P3 March 2012 answers

Strategic Level Paper

P3 – Performance Strategy Senior Examiner’s Answers SECTION A

Answer to Question One

(a) (i)

M plc is a newspaper and so relies on its reputation for truthful and accurate reporting.

Publishing unedited and unverified facts creates the risk that commentators will abuse the site for the sake of attracting much more publicity than if the same comment had been made on a personal website or blog. There have been many cases where false claims have attracted significant (albeit short-lived) attention, such as false statements that celebrities or politicians had died suddenly.

Anyone affected by such a false claim is likely to take action against M plc rather than the person who made the false posting. This is partly because M plc is potentially a more lucrative target for a damages action and partly because the injured party is more likely to deter any repetition if the owner of the website has an incentive to block any future defamation.

The public is unlikely to view such controversial postings as acceptable and so M plc’s reputation may be harmed. Newspapers are frequently criticised for stirring up controversial stories and printing false allegations in order to boost sales. Establishing a website that invites unverified statements is likely to be seen as such an act.

M plc’s rivals are likely to do their utmost to draw attention to any harmful publicity that could undermine the company’s credibility. That is what happened in the case of the story about J. Readers of those rival newspapers will base their opinion on what they are told in the press rather than taking the trouble to establish the facts.

(ii)

M plc should ensure that it has genuine contact details for all of the subscribers to its website. Subscribers cannot be permitted to make posts anonymously before disappearing and leaving M plc with the scandal. All subscriptions should be paid by a major credit card so that there is a trail back to the customer via their banking details.

All subscribers should be made to accept responsibility for anything posted using their account. That will ensure that they are careful about safeguarding their login information.

Otherwise, it will be easy for a subscriber to make a defamatory post and then to deny authorship by claiming that the post was made by an imposter.

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All login attempts should be checked carefully, with realistic security in place such as a limited number of login attempts before the account is blocked. Passwords should be tested to ensure that they are reasonably secure. The website should not permit web browsers to “remember” passwords so that login can be automatic.

M plc should pursue action against any subscriber whose use of the website brings the company into disrepute. If it does so in a very public way then it may deter any further such acts. It may also help to demonstrate that M plc is behaving honestly and in the public interest.

There should be a facility for anybody who reads a post to flag it as inappropriate.

Hopefully that would mean that electronic subscribers will flag up a number of unacceptable statements that do not trigger the automatic filters. Clicking on this notification could hide the post until it has been reviewed by one of M plc’s staff and confirmed as fit for publication.

(b) (i)

All staff look to the control environment in order to decide whether behaviour is acceptable or not. The control environment is essentially the attitude of senior management towards the control system’s operation and effectiveness. Arguably, it is the exception that proves the rule. Mismanagement and misbehaviour will be accepted according to custom and practice if action is not taken.

(ii)

It appears that the directors have been receiving monthly management accounts that have shown increasing costs associated with journalist expenses. This increase has not been budgeted and there has been no investigation until now. The message that has been communicated to journalists is that the board is perfectly happy to tolerate such extravagance.

Presumably, expenses have either been paid without any further authorisation or those responsible for authorising payments have been happy to sign almost anything without considering whether the cost is justified or not. It may be that M plc has created a culture in which journalists believe that they are entitled to eat in the best restaurants or to buy expensive equipment at the company’s expense. If colleagues share stories about such claims then all staff will quickly feel that this behaviour is the norm.

The fact that editors do not believe that they can refuse claims suggests that they have had insufficient support from senior management. The board has made it difficult for editors to enforce acceptable standards of behaviour by allowing these costs to spiral out of control. Editors will find it difficult to exert their authority if they cannot rely on senior management to support them when faced with a dispute with a journalist over expenses.

(iii)

The internal audit department is generally responsible for monitoring compliance with rules. The very nature of a journalist’s expense claims make it difficult to set hard and fast rules. For example, setting a fixed upper limit for the cost of a meal may be embarrassing when a journalist has to interview a senior politician or business leader.

The internal audit department will find these rules difficult to investigate because of the lack of clear and observable benchmarks for acceptable claims. Such reviews could involve asking the journalist who lodged a claim to explain why it was appropriate to spend that amount under those circumstances. Such reviews could cause some resentment on the part of journalists who feel that their expenses are a necessary part of their effectiveness in gathering news and writing stories. That risk could be reduced if the internal audit department approaches these reviews with an open mind and gives the subjects of the investigations the opportunity to explain why a particular choice was made when there may have been a less expensive alternative.

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One possible danger is that journalists will start to pass up opportunities to investigate important stories because of the difficulties associated with processing expenses claims.

The involvement of internal audit in reviewing expenses on a day-to-day basis could deter staff from incurring reasonable costs if they feel that the internal audit department does not understand the process of gathering news.

