 279,000

WORKING
(1) Writing down allowances
Capital Year of
allowance Tax cash flow
benefit
'000 '000 '000
Initial investment 320
Allowances at 20% pa reducing
balance over 3 years
Year 1 (64) (64) 15 Y2
256
Year 2 (51) (51) 12 Y3
205 C
Year 3 H
Proceeds on sale (50) A
Balancing allowance 155 36 Y4 P
T
(ii) Net present value of leasing machine E
R
'000 '000 '000 '000 '000
Cash outflows 7
Annual lease rentals (120) (120) (120)
Cash inflows
Taxation (at 23% in
following year) tax
deduction for lease
rentals 28 28 28
Net cash flows (120) (120) (92) 28 28
Discount at 7% 1.000 0.935 0.873 0.816 0.763
PV of cash flow (120) (112) (80) 23 21
NPV of cash outflow 268,000
It is therefore cheaper to lease the machine rather than to purchase it.
(b) Key differences between operating and finance leases

Finance lease
A finance lease is an agreement between the user of the leased asset and a provider of finance
that covers the majority of the asset's useful life.
Key features of a finance lease
(i) The provider of finance is usually a third party finance house and not the original
provider of the equipment.
(ii) The lessee is responsible for the upkeep, servicing and maintenance of the asset.
(iii) The lease has a primary period, which covers all or most of the useful economic life of
the asset. At the end of the primary period the lessor would not be able to lease the
equipment to someone else because it would be worn out.
(iv) It is common at the end of the primary period to allow the lessee to continue to lease the
asset for an indefinite secondary period, in return for a very low nominal rent,
sometimes known as a 'peppercorn' rent.
(v) The lessee bears most of the risks and rewards and so the asset is shown on the lessee's
statement of financial position.

Operating lease
Operating leases are shorter-term rental agreements between a lessor and a lessee.
Key features of an operating lease
(i) The lessor supplies the equipment to the lessee.
(ii) The lessor is responsible for the upkeep, servicing and maintenance of the asset.
(iii) The lease period is fairly short, less than the expected economic life of the asset. At the
end of one lease agreement the lessor can either lease the same equipment to someone
else and obtain a rent for it or sell it second-hand.
(iv) The asset is not shown on the lessee's statement of financial position.


The asset underlying the future is a notional three-month deposit of 500,000. For every 0.01% change
in interest rates, the interest earned on such a deposit would change by:
500,000 0.01% 3/12 = 12.50
This is the tick value of the contract. In the example, the price of the future alters by 0.10 (94.63
94.53), or 10 ticks. So the profit on each contract would be: C
H
12.50 10 ticks = 125 A
P
T
Answer to Interactive question 2 E
R
On the settlement date, the borrower will receive the following amount from the lender:
(0.038 0.035) (180 /360)
S = $10 million 7
1 (0.038 (180 /360))
S = $14,720.31

The interest rates for three months are 2.15% to borrow in pounds sterling and 2.5% to deposit in
kroners. The company must deposit sufficient kroners now to ensure that the total including interest in
three months' time will be Kr3,500,000. This means depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634
The spot rate is 7.5509, therefore these kroners will cost 452,215 now. The company must borrow
this amount and, with three months' interest of 2.15%, will have to repay:
452,215 (1 + 0.0215) = 461,938
Thus in three months' time the Danish creditor will be paid out of the Danish bank account and the
company will effectively be paying 461,938 to satisfy this debt. The effective forward rate which the
company has 'manufactured' is:
3,500,000/461,938 = 7.5768
This effective forward rate shows the kroner at a discount to the pound as the kroner interest rate is
higher than the sterling rate.

The target receipt at today's spot rate is 20,000,000/19.3582 = 1,033,154.
(a) The receipt using a forward contract is fixed with certainty at 20,000,000/19.3048 = 1,036,012.
This applies to both exchange rate scenarios.
(b) The cost of the option is 20,000,000/100 12/100 = 24,000. This must be paid at the start of the
contract.
The results under the two scenarios are as follows.
Scenario (a) (b)

Exchange rate 21.0000 17.6000
Exercise price 19.3000 19.3000
Exercise option? YES NO
Exchange rate used 19.3000 17.6000

Pounds received 1,036,269 1,136,364
Less: Option premium 24,000 24,000
Net receipt 1,012,269 1,112,364
(c) The results of not hedging under the two scenarios are as follows.
Scenario (a) (b)

Exchange rate 21.0000 17.6000
Pounds received 952,381 1,136,364
Summary. The option gives a result between that of the forward contract and no hedge.
If the South African rand weakens to 21.0000, the best result would have been obtained using the
forward market (1,036,012).
If it strengthens to 17.6000, the best course of action would have been to take no hedge
(1,136,364).
In both cases the option gives the second best result, being 24,000 below the best because of its
premium cost.

The following forex (FX) swap could be used:
Swap pounds today at an agreed swap rate for the rupees required to make the initial investment.
Take out a sterling loan today to purchase the rupees.
In one year's time, swap back the rupees obtained in bullet point one for pounds at the same
agreed swap rate.
In a similar way to taking out a loan in rupees, El Dorado is only exposed on the profit earned from
the project.

With the swap
Year 0 Year 1
m m
Buy 500 million rupees (spot rate = 100) (5.0)
Swap 500 million rupees back (spot rate 100) 5.00
Sell 400 million rupees at 180/ 2.22
Interest on sterling loan (5 million 8%) (0.40)
(5.0) 6.82
Net outcome is a net receipt of 1.82 million.
Do nothing
Year 0 Year 1
m m
Buy 500 million rupees (spot rate = 100) (5.0)
Sell 900 million rupees (spot rate = 180) 5.0
Interest on sterling loan (5 million 8%) (0.4)
(5.0) 4.6
Net outcome is a net payment of 0.4 million.
El Dorado is better off undertaking the swap.

Today, $S1.000 buys NF4.7250.
NF4.7250 could be placed on deposit for 90 days to earn interest of NF (4.7250 0.075 90/365) =
NF0.0874, thus growing to NF (4.7250 + 0.0874) = NF4.8124.
This is then worth $S 1.0130 at the 90 day exchange rate (4.8124/4.7506).
This tells us that the annualised expected interest rate on 90-day deposits in Southland is 0.013
365/90 = 5.3%.
Alternatively, applying the formula given in Section 5.1.2, we have the following.
Northland interest rate on 90-day deposit = in = 7.5% 90/365 = 1.85%
Southland interest rate on 90-day deposit = is C
H
90-day forward exchange rate = Sf = 0.21050 A
P
Spot exchange rate = S0 = 0.21164 T
E
1 is 0.21050 R
=
1 0.0185 0.21164
1 + is = 1.0185 0.21050 0.21164 = 1.013
7
is = 0.013, or 1.3%
Annualised, this is 0.013 365/90 = 5.3%

The exchange rate will be:
1.05
Future spot rate 1.7 1.716
1.04
That is the dollar is expected to depreciate relative to the pound by $0.016 or 0.9%

The nominal interest rate in the US is:
1 ic 1 hc

1 i 1 h
b b
1+ hc
1 + ic = 1+ ib
1+ hb
1 0.05
= (1 0.06)
1 0.04
= 1.070
The nominal interest rate in the US is therefore 7%
The real interest rate in both countries is approximately 2 per cent (the difference between the nominal
interest rate and the inflation rate for each country).

Since
$ interest rate interest rate = 0.01
it means that:
Future spot rate Current spot rate
1%
Current spot rate
And the implication is that the dollar will depreciate by 1 per cent.

(a) Techniques for protecting against the risk of adverse foreign exchange movements include the
following. (Note: You were only required to give four.)
(i) A company could trade only in its own currency, thus transferring all risks to suppliers and
customers.
(ii) A company could ensure that its assets and liabilities in any one currency are as nearly equal
as possible, so that losses on assets (or liabilities) are matched by gains on liabilities (or assets).
(iii) A company could enter into forward contracts, under which an agreed amount of a currency
will be bought or sold at an agreed rate at some fixed future date or, under a forward option
contract, at some date in a fixed future period.
(iv) A company could buy foreign currency options, under which the buyer acquires the right to
buy (call options) or sell (put options) a certain amount of a currency at a fixed rate at some
future date. If rates move in such a way that the option rate is unfavourable, the option is
simply allowed to lapse.
(v) A company could buy foreign currency futures on a financial futures exchange. Futures are
effectively forward contracts, in standard sizes and with fixed maturity dates. Their prices
move in response to exchange rate movements, and they are usually sold before maturity, the
profit or loss on sale corresponding approximately to the exchange loss or profit on the
currency transaction they were intended to hedge.
(vi) A company could enter into a money market hedge. One currency is borrowed and converted
into another, which is then invested until the funds are required or funds are received to
repay the original loan. The early conversion protects against adverse exchange rate
movements, but at a cost equal to the difference between the cost of borrowing in one
currency and the return available on investment in the other currency.
(b) (i) 1 Forward exchange market
The rates are:
$/
Spot 1.7106 1.7140
3 months forward 1.7024 1.7063
6 months forward 1.6967 1.7006
The net payment three months hence is 116,000 $197,000/1.7063 = 546.
The net payment six months hence is $(447,000 154,000)/1.6967 = 172,688.
Note that the dollar receipts can be used in part settlement of the dollar payments, so
only the net payment is hedged.
2 Money market
3
$197,000 will be received three months hence, so $197,000/(1 + 0.09 ) may be
12
borrowed now and converted into sterling, the dollar loan to be repaid from the receipts.
The net sterling payment three months hence is:

$197 ,000 1
116,000 (1 (0.095 3 )) 924
3
1 (0.09 ) 1.7140 12
12
The equation for the $197,000 receipt in three months is to calculate the amount of
dollars to borrow now (divide by the dollar borrowing rate) and then to find out how
much that will give now in sterling (divide by the exchange rate). The final amount of
sterling after three months is given by multiplying by the sterling lending rate.
$293,000 (net) must be paid six months hence. We can borrow sterling now and
convert it into dollars, such that the fund in six months will equal $293,000. The sterling
payment in six months' time will be the principal and the interest thereon. A similar logic
applies as for the equation above except that the situation is one of making a final
payment rather than a receipt.
C
The sterling payment six months hence is therefore: H
A
293,000 1 6 P
(1+ 0.125) = 176,690 T
6 1.7106 12
1+ 0.06 E
12 R
(ii) Available put options (put, because sterling is to be sold) are at $1.70 (cost 3.45 cents per )
and at $1.80 (cost 9.32 cents per ).
7
Using options at $1.70 gives the following results.
$293,000
= 172,353
1.70$ /
172,353
Contracts required = = 14(to the next whole number)
12,500
Cost of options = 14 12,500 3.45 cents = $6,038.

14 contracts will provide, for 12,500 14 = 175,000, $(175,000 1.70) = $297,500.
$293,000 + $6,038 $297,500
The overall cost is 175,000 + = 175,906
1.6967
As this figure exceeds the cost of hedging through the forward exchange market (172,688),
use of $1.70 options would have been disadvantageous.
Note: The rate of 1.6967 is used instead of 1.7006 because buying 14 contracts leaves the
company slightly short of dollars (by $293,000 + $6,038 $297,500 = $1,538).
Using options at $1.80:
$293,000
= 162,778
1.80$ /
162,778
Contracts required = = 14 (to next whole number)
12,500
Cost of options = 14 12,500 9.32 cents = $16,310

14 contracts will provide, for 12,500 14 = 175,000, 175,000 1.80 = $315,000.
$293,000 + $16,310 $315,000
The overall cost is 175,000 + = 171,654
1.7006
This figure is less than the cost of hedging through the forward exchange market, so use of
$1.80 options would have been preferable.
(iii) Foreign currency options have the advantage that while offering protection against adverse
currency movements, they need not be exercised if movements are favourable. Thus the
maximum cost is the option price, while there is no comparable limit on the potential gains.

WORKING
Tax allowable depreciation
Year
1 (20% of 63,000) 12,600
2 (80% of 12,600) 10,080
3 (80% of 10,080) 8,064
30,744
4 (63,000 30,744) 32,256
The financing decision will be appraised by discounting the relevant cash flows at the after-tax cost of
borrowing, which is 10% 77% = 7.7%.
(a) Purchase option
Cash Discount Present
Year Item flow factor value
7.7%

0 Cost of machine
Tax saved from tax allowable (63,000) 1.000 (63,000)
depreciation
2 23% 12,600 2,898 0.862 2,498
3 23% 10,080 2,318 0.800 1,854
4 23% 8,064 1,855 0.743 1,378
5 23% 32,256 7,419 0.690 5,119
(52,151)
(b) Leasing option

It is assumed that the lease payments are tax-allowable in full.
Cash Discount Present
Year Item flow factor value
7.7%

14 Lease costs (20,000) 3.334 (66,680)
25 Tax savings on lease costs ( 23%) 4,600 3.095 14,237
(52,443)
The purchase option is slightly cheaper, using a cost of capital based on the after-tax cost of
borrowing, but the difference between the cost of the two options is small.

Memorandum
To: Directors of all foreign subsidiaries
From: Group Finance Director
Date: 1 July 20X0
Centralisation of treasury management operations
At its last meeting, the board of directors of Touten made the decision to centralise group treasury
management operations. A further memo giving detailed plans will be circulated shortly, but my
objective in this memo is to outline the potential benefits of treasury centralisation and how any
potential problems arising at subsidiaries can be minimised. Most of you will be familiar with the basic
arguments, which we have been discussing informally for some time.
What it means
Centralisation of treasury management means that most decisions on borrowing, investment of cash
surpluses, currency management and financial risk management will be taken by an enhanced central
treasury team, based at head office, instead of by subsidiaries directly. In addition we propose to set
most transfer prices for inter-company goods and services centrally.

The potential benefits
The main benefits are:
(a) Cost savings resulting from reduction of unnecessary banking charges
(b) Reduction of the group's total taxation charge
(c) Enhanced control over financial risk
Reduction in banking charges will result from:
(a) Netting off inter-company debts before settlement. At the moment we are spending too much on
foreign exchange commission by settling inter-company debts in a wide range of currencies
through the banking system.
(b) Knowledge of total group currency exposure from transactions. Amounts receivable in one C
subsidiary can hedge payables in another, eliminating unnecessary hedging by subsidiaries. H
A
(c) Knowledge of the group's total cash resources and borrowing requirement. This will reduce the P
incidence of one company lending cash while a fellow subsidiary borrows at a higher interest rate T
E
and will also eliminate unnecessary interest rate hedging. It will also facilitate higher deposit rates
R
and lower borrowing rates.
Reduction in the group's tax charge will be made possible by a comprehensive centrally-set transfer
pricing policy. 7
Enhanced control over financial risks will be possible because we will be able to develop a central team
of specialists who will have a clear-cut strategy on hedging and risk management. Many of you have
requested help in this area.
This team will be able to ensure that decisions are taken in line with group strategy and will also be able
to provide you with enhanced financial information to assist you with your own decision making.
Potential problems for subsidiaries and their solution
Our group culture is one of decentralisation and enablement of management at individual subsidiary
level. There is no intention to change this culture. Rather, it is hoped that releasing you from specialist
treasury decisions will enable you to devote more time to developing your own business units.
The system can only work properly, however, if information exchange between head office and
subsidiaries is swift and efficient. Enhanced computer systems are to be provided at all centres to assist
you with daily reports. It is also important that you keep head office informed of all local conditions that
could be beneficial to the treasury function, such as the availability of local subsidised loans, as well as
potential local risks such as the threat of exchange control restrictions.
You will find that movements in your cash balances will be affected by group policy, as well as reported
profitability. Any adjustments made by head office will be eliminated when preparing the performance
reports for your own business units and we will ensure that joint venture partners are not penalised by group
policy.
Please contact me with any further comments that you may have on our new treasury policy.

If a profit centre approach is being considered, the following issues should be addressed.
(a) Competence of staff
Local managers may not have sufficient expertise in the area of treasury management to carry out
speculative treasury operations competently. Mistakes in this specialised field may be costly. It may
only be appropriate to operate a larger centralised treasury as a profit centre, and additional
specialist staff demanding high salaries may need to be recruited.
(b) Controls
Adequate controls must be in place to prevent costly errors and overexposure to risks such as
foreign exchange risks. It is possible to enter into a very large foreign exchange deal over the
telephone.
(c) Information
A treasury team which trades in futures and options or in currencies is competing with other
traders employed by major financial institutions who may have better knowledge of the market
because of the large number of customers they deal with. In order to compete effectively, the team
needs to have detailed and up-to-date market information.
(d) Attitudes to risk
The more aggressive approach to risk-taking which is characteristic of treasury professionals may be
difficult to reconcile with the more measured approach to risk which may prevail within the board
of directors. The recognition of treasury operations as profit making activities may not fit well with
the main business operations of the company.
(e) Internal charges
If the department is to be a true profit centre, then market prices should be charged for its services
to other departments. It may be difficult to put realistic prices on some services, such as
arrangement of finance or general financial advice.
(f) Performance evaluation
Even with a profit centre approach, it may be difficult to measure the success of a treasury team for
the reason that successful treasury activities sometimes involve avoiding the incurring of costs, for
example when a currency devalues. For example, a treasury team which hedges a future foreign
currency receipt over a period when the domestic currency undergoes devaluation (as sterling did
in 1992 when it left the European exchange rate mechanism) may avoid a substantial loss for the
company.

CHAPTER 8
International financial
management
Introduction
Topic List
1 Financing international investment
2 Costs and benefits of alternative sources of finance for international investments
3 International trade export risks and financing
4 Financing overseas expansions and acquisitions
363
Introduction
Demonstrate a detailed understanding of the various methods of financing available for

overseas investments
Demonstrate and apply knowledge of the impact of exchange controls and how
companies can overcome the effects of these controls
Demonstrate and apply knowledge of the factors affecting the capital structure of a
multinational company
Demonstrate a detailed understanding of the advantages and risks associated with

international borrowing
Demonstrate a detailed understanding of the risks associated with international trade and
the ways in which these risks can be contained
Demonstrate a detailed understanding of the different avenues open to multinationals

wishing to set up overseas operations and the choices of finance available

1 Financing international investment
Section overview
Companies with overseas investments face such challenges as political risks, overseas taxation and
exchange controls when trying to finance such investments.
To ensure that international projects are appraised correctly, these factors must be taken into
consideration in the evaluation process.
Many of the projects that companies are appraising may have an international dimension. For example,
the assumption can be made that part of the production from a project may be exported. In appraising
a tourist development, a company may be making assumptions about the number of tourists from
abroad who may be visiting. Imported goods and materials could be a factor in the determination of
cash flows. All these examples show that exchange rates will have an influence on the cash flows of the
company.
Companies that undertake overseas projects are exposed, in addition to exchange rate risks, to other
types of risk such as exchange control, taxation or political risks. The latter is particularly true in
countries with undemocratic regimes that may be subject to abrupt change.
Capital budgeting techniques for multinational companies therefore need to incorporate these
additional complexities in the decision-making process. These can be based on similar concepts to those
used in the purely domestic cases that you have covered previously but special considerations, examples
of which were given above, may apply.
C
We have already covered international investment in detail in an earlier chapter. However, there are H
several important issues that have not yet been dealt with. A
P
1.1 Exchange controls T
E
Exchange controls restrict the flow of foreign exchange into and out of a country, usually to defend the R
local currency or to protect reserves of foreign currencies. Exchange controls are generally more
restrictive in developing and less developed countries although some still exist in developed countries.
These controls take the following forms. 8
Rationing the supply of foreign exchange. Anyone wishing to make payments abroad in a
foreign currency will be restricted by the limited supply, which stops them from buying as much as
they want from abroad.
Restricting the types of transaction for which payments abroad are allowed, for example by
suspending or banning the payment of dividends to foreign shareholders, such as parent
companies in multinationals, who will then have the problem of blocked funds.
1.1.1 Strategies of dealing with exchange controls

Multinational companies have used many different strategies to overcome exchange controls, the most
common of which are listed below.
Transfer pricing where the parent company sells goods or services to the subsidiary and obtains
payment. The amount of this payment will depend on the volume of sales and also on the transfer
price for the sales.
Royalty payments when a parent company grants a subsidiary the right to make goods protected
by patents. The size of any royalty can be adjusted to suit the wishes of the parent company's
management.
Loans by the parent company to the subsidiary. If the parent company makes a loan to a
subsidiary, it can set the interest rate high or low, thereby affecting the profits of both companies.
A high rate of interest on a loan, for example, would improve the parent company's profits to the
detriment of the subsidiary's profits.
Management charges may be levied by the parent company for costs incurred in the
management of international operations.
International financial management 365

1.2 Pre-export financing
International trade is dealt with in detail in Section 3 of this chapter but it is worth mentioning pre-
export financing here.
Increased globalisation means that many companies rely heavily on export revenue. If large amounts of
money have to be spent to allow the company to fulfil an export order, financing may be required to
bridge the gap between fulfilling the order and being paid by the customer. For example, expensive
capital equipment may be required this is particularly true for companies dealing in commodities.
Pre-export financing is often structured, meaning that banks will provide funding for the exporter but
the funding will be tied to production and export activities.
Export Credit Agencies (ECAs) can also provide finance to exporters. These agencies are government
departments whose main function is to assist exporters by providing state insurance against political and
commercial risks. Whilst ECAs initially provided finance mainly to manufacturers, their role more
recently has had to change, given the decline in some countries' manufacturing base. The UK is a prime
example of this, meaning that the role of the Export Credits Guarantee Department (ECGD) the UK's
ECA has altered, providing assistance to companies exporting services as well as manufactured goods.
ECA-covered finance is a suitable way of exceeding the natural limits of pre-export financing that is,
the total value of proceeds under long-term export contracts.
1.3 Post-export finance

This type of finance covers the period between the goods being shipped and the payment being
received. As overseas customers often negotiate lengthy credit periods, this can be a considerable
period of time.
Post-export finance protects against commercial and political risk. The cost of finance depends on
various risk factors such as length of credit period, payment method and the country to which the
export was made. This will be dealt with in more detail in Section 3 of this chapter.
2 Costs and benefits of alternative sources of finance for

international investments
Section overview
Multinational companies have a wide choice of financing options to fund overseas investments.
In order to determine which financing options to choose, such companies must weigh up the
costs and benefits of each, bearing in mind the potential impact on capital structure and company
risk.
Multinational companies (MNCs) fund their investments from: cash flow generated from operations,
from the issue of new equity and from the issue of new debt. Equity and debt funding can be secured
by accessing both domestic and overseas capital markets. Thus multinational companies have to make
decisions not only about their capital structure as measured by the debt/equity ratio but also about the
source of funding, that is whether the funds should be drawn from the domestic or the international
markets.
2.1 Factors affecting the capital structure of a MNC

The source of funding for a multinational company will be influenced by a number of specific factors
such as:
Global taxation
Exchange risk
Political risk
Business risk