(c)

UK supplier This arrangement effectively proposes passing the cost of a rise in the cost of pulp to a third party. It is very unlikely that a sophisticated supplier will tolerate such additional risk without seeking compensation. The cost of hedging in this way will be implicit in the fixed cost set by the supplier for the duration of the contract.

The first risk associated with this arrangement is that M plc may have to pay more for its pulp than its competitors. That may make it possible for rival newpapers to undercut M plc on price. That risk is likely to arise if the cost of pulp declines or if the fixed price exceeds the present market price and market prices remain constant.

There is a risk that M plc may be too aggressive in negotiating a fixed price so that the supplier cannot afford to honour the contract if prices increase substantially.

USD deposit The primary cost associated with this arrangement will be the fact that the rate of interest received on the bank balance is unlikely to exceed M plc’s cost of capital. There is effectively an opportunity cost associated with tying up large amounts of capital in a bank balance.

This arrangement is likely to protect the company against translation risk only. It will only reduce economic risk if the directors plan to draw upon the funds deposited to pay for pulp in the event that the USD strengthens. In that case, it could provide an effective hedge against exchange risk, at least until the balance is exhausted.

The funds invested are likely to be safe provided they are placed with a reputable bank.

Shareholders may be concerned that any substantial bank balance created in order to hedge in this manner indicates weak and unimaginative management.

Take the risk This is clearly a relatively low-cost strategy. The question is whether is opens the company to an excessive risk.

M plc will be subject to the full risk of prices increasing, but will also enjoy the upside risk associated with the possibility of prices falling.

The downside risk is partly a function of the hedging behaviour of competitors and the price elasticity of newspapers. If other newspaper prices have to increase then M plc will not be at a competitive disadvantage and if readers continue to buy newspapers in the face of increases then there is no real cost associated with pushing up prices to cover costs. Generally, the cover price of a newspaper is so small that a price rise is unlikely to affect the decision to purchase.

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SECTION B

Answer to Question Two

(a)

Financial Revenue growth would be a useful means of encouraging the divisional managers to enable the business to grow through generating sales. That could be measured on a short-term basis, e.g. by measuring month-by-month sales in comparison with previous years, or longer term, e.g. by aiming for annual growth.

Return on equity would be a useful longer term measure to counter the potential for dysfunctional behaviour if sales or some other short term measure is introduced. Aiming for an increase in annual RE will give divisional managers a long-term goal for financial performance.

Customer Repeat sales, perhaps measured in terms of sales made to customers who purchased a car from D during the previous three years, would give the divisions a long-term goal of developing a good working relationship with existing customers. Ideally, customers will buy a car from D and be encouraged to return after, say, two or three years to trade it in and buy another.

Conversion of car sales into service sales should be measured. D should aim to generate as much revenue as possible from car buyers by selling additional products such as regular servicing and maintenance. Apart from the contribution from that activity, the company will also be keeping contact with customers and may be able to target promotion more effectively, e.g. by having a member of sales staff telephone a customer whose mileage is high to point out the benefits of switching to a newer model.

Learning and growth The development of innovative marketing and promotional techniques is vital because D’s products are essentially identical to those of the other vehicle dealerships that it is competing against. Cost effective marketing strategies must be developed in order to maintain footfall through dealerships. Those strategies should not focus on price because there is little to be gained from entering a price war with competitors.

New products may be difficult to develop in this market, but that does not make innovation impossible. For example, the dealerships could offer to collect customers’ cars for servicing during the working day and return them after the work has been completed.

Such developments would possibly generate revenue in themselves and would also give the opportunity to correspond with customers to remind them of D’s interest in their business.

Internal business processes The number of complaints or requests for rectification of faults on new cars should be minimised (or eliminated). The dealership is responsible for preparing new cars for delivery, which would include valeting and cleaning the vehicle and checking for any manufacturing defects that were not noticed by the maker. All of this work should be done to such a high order that customers are not disappointed because of an avoidable complaint.

Sales effort should be linked to inventory availability to avoid old inventory and also to ensure that customers are committed to a purchase before a competitor has the opportunity to take their business. If supplies of popular models are running low then sales staff should be encouraged to press the possibility of an alternative from the

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dealership’s product range or to offer a new car in place of a second hand car or vice versa.

(b) (i)

The biggest problem is that of transfer price. If a customer offers a car of a different make as a trade-in then the dealership will be aware that it will be passed on to another dealership or division. The dealership may feel that there is no real incentive to negotiate the lowest acceptable price or the trade in with the customer if that cost will be recovered from elsewhere within D. Vehicles are to be serviced before their sale and that will be a cost to the dealership that undertakes the work. Dealerships may underspend on servicing because of the possibility that the car will be transferred to another dealership or division. That could harm the company’s reputation when the cars are subsequently sold with defects that should have been corrected. Problems with cars may take some time to appear and so it may be possible to overlook defects that will not be obvious until after the vehicle has been resold.