Interest tax deductibility plays a major role in the determination of the optimal structure of the firm.
Global taxation is also an important factor in determining the capital structure of the multinational
company. Tax deductibility in any specific country in which they operate is still the main aspect, but
because multimodal companies operate in several tax jurisdictions, a multinational company will have to
consider other issues, such as double taxation, withholding taxes, investment tax allowances and so on.
A multinational company may choose the level of debt and the type of debt in a way that minimises its
global tax liabilities.
Exchange rate risk may also influence the capital structure of the multinational. When a UK company
wishes to finance operations overseas, there may be a currency (foreign exchange) risk arising from the
method of financing used. For example, if a UK company decides on an investment in the US, to be
financed with a sterling loan, the investment will provide returns in US dollars, while the investors (the
lenders) will want returns paid in sterling. If the US dollar falls in value against sterling, the sterling value
of the project's returns will also fall.
To reduce or to eliminate the currency risk of an overseas investment, a company might finance it with
funds in the same currency as the investment. The advantages of borrowing in the same currency as an
investment are as follows.
Assets and liabilities in the same currency can be matched, thus avoiding exchange losses on
conversion in the group's annual accounts.
Revenues in the foreign currency can be used to repay borrowings in the same currency, thus
eliminating losses due to fluctuating exchange rates.
Political risk to which companies may be exposed when investing overseas may also be reduced by the
choice of an appropriate financing strategy. For example, a multinational company may fund an C
international project by borrowing from banks in the country in which the project will be built. In this H
A
way the loss in the case of nationalisation will be borne by the local banks rather than by the parent P
company. In the absence of political risk, the company may prefer to finance the project by providing T
equity capital. E
R
Business risk is also a determinant of the capital structure. Business risk is normally proxied by the
volatility of earnings and there is a negative relationship between business risk and leverage. As
multinational companies are able to diversify and reduce the volatility of earnings, they should be able 8
to take on more borrowing.
2.2 The advantages of borrowing internationally

There are three main advantages to borrowing from international capital markets, as opposed to
domestic capital markets.
Availability. Domestic financial markets, with the exception of the large countries and the Euro
zone, lack the depth and liquidity to accommodate either large debt issues or issues with long
maturities. The classic example is Novo Industri, a Danish pharmaceutical company that issued
dollar convertible Eurobonds in 1978 in order to pursue its expansion strategy.
Lower cost of borrowing. In Eurobond markets interest rates are normally lower than borrowing
rates in national markets.
Lower issue costs. The cost of debt issuance is normally lower than the cost of debt issue in
domestic markets.
2.3 The risks of borrowing internationally

A multinational company has three options when financing an overseas project by borrowing. The first
is to borrow in the same currency as the inflows from the project. The second option is borrowing in a
currency other than the currency of the inflows but with a hedge in place and the third option is
borrowing in a currency other than the currency of the inflows but without hedging the currency risk.
The last case exposes the company to exchange rate risk which can substantially change the profitability
of a project.
This topic is covered in Section 4 below. The International Fisher effect was covered in Chapter 7
Financial Engineering.

3 International trade export risks and financing
Section overview
International trade exposes companies to various risks such as credit and liquidity risks.
Companies can take steps to protect themselves from international trade risks using such means as
insurance of goods in transit.
International trade was covered briefly in the Financial Management paper at the Application level,
therefore some of the terms mentioned in this section may be familiar.
When making decisions about financing international trade transactions, companies should consider:
The need for financing to make a sale, as favourable credit terms often make a product more
competitive.
The length of time over which the product is being financed, which will determine how long the
exporter will have to wait to get paid.
The cost of different methods of financing.
The risks associated with financing the transaction the greater the risk, the more difficult and
costly it will be to finance.
The need for pre-export finance and post-export working capital. This will be a particular issue if
the order is particularly large.
Any company involved in international trade must assess and plan for the different risks they will
invariably face. As well as physical loss or damage to goods, there are also cash flow problems and the
risk that your customer may not pay either on time or at all. Plans must also be made for risks
associated with goods or services that may be faulty.
3.1 Loss or damage in transit

Goods being exported must be insured from the time they leave the company till their arrival with the
customer. Depending on the agreement, the exporter may bear the cost of insurance or it may be
passed onto the customer.
The danger of leaving the customer to arrange insurance is that the exporter may not receive full
payment from the customer if a problem arises and they are not adequately insured. If there is
inadequate insurance and the goods are rejected, either at the port of entry or when they reach the
customer's premises, the responsibility will be bounced back to the exporter.
3.2 Faults with products

When supplying goods for export, companies must consider the risk that the product in very rare
cases could cause damage to a third party, whether it is a person or property. Product liability
insurance covers such risks.
However, product liability insurance does not provide cover for claims against poor quality goods or
services. Exporting companies must take responsibility for such risks themselves, by such means as
improved quality control measures. By introducing such measures, companies may benefit from
reduced insurance premiums, as it demonstrates the serious assumption of responsibility for the quality
of the goods and services.
3.3 Non-payment by customers

Regardless of whether goods are sold at home or abroad, there is always the risk that customers will
either not pay in full or not pay at all. Insuring against this credit risk is something that many
companies overlook.

Exporters can take out export credit insurance to guard against the risk of partial or non payment.
By taking out such insurance, companies can afford to sell more goods or services on credit and increase
borrowing power, although it does not replace good credit management. One of the problems with
this insurance is the high premiums involved.
As well as export credit insurance, exporters may require bond insurance. Many overseas customers ask
sellers for bonds or bank guarantees to protect themselves against poor quality or performance after
making advance payments.
3.4 Liquidity
We saw in Chapter 6 that exporters can face problems over obtaining cash from customers when they
need funds for investment. As we discussed, there are a number of ways that they can reduce or remove
risks such as factoring and credit insurance.
Interactive question 1: International investment decisions

Tiger Electronics a specialist manufacturer of electronic spare parts of a major car manufacturer is
considering direct investments in several African countries. Business is currently booming and Tiger is
very keen to take advantage of the low cost resources in Africa. However, Tiger's board of directors is
concerned about the potential effects of political and economic volatility in various African countries on
production of spare parts and supply of necessary resources.
Requirements
C
(a) Discuss factors that Tiger should take into consideration when deciding which, if any, African H
countries it should invest in. A
P
(b) How might Tiger handle political risk if it invested in Africa? T
E
(c) What ethical issues might have to be taken into consideration as part of Tiger's overall overseas R
investment strategy?
8
4 Financing overseas expansions and acquisitions
Section overview
Rather than exporting to overseas customers, many companies choose to set up operations in
countries with which they do large amounts of business.
Setting up operations in a foreign country can be a costly business and companies must undertake
considerable research before deciding how their presence should be established.
As well as deciding on the type of overseas operation, companies have to decide how to finance
such operations.
Companies have a wide choice of strategies when it comes to setting up an overseas operation. This
can range from licensing agreements and joint ventures to setting up branches or acquiring established
firms. Each strategy fulfils a different purpose, depending on the type of presence that is required.
4.1 Types of expansion

4.1.1 Takeover of, or merger with, established firms overseas
This type of expansion provides a means of purchasing market information, market share and
distribution channels. If speed of entry into the overseas market is a high priority then acquisition may
be preferred to starting from scratch. The main problem is that the better acquisitions may only be
available at a premium.

4.1.2 Overseas subsidiaries
The basic structure of many multinationals consists of a parent (holding) company with subsidiaries in
several countries. The subsidiaries may be wholly- or partly-owned, and some may be owned through
other subsidiaries. Whatever the reason for setting up an overseas subsidiary, the ultimate aim is to
increase the profits of the parent company. There are different approaches to increasing profits. At the
one extreme, the parent might want to make as much money as it can and as quickly as it can from the
subsidiary. This would involve transferring most or all of the subsidiary's profits to the parent. At the
other extreme, the parent company might encourage the overseas subsidiary to develop its business
gradually in order to achieve long-term growth in sales and profits. For the subsidiary, this would mean
retaining a large proportion of its profits rather than remitting them to the parent.
4.1.3 Branches
Branches may be preferred to subsidiaries when trying to expand overseas for several reasons.
Taxation
In many countries, the remitted profits of a subsidiary will be taxed at a higher rate than those of a
branch, as profits paid in the form of dividends are likely to be subject to a withholding tax.
Formalities
As a separate entity, a subsidiary may be subject to more legal and accounting formalities than a
branch. On the other hand, as a separate legal entity, a subsidiary may be able to claim more relief
and grants than a branch.
Marketing
A local subsidiary may have a greater profile for sales and marketing purposes than a branch.
4.2 Choice of finance

Once the issue of expansion and how it should be carried out has been agreed, the most urgent
problem is how it should be financed. Should the subsidiary be financed in its home currency or that of
the parent?
The issue of financing overseas subsidiaries raises the following questions.
How much equity capital should the parent put into the subsidiary?
Should the subsidiary be allowed to retain a large proportion of its profits to allow it to build up its
own equity reserves, or will the majority of the profits be repatriated to the parent?
Should the parent company hold 100% of the equity of the subsidiary or should it try to create a
minority shareholding, perhaps by floating the subsidiary on the country's domestic stock
exchange?
Should the subsidiary be encouraged to borrow as much long term debt as it can and if so, should
the debt be in the subsidiary's home currency or in a foreign currency?
Should the subsidiary be encouraged to minimise its working capital investment by relying heavily
on trade credit?
The way in which a subsidiary is financed will give some indication of the nature and the length of time
of the investment that the parent company is prepared to make. A sizeable equity investment (or long-
term loans from the parent company to the subsidiary) would suggest a long-term investment by the
parent.
The choice of the source of funds will depend on:
The local finance costs and any available subsidies
The taxation systems of the subsidiary's home country
Any restrictions on dividend remittances
The possibility of flexibility in repayments that may arise from the parent/subsidiary relationship
Tax-saving opportunities may be maximised by structuring the group and its subsidiaries in such a way
as to take advantage of the different local tax systems.

As subsidiaries may be operating with a guarantee from the parent company, different gearing
structures may be possible. Thus a subsidiary may be able to operate with a higher level of debt than
would be acceptable for the group as a whole.
Parent companies should also consider the following factors.
Reduced systematic risk. There may be a small incremental reduction in systematic risk from
investing overseas due to the segmentation of capital markets.
Access to capital. Obtaining capital from overseas markets may increase liquidity, reduce costs
and make it easier to maintain optimal gearing.
Agency costs. These may be higher owing to political risk, market imperfections and complexity,
which will lead to a higher cost of capital.
4.2.1 Dealing with currency risk

To reduce or eliminate the currency risk of an overseas expansion, a company might finance it with
funds in the same currency as the expansion's home country. This means that assets and liabilities in
the same currency can be matched, thus avoiding exchange losses on conversion in the group's annual
accounts. Another benefit of using the local currency is that revenues in that currency can be used to
repay the borrowings which will eliminate losses due to fluctuating exchange rates.
4.3 Developing markets

Although companies in developed markets take the availability of a wide choice of finance options for
granted, those operating in developing markets may not be quite so fortunate. Lack of regulation and a
limited understanding of such markets make the funding of overseas acquisitions, by for example stock C
swaps (ie a share-for-share exchange), less likely as the target firms may be reluctant to accept payment H
in the form of risky equity. As a result companies in developing markets tend to finance overseas A
P
acquisitions using cash.
T
E
Case example: How Indian companies finance overseas acquisitions R
In January 2007, India's largest steel manufacturer Tata Steel won the battle to control Corus, the Anglo-
Dutch steelmaker. The offer represented a premium of 68% to Corus' pre-bid price. As Tata Steel did 8
not have the ready cash to pay for the acquisition it geared its own statement of financial position and
that of Corus to finance the deal. The deal was partly financed by Tata Steel's UK debt of approximately
$6.14 billion and partly by equity contributions from subsidiaries.
The financing of this $12.9 billion acquisition echoes Indian companies' preference for cash over share
swaps for funding overseas acquisitions. Most Indian firms have strong cash flows and low gearing
which makes it easy for them to borrow at favourable rates. Corporate earnings increased on average
by 20 25% between 2002 and 2006, convincing investors that Indian firms will add value to overseas
acquisitions, hence the desire to back such deals.
Unlike most international mergers and acquisitions that typically feature share swaps, Indian firms have
mainly paid cash for their targets, helped by internal resources and borrowings. One reason for this is
that Indian firms are often owned directly by 'promoter shareholders' who also manage the company.
Overseas targets are reluctant to invest through share swaps in such companies. In addition the Indian
market is not as well understood as the developed markets, hence share swaps may be viewed as risky.
Private equity funds are also becoming a major source of funding for overseas acquisitions but while
leveraged buyouts were used for the Tata Tea acquisition of Tetley in 2000 for $431.2 million this form
of financing has yet to gain popularity in India.

Interactive question 2: Overseas investment [Difficulty level: Intermediate]
Watson plc is considering an investment in Buzzland, a country with a population of 80 million that has
experienced eight changes of government in the last 15 years. The investment would cost 580 million
Buzzland francs for machinery and other equipment, and an additional 170 million francs would be
necessary for working capital.
While Buzzland has a wealth of resources, including skilled labour and excellent communications
networks, the country has suffered from the relatively high price of its resources compared with
countries with similar infrastructure and skills. Its main export product, a special type of exotic fruit, has
been significantly damaged in the last few years due to extremely high temperatures and lack of rain.
Buzzland has been 'bailed out' several times by the IMF and such is the severity of the economic and
financial situation that there have been several temporary restrictions imposed on the remittance of
funds from Buzzland in the last five years. The Buzzland government has taken on huge amounts of
debt from overseas countries the interest on the debt alone is crippling the economy.
Watson plc's proposed investment would be in the production of a new type of video 'mobile phone',
which is currently manufactured in the UK. If the Buzzlandian investment project was undertaken the
existing UK factory would either be closed down or downsized. Watson plc hopes to become more
competitive by shifting production from the UK.
Additional information:
(i) UK corporate tax is at the rate of 23% per year, and Buzzlandian corporate tax at the rate of 20%
per year, both payable in the year that the tax charge arises. Tax allowable depreciation in
Buzzland is 25% per year on a reducing balance basis. A bilateral tax treaty exists between
Buzzland and the UK.
(ii) The after-tax realisable value of the machinery and other equipment after four years is estimated to
be 150 million Buzzland francs.
(iii) 140,000 has recently been spent on a feasibility study into the logistics of the proposed
investment. The study reported favourably on this issue.
(iv) The Buzzland government has offered to allow Watson plc to use an existing factory rent free for a
period of four years on the condition that Watson employs at least 300 local workers. Watson has
estimated that the investment would need 250 local workers. Rental of the factory would normally
cost 75 million Buzzland francs per year before tax.
(v) Almost all sales from Buzzland production will be to the European Union priced in euros.
(vi) Production and sales are expected to be 50,000 units per year. The expected Year 1 selling price is
480 euros per unit.
(vii) Unit costs throughout Year 1 are expected to be:
Labour: 3,800 Buzzland (B) francs based upon using 250 workers
Local components: 1,800 B francs
Component from Germany: 30 euros
Sales and distribution: 400 B francs
(viii) Fixed costs in Year 1 are 50 million B francs.
(ix) Local costs and the cost of the German component are expected to increase each year in line with
Buzzland and EU inflation respectively. Owing to competition, the selling price (in euros) is
expected to remain constant for at least four years.
(x) All net cash flows arising from the proposed investment in Buzzland would be remitted at the end
of each year back to the UK.
(xi) If the UK factory is closed Watson will face tax allowable redundancy and other closure costs of
35 million. Approximately 20 million after tax is expected to be raised from the disposal of land
and buildings.
(xii) If Watson decides to downsize rather than close its UK operations then tax allowable closure costs
will amount to 20 million, and after-tax asset sales to 10 million. Pre-tax net cash flows from the
downsized operation are expected to be 4 million per year, at current values. Manufacturing

capacity in Buzzland would not be large enough to supply the market previously supplied from the
UK if downsizing does not occur.
(xiii) The estimated beta of the Buzzland investment is 1.5 and of the existing UK investment 1.1.
(xiv) The relevant risk free rate is 4.5% and market return 11.5%.
(xv) Money market investment in Buzzland is available to Watson paying a rate of interest equivalent to
the Buzzlandian inflation rate.
(xvi) Forecast % inflation levels:
UK and the EU Buzzland
Year 1 2% 20%
Year 2 3% 15%
Year 3 3% 10%
Year 4 3% 10%
Year 5 3% 10%
(xvii) Spot exchange rates:
Buzzland francs/36.85
Buzzland francs/Euros 23.32
Requirements
(a) Should Watson plc undertake the proposed investment in Buzzland and consequently close or
downsize its UK operation? Show all relevant workings and clearly state all assumptions.
(b) What other issues, in addition to the appraisal above, should Watson plc consider before making C
H
the final decision as to whether to invest in Buzzland?
A
See Answer at the end of this chapter. P
T
E
R

Summary

Self-test
1 Upowerit plc
Upowerit plc is a UK-based company that has been trading for some years, selling self-powered
equipment. It has recently expanded rapidly in Europe and Africa. In Europe consumers have
responded to Upowerit's marketing message that self-power is an environmentally preferable
alternative to using disposable batteries. Upowerit's products have been popular in Africa because
they have been seen as more economical than disposable battery-powered products, and because
they do not require mains-supplied electricity that may be unreliable or unavailable.
The board of Upowerit is considering establishing an operational presence in an African country, to
enhance its sales operations in that continent, and eventually to establish a manufacturing base
there to reduce costs of production and distribution. The board is considering what form the
operations should take and various financing issues.
Requirements
(a) Explain why setting up a branch to establish an overseas presence may be more attractive to
the board of Upowerit than setting up a subsidiary.
(b) Identify the factors that may influence the choice of finance for overseas operations.
(c) Identify the methods that governments can use to impose exchange controls and identify
ways in which Upowerit could overcome exchange controls.
2 Look again at Self-test question 2 in Chapter 4 Investment Appraisal.
PG plc is now considering how to finance the Canadian project. It has originally planned to use C
internal funds generated in the UK, but the finance director has suggested that there would be H
advantages in raising debt finance in Canada. A
P
Requirement T
E
Discuss the advantages and disadvantages of matching investment and borrowing overseas R
compared with UK-sourced debt or equity. You should relate your answer as much as possible to
PG plc's particular circumstances.
8
3 Snazzy
Snazzy is a manufacturer of low-cost bedroom furniture for children in Dinoville (whose currency is
the Dinoville the D). However, the Dinoville market is becoming saturated and Snazzy is
considering setting up a manufacturing operation in either Lexland or Jibrovia to take advantage of
the high demand for such products in these countries. Owing to the high cost and limited
availability of suitable transportation, it would not be financially viable to export from Dinoville.
The Lexland subsidiary would involve the construction of completely new state-of-the-art
manufacturing plant. The projected costs are shown below.
Lexland subsidiary (currency: Lexland franc)
Now Year 1
LFr'000 LFr'000
Land 2,300
Building 1,600 6,200
Machinery 6,400
Working capital 11,500
Production and sales in Year 2 are estimated to be 2,000 sets of bedroom furniture at an average
price of LFr20,000 (at current prices). Production in each of Years 3-6 is forecast at 2,500 sets of
furniture. Total local variable costs in Lexland in Year 2 are expected to be LFr11,000 per unit (at
current prices). In addition a fixed royalty fee of D750,000 per year would be payable to the
Dinoville parent company. Tax allowable depreciation in Lexland on machines is at 25% per year
on a reducing balance basis. No tax allowable depreciation exists on other non-current assets.
The Jibrovia investment (currency Jibrovia $ the J$) would involve the purchase, via a takeover
bid, of an existing kitchen furniture manufacturer based in its second city of Nicktown. The cost is
not precisely known but Snazzy's managers are confident that a bid within the range J$8m-10m
will be successful. Additional investment of J$2 million in new plant and J$4 million in working

capital would immediately be required, resulting in forecast pre-tax net cash flows (after tax savings
from depreciation) in Year 1 of J$2 million (at current prices) rising to J$3 million (at current prices)
in Year 2 and subsequent years.
All prices and costs in Lexland and Jibrovia are expected to increase annually by the current rate of
inflation. The after-tax realisable value of the investments in six years' time is expected to be
approximately LFr16.2 million and J$14.5 million at price levels of six years in the future, excluding
working capital.
Inflation rates for each of the next six years are expected to be:
Jibrovia 6%
Dinoville 3%
Lexland 5%
Exchange rates
LFr/D J$/D
Spot 2.3140 2.3210 1.5160 1.5210
Snazzy can borrow funds for the investment at 10% per year in Dinoville. The company's cost of
equity capital is estimated to be 17%. After either proposed investment Snazzy's gearing will be
approximately 50% debt, 50% equity by book value, and 30% debt, 70% equity by market value.
Corporate tax in Lexland is at 40%, in Dinoville 33% and Jibrovia 30%. Full bilateral tax treaties
exist between Dinoville and both Lexland and Jibrovia. Taxation is payable, and allowances are
available, one year in arrears.
Requirement
Evaluate which, if either, of the two subsidiaries should be established by Snazzy. Include discussion
of the limitations of your evaluation. State clearly any assumptions that you make.
4 Gordon plc
Gordon plc is a health club chain based in Northern Ireland. The company has decided to purchase
an existing health club chain in New Jersey, USA. The purchase will cost an agreed $72 million for
non-current assets and equipment, and in addition $8 million of working capital will be needed.
No additional external funding for the proposed US subsidiary is expected to be needed for at least
five years, and sales from the subsidiary would be exclusively to the US market. Gordon has no
other foreign subsidiaries, and the company's managers are considering how to finance the US
investment. Gordon's bank has advised that, taking into account Gordon's credit rating, the
following alternatives might be possible, with finance available up to the amount shown.
(a) A one for four rights issue, at a price of 280 pence per share. Underwriting and other costs are
expected to be 5% of the gross amount raised.
(b) Five-year sterling 7% fixed-rate secured bank term loan of up to 50 million, initial
arrangement fee 1%.
(c) $15 million one-year commercial paper, issued at $US LIBOR plus 1.5%. This could be
renewed on an annual basis. An additional 0.5% per year would be payable to a US bank for a
back-up line of credit.
(d) 80 million Swiss franc five-year fixed rate secured bank loan at 2.5%. This may be swapped
into fixed rate $ at an additional annual interest rate of 2.3%. An upfront fee of 3.0% is also
payable.
No currency swaps are available other than those shown. Currency swaps would involve swapping
the principal at the current spot exchange rate, with the reversal of the swap at the same rate at
the swap maturity date.
$US LIBOR is currently 3%.
Exchange rates
Spot One-year forward
$/ 1.7985 1.8008 1.7726 1.7746
SF/ 2.256 2.298 2.189 2.205

Gordon's current statement of financial position is summarised below.
m
Non-current assets 117.8
Investments 8.1
Current assets 98.1
Current payables
Loans and other borrowings (38.0)
Other payables (48.6)
137.4
Non-current payables
Medium and long-term bank loans 30.0
8% Bond 20X9 (par value 100) 18.0
48.0
Capital and reserves
Ordinary shares (25 pence par value) 20.0
Reserves 69.4
137.4
A covenant exists that prevents the book value of Gordon's debt finance from exceeding 50% of
total assets. Gordon's current dividend per share is 22.2 pence and dividend growth is
approximately 4% per year. The company's current share price is 302 pence.
Interest payments on debt financing may be assumed to be made annually at the end of the year.
Corporate tax in the UK, USA and Switzerland is at a rate of 28%. Issue costs and fees such as swap
fees are not tax allowable.
Requirements C
H
(a) Discuss the factors that Gordon should consider before deciding how to finance the proposed A
US subsidiary. P
T
(b) Prepare a report discussing and evaluating each of the four possible sources of finance, and E
provide a reasoned recommendation of which source, or combination of sources, Gordon R
should use. Supporting calculations, including costs, should be provided wherever relevant.