(ii)

All transfers should be valued at their market value, using the “going rate” for a model of that age and mileage. Such rates are relatively easy to determine for used cars and so there should be little cause for dispute.

All trade-ins should be serviced by the dealership that receives the cars for sale, which may not be the dealership that accepts the car as a trade-in if the car is not of the same make as the dealership’s franchise. The dealership that receives the car for sale should pay full market value, but should be able to recover repair costs against that as an incentive to check the car carefully before accepting it.

If a car is subsequently transferred to another division in order to balance inventories then the receiving division should be able to recover any rectification costs from the other division, again to avoid dealerships having an incentive to leave faults uncorrected.

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Answer to Question Three

(a) (i)

H must be totally confident that the backup arrangements will be available and effective if the time ever comes when they must be relied upon. An exercise that brings the system online and tests its operation will demonstrate that the hardware and software operate as expected and that staff are able to work effectively in the alternative site. It is far better to discover an unexpected problem while the primary system is still available than to wait until the primary system is taken out of operation for an extended period.

The simulation will also help to train staff and ensure that they are confident and capable of running the backup system. The call centre staff in particular must be able to deal with complex queries and transactions and must be familiar with the IT systems that underpin their work.

The most obvious disadvantage is cost. It will be expensive to bring a standby system online and to transport and accommodate staff. It is possible that the costs will not be justified if many of the tests could be conducted just as effectively without actually running a full-scale simulation. For example, the systems staff at the remote site could practise recreating the records from backups on a frequent basis and the resulting files could be compared with the files on the primary system. That would be just as valid a test as shutting down the primary system and it would be far less expensive and disruptive.

(ii)

Perhaps understandably, H is conducting the exercise under the simplest of conditions: the quietest day of the year and at a time when the call centre is closed anyway. Proving that the entity can cope with the simplest case may not give real reassurance that it is robust.

The staff are all being warned well in advance. It is very likely that systems staff will take the opportunity to check things more carefully than usual to prevent any problems that may reflect badly upon them. That may invalidate the results slightly if the system in operation at the time of the “disaster� is different from the usual one.

A real disaster may make it impossible for H to communicate with staff to ask them to make their way to an assembly point for transportation to the remote site. Unless H keeps a database of mobile phone numbers at the remote site so that a text can be sent to all staff, they will make their way to the primary site as usual. The logistics of dealing with a real disaster are not being tested.

The test is effectively taking the backup facility offline for the duration of the exercise.

Unless there is a system in place to back the remote site up at the primary site the transactions recorded at the remote site could be lost if a disaster strikes there. H will be totally dependent upon the system for reinstating the files from the remote site and any shortcoming in that system may lead to errors being introduced into the records that will prove difficult to correct.

(b)

H should make it a condition of employment that staff agree to work at the remote site as and when circumstances dictate that it is necessary for them to do so. That may mean changing contracts of employment to ensure that the company can impose that as a duty whenever it is necessary to do so.

It should be made clear that staff will be likely to be asked to be examined by a medical professional in the event that they claim to be ill at such an inconvenient time.

H must also investigate ways of dealing with the causes of the absenteeism. H should ensure that staff become familiar with the location of the remote site and have a realistic understanding of the implications of working there. It may be possible to run training courses there or organise other functions so that staff become used to making their way to and from the site.

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All staff will be reluctant to have their working day extended and so it might be necessary to compensate them with overtime pay. Call centre staff are not always particularly well paid and so paying time and a half or double time for any additional travelling time may be a worthwhile investment.

It may also be necessary to address the transportation issues faced by staff. Public transport may be more frequent during the morning and evening rush hours and so asking staff to arrive early and travel home late may cause some inconvenience. H could organise a car-share system with the driver being paid a realistic rate per mile for the journey. That could require organising parking facilities and ensuring that staff are properly insured to carry colleagues as passengers under such circumstances.

H could also attempt to deal with the childcare problem by paying for any additional carer or nursery fees or by establishing a crèche close to the remote facility. Again, that could raise liability and insurance issues and so care would have to be taken.

H will also have to ensure that there is not a deeper issue such as a lack of loyalty that discourages employees from cooperating when some flexibility is required. This may be worth investigating as a more general HR matter.

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Answer to Question Four

(a)

The French subsidiary will (hopefully) generate a surplus in EUR, so any weakening of the EUR against the LKR will reduce the value when converted to Q’s home currency. If Q borrows in € then any decline in the exchange rate will reduce the value of the loan and so there will be a degree of hedging associated with the finance.