1 (a) A branch may be more attractive than a subsidiary due to there being fewer legal formalities
and more favourable tax treatment (branches are not subject to withholding tax).
(b) Factors that may influence the choice of finance are:
Local finance costs
Taxation systems
Restrictions on dividend remittances
Flexibility in repayments
(c) Governments impose exchange controls by:
Rationing the supply of foreign exchange
Restricting the types of transactions for which payments abroad are allowed
Upowerit can overcome exchange controls by:
Selling goods or services to a subsidiary
Charging a royalty on goods sold by a subsidiary
Interest rate manipulation
Management charges
2 The decision to finance a foreign investment by borrowing in the foreign country's currency is
influenced by a number of factors.
(a) Loan in the same currency
For any income-generating foreign investment there is a risk that the foreign currency will
depreciate, which will result in revenue value being lower when converted to the home
currency. If borrowings are in the same currency as the income they generate then reduced
income is at least partially offset by reduced loan interest costs. The downside is that this
form of hedging reduces the possibility of currency gains an appreciation of the currency
will lead to increased income but also increased interest repayments on the loan.
(b) Unexpected losses
In the PG plc example, the Canadian dollar steadily devalues against the pound. Borrowing in
Canadian dollars would therefore enable currency risk to be managed better than if
borrowing is arranged in sterling. However, in a system of free floating exchange rates, if the
Canadian dollar depreciates by 5% per year against sterling the cost of borrowing in Canadian
dollars is likely to be approximately 5% more expensive than borrowing in sterling. This
increased interest cost will remove the advantage of the devaluation of the Canadian dollar
loan. If currencies always moved in predictable ways there would be little advantage in
financing the Canadian investment with a Canadian loan. However, currency devaluations
can sometimes be unexpected and much larger than predicted. It is to prevent these
unexpected losses that hedging using a foreign loan is recommended.
(c) Cost of foreign loans
The cost of foreign loans may be higher than the theoretical equivalent cost of a domestic
loan because the company does not have such a good credit standing in the foreign country.
A further consideration is the availability of tax savings on the loan interest. The effect on the
company's overall tax charge should be included in the decision process.
(d) Impact of political risk
For countries with high political risk that may impose exchange controls or even expropriate
assets, borrowing in the local currency is recommended to offset investment losses that might
result from political action. As Canada is not considered to have high political risk, this should
not have a great impact on PG plc.

3 Snazzy
Contribution to organisational objectives
The evaluation of each of the two alternatives is made in terms of how well each one contributes to
the achievement of organisational objectives and strategies. The information given enables a
financial appraisal of each alternative to be made. This will only be part of the input to the final
decision, albeit an important part. Many non-financial factors will also have to be taken into
account.
Approach used
The financial appraisal is shown below. The basic approach is to estimate cash flows in the foreign
currency, convert them to the home currency and discount them at a rate based on home country
cost of capital.
Financial appraisal of the two alternative investments
The time horizon for appraisal of both investments is seven years: six years of operation plus one
further year to allow for the tax delay.
Appraisal of Lexland investment
Year 0 1 2 3 4 5 6 7
Production/sales units 2,000 2,500 2,500 2,500 2,500
Cntbn. per unit, LFr 9,923 10,419 10,940 11,487 12,061
(W1)
LFr '000 LFr '000 LFr '000 LFr '000 LFr '000 LFr '000 LFr '000 LFr '000
Total contribution 19,846 26,048 27,350 28,718 30,153 C
H
Royalty (750,000 (1,806) (1,841) (1,877) (1,914) (1,951)
A
exch.rate) P
Operating cash flow 18,040 24,207 25,473 26,804 28,202 T
E
Tax at 40% (7,216) (9,683) (10,189) (10,722) (11,281) R
Tax saved by dep'n all. 1,120 360 270 202 152
(W2)
Land (2,300) 8
Building (1,600) (6,200)
Machinery (6,400)
After-tax realisable value 16,200
Working capital (W3) (11,500) (575) (604) (634) (666) (699) 14,678
Cash remitted to (3,900) (24,100) 17,465 17,507 15,516 16,219 33,183 3,549
Dinoville
Exchange rate LFr/D 2.3175 2.3625 2.4084 2.4551 2.5028 2.5514 2.6010 2.6515
(W4)
D'000 D '000 D'000 '000 D '000 D '000 D'000 D'000

Cash remitted from (1,683) (10,201) 7,252 7,131 6,199 6,357 12,758 1,338
Lexland
Royalty received 750 750 750 750 750
Tax at 33% on royalty (248) (248) (248) (248) (248)
Net cash (1,683) (10,201) 8,002 7,633 6,701 6,859 13,260 1,090
14% d.f. (W5) 1.000 0.877 0.769 0.675 0.592 0.519 0.456 0.400
Present value (1,683) (8,946) 6,154 5,152 333,967 3,560 6,047 436
The Lexland investment has a positive net present value of D14.69 million.

Appraisal of Jibrovia investment
Year 0 1 2 3 4 5 6 7
J$'000 J$'000 J$'000 J$'000 J$'000 J$'000 J$'000 J$'000
Pre-tax cash flow 2,120 3,371 3,573 3,787 4,014 4,255
Tax at 30% (636) (1,011) (1,072) (1,136) (1,204) (1,277)
Cost of acquisition (10,000)
(assume maximum)
Machinery (2,000)
After-tax realisable value 14,500
Working capital (W6) (4,000) (240) (254) (270) (286) (303) (321) 5,674
Cash remitted to/from (16,000) 1,880 2,481 2,292 2,429 2,575 17,230 4,397
Jibrovia
Exchange rate (W4) 1.5185 1.5627 1.6082 1.6551 1.7033 1.7529 1. 1.8565
Cash remitted to/from (10,537) 1,203 1,543 1,385 1,426 1,469 9,551 2,368
Jibrovia (D'000)
Additional Dinoville tax (41) (63) (65) (67) (69) (71)
(3%) (W7)
(See Note below)
Net cash (10,537) 1,203 1,502 1,322 1,361 1,402 9,482 2,297
14% d.f. (W5) 1.000 0.877 0.769 0.675 0.592 0.519 0. 0.400
Present value (10,537) 1,055 1,155 892 806 728 4,324 919
Net present value of (D658,000)
WORKINGS
(1) Contribution per unit Lexland
At current prices (year 0): LFr
Sales price 20,000
Variable costs 11,000
Contribution 9,000
This will increase by 5% per year. Contribution per unit in Year 2 will be
2
9,000 1.05 = LFr 9,923.
(2) Tax saved by tax-allowable depreciation (machinery only) in Lexland
(Figures in LFr'000)
Year 1 234567
Asset value at start of year 6,400 4,800 3,600 2,700 2,025 1,519
25% depreciation 1,600 1,200 900 675 506 380
Tax saved at 40% 1,120 360 270 202 152
It is assumed that, because the Lexland subsidiary earns no profits in Year 1, the tax
depreciation in Year 1 cannot be claimed until Year 2. The allowance in Year 2 will therefore
be 2,800, giving rise to a tax saving of 1,120 in Year 3.
No balancing allowance has been shown, as the asset will still be in use after Year 6 and its
value is included in the after-tax realisable value of the investment, LFr16.2m.
(3) Investment in working capital Lexland
It is assumed that total working capital requirement increases with inflation at 5% per year
and is returned at the end of Year 7. It is assumed that the amount of working capital at Year
6 is not included in the value of the investment at that stage.
(Figures in LFr'000)
Year 1 23 4 567
Total working 11,500 12,075 12,679 13,313 13,979 14,678
capital
Investment in WC (11,500) (575) (604) (634) (666) (699) 14,678

(4) Computation of exchange rates for the next seven years
For ease of computation, the spot rate will be taken as the mid-market exchange rate.
Spot rate for LFr = (2.3140 + 2.3210)/2 = 2.3175
Spot rate for J$ = (1.5160 + 1.5210)/2 = 1.5185
Using purchasing power parity theory, each year the LFr/D exchange rate is multiplied by
1.05/1.03 and the J$/D rate is multiplied by 1.06/1.03.
Year LFr/D J$/D
0 2.3175 1.5185
1 2.3625 1.5627
2 2.4084 1.6082
3 2.4551 1.6551
4 2.5028 1.7033
5 2.5514 1.7529
6 2.6010 1.8040
7 2.6515 1.8565
(5) Discount rate for the investments
Because both investment alternatives represent an expansion of the existing business, the
company's existing weighted average cost of capital can be used as a discount rate.
The debt is borrowed in Dinoville where interest will save tax at the rate of 33%. Its after-tax
cost is 10% (1 0.33) = 6.7%
C
Market values should be used as weights. H
A
WACC = 0.7 17% + 0.3 6.7% = 13.91%, say 14% P
(6) Working capital Jibrovia investment T
E
Year 0 1 2 34567 R
J$'000 J$'000 J$'000 J$'000 J$'000 J$'000 J$'000 J$'000
Total working
capital 4,000 4,240 4,494 4,764 5,050 5,353 5,674 8
Investment in WC (4,000) (240) (254) (270) (286) (303) (321) 5,674
(7) Additional tax Jibrovia investment
Additional tax of 3% (33% 30%) is suffered in Dinoville on Jibrovia taxable profits. This is
computed by converting the pre-tax cash flow at the exchange rate for the year and then
multiplying by 3% eg Year 1: 2,120 1.5627 3% = 40.69, rounded to 41.
The net present value of the Jibrovia investment is negative D658,000 if the investment cost
is the maximum J$10 million.
If the cost is only J$8m, the NPV is increased by J$2m/1.5185 = D1.317m, giving a positive
NPV of D659,000.
Conclusion
From the financial appraisal, the Lexland investment is the better alternative. If the Jibrovia
investment is thought to have a positive NPV, then both investments could be undertaken
(they are not mutually exclusive) provided adequate funds and management resources were
available.
Assumptions
The financial appraisals are based on several assumptions, which are stated during the course
of the computation.

Uncertainties
Most of the estimates are subject to considerable uncertainty, for example:
(i) Estimates of future exchange rates are based upon forecast inflation levels and
purchasing power parity theory.
(ii) Inflation is unlikely to remain at the levels given and may affect different types of costs
and revenues in different ways.
(iii) Tax rates may change.
(iv) As in most financial appraisals, the most difficult figure to estimate is the residual value at
the end of the time horizon of six years.
(v) Estimates for the Lexland sales figures are more difficult to make than for the Jibrovia
investment, because it is a start-up business.
(vi) The systematic risk of both investments is assumed to be the same as Snazzy's existing
business. If this is not the case then project specific discount rates should be used.
(vii) Sensitivity analysis could be used to provide more information on which of the above
uncertainties cause the most problems.
4 Gordon plc
(a) Foreign exchange risk
It is possible to reduce foreign exchange risk by matching; using one of the dollar finance
options to set against the dollar receipts.
Cost of finance
This covers not only any annual interest payment costs, but also arrangement fees, issue
costs and so on.
Availability
If the purchase is to take place rapidly, the finance should be available quickly, or
(expensive?) short-term bridging finance will be required.
Flexibility
If the directors are expecting to use different sources of finance, they will prefer to use
sources that can be changed without significant cost.
Period of investment
The length of time the finance is available should match the length of the investment period.
Tax
The tax consequences of the different sources of finance must be considered, as these may
significantly affect their costs.
Desired debt-equity finance mix
The maximum amount of debt is limited by a covenant in any event, but the directors may
have their own views about the desired balance and hence the desired level of finance risk.
It will be determined by whether they believe that there is an optimal level of gearing, at
which the company's weighted average cost of capital will be at its lowest.
Signalling
By issuing the maximum amount of debt, the directors may wish to demonstrate to the stock
market their confidence in the future.

Interest rate expectations
The directors will prefer floating rate finance if interest rates are expected to go down,
fixed rate finance if interest rates are expected to increase.
Maturity of debt
Directors will be concerned about when the debt is due to mature, and Gordon's likely cash
position around that date.
Security
Directors will be concerned about the amount of security required, also how any restrictions
over assets secured might limit business decisions, including the ability to raise loan finance
in the future.
Other sources
Other sources of finance such as convertible and deep-discount bonds may be appropriate.
(b) To: Directors, Gordon
From: Accountant
Date: 15 December 20X5
Subject: Sources of finance
Finance required
Amount required = $80m = 80/1.7985m = 44.48m C
38 30 18 44.48 H
If all raised by debt, gearing = = 48.6% A
117.8 8.1 98.1 44.48 P
T
This would still be within the terms of the covenant, although it would not allow much scope E
for further investments to be financed solely by debt. There is also no indication that this is R
the optimal mix of gearing and hence cost of capital is at its lowest.
Rights issue 8
Amount raised = (80 2.80)0.95 = 53.2m
22.2(1.04)
Cost of equity = + 0.04 = 11.6%
302
Advantages
(i) The proposed rights issue would comfortably exceed the amount required.
(ii) The company's gearing, and thus financial risk, would decrease.
(iii) There would be no change in control if the current shareholders took up the rights
issue.
(iv) Gordon would not have a commitment to make interest payments.
(v) Gordon would not face exchange risk on payments to providers of finance.
Disadvantages
(i) The arrangement costs are higher than for some of the other alternatives.
(ii) A rights issue is likely to take longer to arrange than the other alternatives.
(iii) The cost of equity is higher than the cost of debt because of the greater risk to equity
shareholders and the company does not obtain the benefit of tax relief.
(iv) The exchange risk on the income from the US investment remains, as it cannot be
matched against the payments to finance providers.
Fixed rate sterling loan
Amount issued = 44.48 100/99 = 44.93m

Cost of debt
Year(s) Cash Disc factor DCF Disc DCF
flow factor
m 10% m 7% m
0 Issue net of issue (44.48) 1.000 (44.48) 1.000 (44.48)
costs
15 Interest
44.93 7% 3.15 3.791 11.94 4.100 12.92
5 Repayment 44.93 0.621 27.90 0.713 32.04
(4.64) 0.48
0.48
Pre-tax cost of loan= 7 + [ ] [10 7] = 7.3%
0.48 (4.64)
Post-tax cost of loan = 7.3% (1 0.28) = 5.3%

Advantages
(i) Cost is lower than some of the other options.
(ii) There is a further facility available which has not been drawn.
Disadvantages
(i) Because the loan is in sterling, there will be foreign exchange risk as the finance is not
matched with the dollar income.
(ii) Conditions may be attached to the security that impose restrictions over and above the
debt limit.
Commercial paper
Amount issued = $15m
Cost = 0.72 (3.0 + 1.5 + 0.5) = 3.6%
Advantages
(i) Gordon will be able to take advantage of short-term falls in interest rates.
(ii) The cost looks low compared with other sources.
Disadvantages
(i) The commercial paper provides less than 20% of the finance required.
(ii) The maturity is wrong for the majority of the requirement; commercial paper is a short-
term source to finance a long-term requirement of $72m.
(iii) There are likely to be some issuing costs.
(iv) The floating rate is not attractive if interest rates are expected to rise.
Swiss franc loan
Amount raised = 80 (1 0.03)/2.298 = 33.77m
Cost of loan
Disc Disc cash Disc Disc cash
Year Cash flow factor flow factor flow
SFrm 5% SFrm 7% SFrm
0 Issue net of
issue costs
(80 (1 (77.60) 1.000 (77.60) 1.000 (77.60)
0.03))
15 Interest: 3.84 4.329 16.62 4.100 15.74
80m (2.5
+2.3%)
5 Repayment 80.00 0.784 62.72 0.713 57.04
1.74 (4.82)

1.74
Pre-tax cost of loan = 5 + 7 5 = 5.5%
1.74 (4.82)
Post-tax cost of loan = 5.5% (1 0.28) = 4.0%
Advantages
(i) The cost of finance is still low even after the swap fees.
(ii) Gordon can pay interest in the currency in which it is obtaining returns, and thus reduce
exchange risk by gearing.
Disadvantages
(i) The loan will not be enough to cover the whole US investment; approximately
10 million further finance will be required.
(ii) Gordon would still be exposed to foreign exchange risk on the Swiss franc loan itself as
against sterling.
(iii) Gordon may be subject to counterparty risk although this will be minimal if it uses an
intermediary such as a bank.
Recommendation
If there are concerns about gearing levels and directors are prepared to accept a much higher
cost of finance than is likely for any of the loan finance, then the rights issue should be used.
Of the longer-term sources of finance, the Swiss franc loan offers the lowest rate. However,
the loan is insufficient to cover the entire US investment, which would mean seeking extra C
H
finance from elsewhere. The fixed rate sterling loan covers the entire US investment with
A
funds to spare. Both loans will expose Gordon to foreign exchange risk. P
T
E
R


(a) Tiger should consider such issues as:
(i) Convertibility of currency
If the host country's currency is not easily converted in the foreign exchange markets or no
market exists for this particular currency Tiger might have problems trying to get money out
of the country should it ever wish to withdraw its investment.
(ii) Availability of suitable resources
While Tiger appears to be confident that resources are available at a low price, will these
resources be suitable for purpose (for example, raw materials) and able to perform the
necessary specialist tasks that characterise the manufacture of electronic products (human
resources)? While it is possible to send personnel from the home country, expatriate packages
are expensive and may cancel out the advantage of paying less for other resources. The host
country will obviously be looking for some economic benefit for its own inhabitants in the
form of jobs, therefore it is important to determine whether local employees have the
necessary skills. If there are insufficient raw materials available, Tiger may still be restricted on
how much it can import from elsewhere due to local import controls. Tariffs and taxes may
cancel out any cost advantage of operating in the host country.
(iii) Inflation and economic stability
These are crucial factors. Does the country have a history of high inflation which suggests
economic volatility? Are costs likely to spiral out of control, resulting in loss of cost advantage
for Tiger? Will economic volatility lead to increasing interest rates and/or local currency
collapse?
(iv) Cultural compatibility
Do locals have the same approach to business as the UK for example, profit seeking, quality,
striving for customer satisfaction? Will the importance of quality of product be appreciated?
Are shareholder-owned companies encouraged or are nationalised industries the norm? Is it
likely that the operation could be nationalised in the future? Are there likely to be problems
with training the local workforce? Are there problems relating to the employment of women
or certain classes of society?
(b) Minimisation of political risks
Tiger can take the following steps to minimise the effects of political risk.
(i) Negotiations with host government
Tiger might be able to obtain a concession agreement, covering matters such as the transfer
of capital, remittances and products, access to local finance, government intervention and
taxation and transfer pricing. However, if there is a change in government, the new
government may not feel bound to honour the agreement with the previous government.
(ii) Insurance
Insurance might be available against nationalisation and currency conversion problems.
(iii) Production strategies
Tiger could locate key parts of the production process abroad. If governments take action,
they will not be able to produce the product without investment in new facilities.
Alternatively, risk could be reduced by local sourcing of factors of production or
components.

(iv) Distribution channels
Control by Tiger of distribution channels might limit the risk of government interference
because of the disruption to distribution arrangements that interference might cause.
(v) Patents
Tiger might protect its investment by patents or use of trademark legislation. These might
be difficult to enforce in local courts however.
(vi) Financial management
If businesses obtain funds in local markets, governments might be deterred from intervening
by the risks posed to local lenders.
(vii) Ownership structure
Instead of having a direct ownership interest, Tiger might establish a presence by a joint
venture, or ceding control to local investors and obtaining profits by a management
contract.
(viii) Overcoming blocked funds
Funds can be obtained by 'legitimate' charges such as royalty or management charges, or
making a loan and charging high interest rates. Tiger might also engage in countertrade
(reciprocal or barter arrangements) rather than trade for cash.
(c) Duty of care
All companies have to balance the need to compete against their ethical duty of care to stakeholders.
C
The laws of developed countries have progressively reflected voters' concerns on ethical issues by H
banning activities considered harmful to society (eg drug dealing) or to the economy (eg corruption) A
and by developing numerous constraints on companies' behaviour towards employees, the local P
community and the environment. These are intended to give companies a level playing field on T
E
which they can compete vigorously.
R
Adverse publicity
Where potentially unethical activities are not banned by law, companies need to make difficult
8
decisions, weighing up increased profitability against the harmful effects of bad publicity,
organisational ill-health and the knowledge that some activities are clearly wrong. Whereas in
developed countries such decisions might relate to experimentation on animals or sale of arms, the
laws of developing countries are far less advanced, forcing companies to make their own decisions
on major issues such as the following.
(i) Provision of proper safety equipment and working conditions for employees
(ii) Use of child labour
(iii) Wage rates below subsistence level
(iv) Discrimination against women, ethnic minorities, and so on
(v) Pollution of the environment
(vi) 'Inducement' payments to local officials to facilitate investment
Unethical investment
In addition, multinational companies must decide whether it is right to invest at all in some
countries which are regarded as unethical, for example because of violation of human rights.

(a) UK investment
Cost of closing UK factory = 35 (1 0.23) 20 = 7.0 million
Cost of downsizing = 20 (1 0.23) 10 = 5.4 million
Downsizing is the cheaper option, even before cash flows from the downsized factory and the fact
that closure would mean markets couldn't be fully supplied is taken into account.
Using CAPM, discount rate = 4.5 + 1.1(11.5 4.5) = 12.2%, say 12%
Present value for post-tax cash flows 4 (1 0.23) inflation factor (1.02 yr 1, 1.02 1.03 Year 2
etc)
0 1 2 3 4
m m m m m
Net downsizing costs (5.4)
Post-tax cash flows 3.1 3.2 3.3 3.4
(5.4) 3.1 3.2 3.3 3.4
Discount factor 12% 1.000 0.893 0.797 0.712 0.636
(5.4) 2.8 2.6 2.3 2.2
Net present value = 4.5million
Buzzland investment
WORKING 0 1 2 3 4
Fm Fm Fm Fm Fm
Sales 2 659 735 785 839
German comp. 3 (41) (47) (52) (57)
Labour 4 (228) (262) (288) (317)
Local comp. 5 (90) (104) (114) (125)
Sales and 6 (20) (23) (25) (28)
distrib.
Fixed costs 7 (50) (58) (63) (70)
Tax allow. 8 (145) (109) (82) (94)
deprec.
Taxable profit 85 132 161 148
Tax at 20% (17) (26) (32) (30)
Tax allow. 145 109 82 94
deprec.
Investment (580) 150
Working capital 9 (170) (34) (31) (23) 258
Remittable cash (750) 179 184 188 620
flows Fm
Exch. rate 1 36.85 43.35 48.40 51.69 55.20
Remittable cash (20.4) 4.1 3.8 3.6 11.2
flows m
Add: UK tax 10 (0.1) (0.1) (0.1) (0.1)
Net cash flows (20.4) 4.0 3.7 3.5 11.1
Disc. factor 11 1.000 0.870 0.756 0.658 0.572
Disc. cash flows (20.4) 3.5 2.8 2.3 6.3
Net present value = (5.5) million
Present value overall = 4.5 5.5 = (1.0) million
On these figures, the reorganisation does not appear to be worthwhile.