Even if it is a little more expensive to borrow in € than in LKR the reduction in risk may justify any additional expense. Thus the EUR and LKR costs are not necessarily directly comparable.

Borrowing in France will give Q a little more flexibility in the event that the subsidiary fails.

All of the assets and liabilities will be in France and Q will be in a strong position when it comes to negotiating a deal with the French bank because it could simply abandon its position altogether.

(b)

A similar French business would pay an interest rate of 6% to borrow EUR. That rate is most directly comparable to the LKR rate of 9% that will be charged in Sri Lanka because those rates are effectively adjusted for the same degree of risk. In that case, the rule of interest rate parity could be used to show that the LKR is expected to decline against the €.

The present spot rate is LKR 155.0 = €1.

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The spot rate implied in six years = 1.09 /1.06 x 155.0 = LKR 183.25 = €1

(c)

Cash flows: Exchange rate Time 0 LKR 3,100m

DCF

1.000

LKR 3,100.00m

End of year 1 – Interest €2m

159.4

0.917

(LKR 292.34m)

End of year 2 – Interest €2m

163.9

0.842

(LKR 276.01m)

End of year 3 – Interest €2m

168.5

0.772

(LKR 260.16m)

End of year 4 – Interest €2m

173.3

0.708

(LKR 245.39m)

End of year 5 – Interest €2m

178.2

0.650

(LKR 231.66m)

End of year 6 – Interest €2m + €20m

183.2

0.596

(LKR 2,402.12m)

NPV

(d)

Discount factor

(LKR 607.68m)

A currency swap involves the exchange of the actual sums borrowed (unlike an interest rate swap). That does not mean that Q will be accepting P’s debts, though.

The worst possible outcome that might befall Q is that P defaults on its side of the swap. If that happens then Q will stop making the EUR payments to the French bank that provided P’s loan. Q will then start to pay its own interest of the LKR loan. Q appears to be a solid and successful business and so it will not be difficult to generate the Rs required to meet the loan interest due to the Sri Lankan bank.

At the conclusion of the loan period Q will have to repay the LKR 3,100m rather than the €20m borrowed by P. Given the likely appreciation of the EUR that may actually be an advantage.

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The only significant downside to P’s default would be that Q would lose the potential hedge from the effective use of EUR debt to fund the French subsidiary. There would only be a risk associated with the actual currency swap if Q agreed to pay P’s interest and principal irrespective of whether P met its counterparty obligations.

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The Senior Examiner for Performance Strategy offers to future candidates and to tutors using this booklet for study purposes, the following background and guidance on the questions included in this examination paper.

Section A – Question One – Compulsory Question One This question is based on both the common pre-seen scenario and the unseen scenario. It draws on themes involving the business risks associated with providing customers with the ability to post comments on a corporate website, the implications of a weak control environment and the problems of managing currency risks when a significant cost is incurred in a particular country’s currency.

Part (a) draws mainly on Section B of the syllabus (Risk and Internal Control). This part asks for an evaluation of risks that are created by the application of new technology in order to gain a market advantage. In this case, the entity has a particular business model that generates customer goodwill, but exposes the entity to the risk of publishing defamatory comments on its website. Such a situation requires the risks to be weighed against the potential benefits and also for those risks to be managed so that they are minimised, even if they cannot be eliminated.

Part (b) draws mainly on Section C (Review and Audit of Control Systems). It asks for some consideration of the control environment in the context of a newspaper’s control of journalists’ expenses. The point of this question is that the newspaper must grant its staff considerable latitude in incurring and reclaiming expenses, otherwise it will be virtually impossible for them to do their jobs. At the same time, senior management does have a responsibility to manage those costs to the best of their ability and so it would be unacceptable to permit the expense claims to be left unmanaged.

Part (c) draws on section D (Management of Financial Risk). It asks candidates to consider the ways in which an entity that is heavily exposed to movements in a critical exchange rate that governs the price of a vital and significant raw material can be managed. The approach that should be taken to the management of such ongoing expenses may be different to the management of large and infrequent receipts and payments.

Section B – answer two of three questions Question Two This question draws on section A (Management Control Systems). Part (a) deals with the introduction of balanced scorecard to introduce accountability in an entity that plans to provide local managers with greater autonomy.

Part (b) deals with the risks associated with internal transfers between profit centres and the threat of dysfunctional behaviour when centres work to maximise their own reported profits.

Question Three This question draws mainly on section E (Risk and Control in Information Systems). It relates to the need to plan for contingencies when an entity is dependent upon IT systems for operations. Those contingencies must be effective and must be tested from time to time in order to prove that they are.

Question Four This question draws mainly on section D (Management of Financial Risk). It asks candidates to consider the advantages of borrowing in a subsidiary’s functional currency and also the workings of a swap that might be used in order to obtain such funding.

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