WORKINGS
(1) Exchange rates
Year PP factor Buzzland francs/ Buzzland francs/euro
0 36.85 23.32
1 1.20 43.35 27.44
1.02
2 1.15 48.40 30.64
1.03
3 1.10 51.69 32.72
1.03
4 1.10 55.20 34.94
1.03
(2) Sales
50,000 480 Exchange rate
(3) German component
50,000 30 Exchange rate Inflation factor
Inflation factor = 1.03 Yr 2, 1.03 1.03 Yr 3 etc
(4) Labour
Incremental cost of employing 50 extra workers
C
50,000 3,800 (50/250) = F38 million H
A
This is less than the F75 million a year factory rental, so the extra workers are employed. P
T
Costs
E
50,000 3,800 (300/250) Inflation factor R
Inflation factor 1.15 Yr 2, 1.15 1.1 Yr 3 etc

(5) Local components 8
50,000 1,800 Inflation factor for labour

(6) Sales and distribution
50,000 400 Inflation factor for labour
(7) Fixed costs
50m Inflation factor for labour
(8) Tax allowable depreciation
Year Writing down allowance Tax written down value
Fm Fm
0 580
1 145 435
2 109 326
3 82 244
4 94 0
WDA = 25% previous year's tax written-down value Yr 1-3, (244 150) Yr 4
(9) Working capital
(170m Inflation factor) Previous year's working capital balance
Inflation factor 1.2 Yr 1, 1.2 1.15 Yr 2 etc
Assume working capital is repaid at end of Year 4.

(10) UK tax
Taxable profits (0.23 0.2) 1/exchange rate
(11) Discount factor
k = 4.5 + 1.5 (11.5 4.5)
= 15%
(b) Strategic investments
Watson should consider whether this decision is sensible from the point of view of business
strategy. Is there a particularly good reason for becoming involved in Buzzland, potential future
markets possibly? Might investing in other countries with greater market potential and/or lower
costs be better? Watson should also take into account the PEST factors affecting the business
environment including the legal and regulatory position, enforcement mechanisms, cultural
influences on demand and methods of doing business.
Financial structure
The availability of finance could be a significant issue.
Limitations of analysis
The financial analysis has a number of possible limitations.
(i) If increases in costs are greater than expected, cash flows will be adversely affected, since
Watson cannot increase selling prices.
(ii) Watson may wish to consider prolonging the investment beyond Year 4. If this is so, the
analysis should consider the present value of cash flows after Year 4 rather than the realisable
value of assets at that date, also the rental payable for the factory beyond Year 4.
(iii) Assuming production does cease in Buzzland in four years' time, the analysis fails to consider
what will happen afterwards or what will happen if moving production does not prove
successful because of, for example, adverse effects on quality.
(iv) Purchasing power parity may not be a completely reliable predictor of short-term
exchange rates.
Therefore, to gain a better picture of the desirability of this investment, sensitivity analysis needs
to be undertaken on key variables, the analysis extended beyond four years, and the effects of
changing assumptions investigated.
Bad publicity
Relocating to a market where labour is cheaper may lead to bad publicity for Watson and potential
boycotts of its goods.
Political risk
As discussed below, the investment is subject to political risk from action by the Buzzland
government. Given the uncertainty, it may be worth postponing the analysis until a year's time,
and awaiting developments in the situation (for example whether the IMF will lend more money or
whether further restrictions on remittances have been imposed).

Mathematical tables
391
Mathematical tables
Present value table

-n
Present value of 1, ie (1+r)
where r = discount rate
n = number of periods until payment
Periods Discount rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065

Annuity table
1 (1 r) n
Present value of an annuity of 1, ie
r
where r = discount rate
n = number of periods
Periods Discount rates (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606
11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675

Standard normal distribution table
(x ) 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
Z

0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359
0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753
0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .1064 .1103 .1141
0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517
0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879
0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224
0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549
0.7 .2580 .2611 .2642 .2673 .2704 .2734 .2764 .2794 .2823 .2852
0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133
0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389
1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621
1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830
1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015
1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177
1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319
1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441
1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545
1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633
1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706
1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767
2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817
2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857
2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890
2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916
2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936
2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952
2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964
2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974
2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981
2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986
3.0 .4987 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990
This table can be used to calculate N(d1), the cumulative normal distribution functions needed for the
Black-Scholes model of option pricing. If d1>0, add 0.5 to the relevant number above. If d1<0, subtract
the relevant number above from 0.5.

Index
397
100 year bond, 258 Business angels, 284
3i, 284 Business discontinuation losses, 96
4D model, 24 Business process analysis, 7
Business Process Re-engineering (BPR), 17, 138
Business risk, 75, 76, 105, 367
A
Abbott Laboratories, 34 C
Absorption Costing, 126
Accepting risks, 98 Cadbury, 135, 141
Accounting policies, 212 Call centres, 143
Accounting Rate of Return (ARR), 159 Call option, 313
Accurate, 18 Capital Asset Pricing Model (CAPM), 244
Activity Based Costing (ABC), 127 Capital structure, 239
Adjusted present value, 161, 207 CAPM, 248
Advantages of a formal system of strategic Caps, 321
planning, 13 Case studies, 42
Advocacy, 28 Cash flow hedges, 318
Aggressive approach to financing working Cash Flow Return on Investment (CFROI), 197
capital, 289 Cash management, 342
Aggressive working capital management, 288 Centralisation/Decentralisation, 14
Allocates responsibility, 13 Centralised cash management, 343
Annual cycle, 14 Centralised treasury department, 343
Arbitrage Pricing Theory (APT), 249 Chain of command, 14
Argyll and Bute council, 342 Change, 21
Arsenal, 280 Change management, 20
Asset-based method, 218 Checking, 93
Asset-based model, 201 Checklists, 93
AT&T, 34 Clarifies objectives, 13
Auditing Practices Board (APB), 27 Clientele effect, 240
Avoidance of risk, 97 Clinton Cards, 76
Coca-cola, 34
Collars, 321
B Commercial paper, 264
Committee of Sponsoring Organisations of the
Balanced scorecard, 7 Treadway Commission (COSO), 80
Bank loans, 285 Communication, 26
Barclays, 143 Competitive advantage, 20
Basel Committee, 103 Competitor analysis, 5
Benchmarking, 6, 93 Conformance, 74
Berkshire Hathaway, 269 Conservative approach to financing working
Better control, 13 capital, 289
Big Mac index, 328 Conservative working capital management, 288
Black-Scholes model, 323 Contingency planning, 97
Blocked funds, 365 Contribution, 128
Body Beautiful, 42 Convertible debt, 214
Bond insurance, 369 Co-ordinates, 13
Bond prices and interest rates, 254 Core businesses, 16
Bond pricing, 251 Core competences, 142
Borrowing internationally, 367 Corporate bonds, 257
Bottom-up view, 16 Corporate citizenship, 34
BP, 107 Corporate responsibility, 31
Brainstorming, 93 Corporate social responsibility, 31
Branches, 370 COSO framework, 81
Break even analysis, 128 Cost accounting methods, 131
British Airways, 212 Cost centre, 344
Brundtland report, 8 Cost centre reporting, 132
BS 7750 Environmental Management System, Cost classification, 125
40 Cost of capital, 240, 243
BT, 36 Cost of convertible debt, 245
Budget, 23
Index 399
Cost of debt, 245 E-commerce, 20
Cost of debt capital, 261 Economic exposure, 179
Cost of equity, 244 Economic Profit (Cash Flow), 197
Cost of irredeemable debt, 245 Economic responsibilities, 8
Cost of preference shares, 245 Economic risk, 75, 104
Cost reduction, 132 Economic Value Added (EVA), 195, 206
Cost synergy, 211 Electronic data interchange, 137
Costing systems, 126 Empowerment, 15
Cost-Volume-Profit (CVP) analysis, 51, 128 Enforces consistency at all levels, 13
Coupon rate, 251 Enquiries, 93
Credit (default) risk, 258 Enterprise capital funds, 286
Credit and default risk, 256 Enterprise risk management, 80
Credit default swaps, 260 Environmental and social reporting, 36
Credit insurance, 293 Environmental audit, 40
Credit migration, 260 Environmental Impact Assessments (EIAs), 40
Credit risk, 250, 258 Environmental Quality Management (EQM), 40
Credit risk measurement, 259 Environmental surveys, 40
Credit spread, 250, 261 Environmental SWOT analysis, 40
Credit spreads in Eurozone, 264 Envy Performance Ltd, 293
Cultural risk, 179 Equity finance, 283
Currency of invoice, 330 Ernst and Young, 81
Currency options, 315 Ernst and Young's Working Capital
Currency risk, 367, 371 Management Report, 292
Currency supply and demand, 326 Escalation triggers, 93
Currency swaps, 316 Establish the risk management context, 92
Current assets, 288 Ethical responsibilities, 8
Current share price, 323 Ethics, 27
European call options, 323
Event interdependencies, 93
D Event risk, 77
Everton, 280
Data analysis, 10 Exchange controls, 365
Death or serious injury, 96 Exchange rate fluctuations, 326
Debt factoring, 285 Exchange rate risk, 367
Debt-equity swaps, 267 Exchange rates on NPV, 177
Decentralised cash management, 343 Exchange restrictions, 178
Deloitte, 32 Exercise price of the option, 323
Devaluation, 362 Expatriate staff, 180
Developing markets, 371 Expected loss (EL), 259
DHL, 35, 144 Expected value, 172
Direct Product Profitability analysis, 52 Export credit insurance, 369
Directional policy matrix, 7 Export risks, 368
Discounted cash flow basis of valuation, 199 Exposure of financial assets, 95
Discounted cash flows, 218 Exposure of human assets, 96
Discounted payback, 159 Exposure of physical assets, 95
Disintermediation, 279 External events, 93
Distinctive competence, 137
Diverse businesses, 16
Diversification, 100 F
Dividend policy, 268
Dividend valuation model, 197 Face (par) value, 251
Dividend yield, 198 Factoring, 292
Documentary credits, 292 Fair value hedges, 319
Dow Jones Sustainability Index, 8 Fama and French, 250
Drucker, 13 Fama and French three factor model, 250
Familiarity, 28
Financial control, 17
E Financial control style, 16
Financial Fair Play Rules, 281
Eco-audit, 40 Financial reconstruction, 266
Eco-labelling, 40

Financial reconstruction and firm value, 268 Information Management (IM) strategy, 19
Financial risk, 75, 77, 105 Information Systems (IS) strategy, 19
Financial synergy, 211 Information Technology (IT) strategy, 19
Financing overseas expansions, 369 Initial margin deposit, 313
Fiscal risk, 257 Integrated reporting, 38
Five competitive forces, 51 Intercontinental Hotel Group, 83, 86
Fixing date, 314 Interest rate derivatives, 313
Flat organisation, 15 Interest rate futures, 313
Flat yield, 253 Interest rate hedging, 324
Floors, 321 Interest rate option, 313
Forces decision-making, 13 Interest rate parity, 326
Forces managers to think, 13 Interest rate swap, 314
Foreign currency derivatives, 314 Interest yield, 214
Foreign exchange risk, 367 Internal events, 93
Foreign tax credits, 178 Internal Rate of Return (IRR), 159
Forfaiting, 292 International Federation of Accountants, 82
Forward contracts, 314 International Fisher effect, 328
Forward Rate Agreements (FRAs), 313 International Trade, 368
Free cash flow model, 203 Internet, 20
Futures, 313 Intimidation, 28
FX swaps, 316, 318 Intrinsic value, 323
Irredeemable debt, 213
ISO 14001, 40
G Issue specific risk, 257
Issuer, 251
Gap analysis, 6
Gemini 4Rs framework, 22
Glasgow Rangers, 281 J
GlaxoSmithKline, 75, 104
Global credit crunch, 78 JP Morgan, 320
Global Reporting initiative, 36
Global Taxation, 367
Going private, 271 K
Goold and Campbell, 16
Government credit ratings, 262 Key persons, 96
Grants, 285 Kraft, 135
Greece, 3, 262
Gross Redemption Yield (yield to maturity), 253
L
Labour efficiency variance, 131
H Lam, 87
HBOS, 79, 85, 88 Lam, James, 87
Henry Mintzberg, 13 Leading and lagging, 330
Hierarchy, 14 Leading event indicators, 93
Hold harmless agreements, 99 Lease or buy?, 337
Horizontal organisation, 18 Leasing, 284, 336
Legal responsibilities, 8
Legal risks, 181
I Leveraged buy-outs (LBOs), 268, 271
Leveraged capitalisations, 267
Iberia, 212 Lewin/Schein three-stage model of change, 21
ICAEW Code of Ethics, 27 Likelihood/consequences matrix, 94
ICAEW Code of Ethics for Professional Limitation of liability, 99
accountants working in business, 28 Limitations of risk management, 106
Identifies risks, 13 Liquidity, 369
IKEA, 133 Liquidity and marketability risk, 256
In the money, 313 Litigation risks, 180
Inflation, 160 Loans, 365
Inflation premium, 256 Local managers, 180
Information management, 18 Logistics, 137
Index 401
Loss control, 98 Organisational restructuring, 266
Loss given default (LGD), 259 OTC (over-the-counter) option, 313
Loss or damage in transit, 368 Outsourcing, 140, 342
Outsourcing IT/IS services, 142
Outsourcing to Eastern Europe, 144
M Outsourcing to India, 144
Overseas subsidiaries, 370
Macaulay duration, 258 Owner financing, 283
Machine utilisation, 131
Macro hedging, 318
Maintenance margin deposits, 313 P
Manageable businesses, 16
Management charges, 365 P/E ratio, 198
Management of human resources, 180 Paul Moore, 79, 85, 88
Management systems, 14 Payback period, 159
Manchester City, 281 Pearson, 9, 97
Manchester United, 280 Pecking order theory, 242, 244
Marginal costing, 126 Pension parachute, 212
Market relative model, 202 Pensions, 212
Market threat, 51 Performance, 74
Market Value Added (MVA), 197 Performance measures, 131
Market-based methods, 218 Pestel, 3
Mars, 141 Philanthropic responsibilities, 8
Matching assets and liabilities, 330 Physical inspection, 93
Matching receipts and payments, 330 Physical risk, 75, 104
Maturity, 251 Political risk, 75, 105, 179, 367
Maturity date, 314 Porter's five forces, 3
Maturity matching, 289 Portfolio reconstruction, 266
Modified internal rate of return (MIRR), 162 Portfolio theory, 248
Modigliani and Miller, 240 Post-export finance, 366
Money market hedge, 315 Pre-export financing, 366
Monte Carlo simulation model, 324 Probabilistic valuation, 219
Moody's, 262 Probability analysis, 172
Morris, 85 Probability of default, 259
Multinational companies (MNCs), 366 Process, 138
Multi-product break even analysis, 129 Product development, 51, 137
Product life cycle, 4
Product life cycle risk, 75, 105
N Profit centre, 344
Profit centre approach, 362
Net Present Value (NPV), 159 Project, 22
Netting, 330 Project management, 22, 23
Network or critical path analysis, 26 Project manager, 25
Non-payment by customers, 368 Project planning, 25
Non-recourse debt, 335 Public knowledge, 13
Northern Rock, 78 Purchase price variance, 131
Purchasing power parity, 327, 328
Pure Package, 286
O Put option, 313
Objective, 51
Operational information, 18
Operations planning, 13 Q
Option pricing models, 168 Quality, 23
Option to abandon, 166 Quality control, 26
Option to delay, 165 Quantitative easing, 257
Option to expand, 165
Option to redeploy, 167
Options, 313 R
Organisation structure, 13
Organisational configuration, 14 Real return, 256

Reconstruction schemes, 266 Sensitivity to maturity, 257
Recovery rate, 259 Sensitivity to yield, 257
Redeemable debt, 213 Service Level Agreement (SLA), 142
Reduction of risk, 97 Service Level Contract (SLC), 142
Refinancing, 278 Settlement date, 314
Refreeze, 22 Share price volatility, 323
Repo 105, 318 Shareholder value, 195
Reporting on risk management, 104 Shareholder Value Analysis (SVA), 195
Repurchase agreement, 317 Short-term financial measures, 131
Resource audit, 6 Signalling, 240
Resource planning, 13 Small Firms Loan Guarantee Scheme, 285
Resources, 22 Small to medium sized enterprises (SME), 282
Revenue synergy, 210 Speculation, 344
Reverse repo, 318 Standard and Poor's credit ratings, 262
Reverse repurchase, 317 Standard deviation of the NPV, 172
Risk, 73, 75, 100, 104, 169 Start-ups, 217
Risk acceptance, 98 Strategic alliance, 52
Risk and uncertainty, 73 Strategic change, 22
Risk appetite, 73 Strategic control, 17
Risk architecture, 82 Strategic control style, 16
Risk aversion, 74 Strategic information, 18
Risk avoidance, 97 Strategic planning, 17
Risk committee, 85 Strategic planning style, 16
Risk conditions, 93 Strategic risk analysis, 7
Risk consolidation, 96 Strategic thinking, 14
Risk criteria, 92 Subsidies, 178
Risk culture, 73 Supplier audits, 40
Risk management, 73 Supply chain management, 137
Risk management function, 88 Sustainability, 35
Risk manager, 87 Swaps, 314, 316
Risk monitoring, 102 SWOT analysis, 6
Risk policy statement, 89 Synergy, 209
Risk pooling, 100 Systematic risk, 270
Risk profiling, 94
Risk reduction, 97
Risk register, 89 T
Risk resourcing, 83
Risk retention, 98 Tactical information, 18
Risk sharing, 99 Takeover, 369
Risk specialists, 86 Tall and flat organisations, 15
Risk toleration, 74 Tall organisation, 15
Risk-free rate of interest, 323 Tax havens, 178
Royal Bank of Scotland, 79 Tax planning, 178
Royalty, 365 Taxation, 160
Royalty payments, 365 Taxes, 178
Ryanair, 134 Teambuilding, 23, 26
Tesco, 80, 336
Texas fertiliser plant disaster, 78
S Texas Instruments, 35
The certainty-equivalent approach, 172
Safeguards, 28 The overnight market, 264
Sale and leaseback, 285, 336 Thomas Cook, 77
Santander, 261 Threats, 28
Scottish Power, 33 Ticks, 313
Scrap, 131 Time horizon, 13
Securitisation, 279 Time to expiration of the option, 323
Self-interest, 28 Time value, 323
Self-review, 28 Top-down approach, 16
Sensitivity analysis, 169 Total Shareholder Return, 197
Sensitivity to coupon, 257 Toyota, 97
Index 403
TPK Holding, 270
V
Trade date, 314
Traded caps, 321 Valuation of minority shareholdings, 216
Traded collars, 322 Value Based Management (VBM), 195
Traded floors, 322 Value chain, 142
Traditional absorption costing, 132 Value chain analysis, 6
Transaction costs, 178 Value drivers, 195
Transaction exposure, 178 Valuing majority shareholdings, 216
Transfer of risk, 98 Venture capital, 284
Transfer pricing, 365 Vickers Commission, 79
Translation exposure, 178 Vodafone, 291
Treasury centralisation, 344 Volkswagen, 4
Treasury department, 341
Treasury department as cost centre, 344
Treasury department as profit centre, 344 W
Treasury policy, 341
Trends and root causes, 93 Walker report, 84
Trinity Mirror, 270 Weighted average cost of capital (WACC), 240,
Triple bottom line, 35 246
Turnbull Report, 90, 104 Working capital, 287
Turner report, 95 Worst possible outcomes, 172
Turner review, 79
Y
U Yield curve, 255
UBS, 320
UK Corporate Governance Code, 83
Uncertainty, 73, 169 Z
Unfreeze, 21 Zero coupon bonds, 252
United Airlines, 276
Unquoted shares, 215

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The Institute of Chartered Accountants in England and Wales

For exams in 2014

British Library Cataloguing-in-Publication Data

Printed in the United Kingdom by Polestar Wheatons

The Institute of Chartered Accountants in England and Wales

ICAEW publications for further reading xix

2 Business risk management 71

3 Cost analysis and control 123

4 Investment appraisal 157

5 Business and securities valuation 193

6 Cost of capital and financial structuring 237

7 Financial engineering 311

8 International financial management 363

The knowledge level

2.2 Specification grid

viii Business Analysis

4.2 Assessing your professional skills

Initial Professional Development

4.3 Assessment grids

xiv Business Analysis

Project appraisal and sensitivity analysis B A

xvi Business Analysis

Ethics Codes and Standards Level Professional Stage modules

IFAC Code of Ethics for Professional Accountants A Assurance

xviii Business Analysis

Audit and Assurance Faculty icaew.com/aaf

Corporate Finance Faculty icaew.com/corpfinfac

Corporate governance icaew.com/corporategovernance

Corporate responsibility icaew.com/corporateresponsibility

Finance and Management Faculty icaew.com/fmfac

Financial Reporting Faculty icaew.com/frfac

Financial Services Faculty icaew.com/fsf

xxii Business Analysis

Information Technology Faculty icaew.com/itfac

Tax Faculty icaew.com/taxfac

xxiv Business Analysis

Learning objectives Tick off

1.1 Environmental and market analysis tools

1.1.1 PESTEL analysis

Case example: Greece

1.1.2 Porter's five forces

1.1.3 Product life cycle

Case example: Volkswagen

Market High Stars Question marks

1.1.5 Competitor analysis

Interactive question 2: Competitor analysis [Difficulty level: Intermediate]

1.2.2 Resource audit

1.2.3 Value chain analysis

1.2.4 Gap analysis

1.2.6 Directional policy matrix

Market High Invest Grow

1.2.7 Business process analysis

1.2.8 Strategic risk analysis

1.2.9 Balanced scorecard

Perspective Question Explanation

1.2.10 Corporate responsibility

Worked example: Measurement of sustainability

2.1 Data analysis skills required

2.2 Key weaknesses in answers

2.3 Recommended approach

2.4 WHAT-HOW-WHY-WHEN-SO WHAT analysis

2.5 Issues with accounts

3.1 Business planning

3.1.2 Advantages and disadvantages of formal business planning