ICAB Advance Level Strategic Business Management Study Manual- Interactive Questions by Optimal Management Solution

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Strategic Business Management Chapter-1 Strategic Analysis Interactive question 1: Opportunities and threats

[Difficulty level: Intermediate]

STF Company provides domestic transport services by air and sea between a country's mainland and a group of islands about 50 kilometres offshore. The company operates two ships: one of these transports freight only, and the other transports passengers and freight. This ship has a capacity of up to 250 passengers. The islands are a popular holiday destination, and the passenger service is well-used, particularly by tourists in the holiday season. STF is the only provider of sea transport to the islands for passengers, although wealthy tourists visit in their private boats. Each ship normally makes a return trip between the mainland and the islands each day. The only exceptions are in the off-peak season when the ships are sometimes taken out of service for repairs and re-fitting and also during bad weather when the seas are rough and it is considered unsafe to sail. STF also operates a number of aircraft between the mainland and the islands. Unlike its sea service, its air service is not a monopoly and other airlines operate a competing service. The main industries on the islands are tourism and agriculture. The main agricultural business is the cultivation of fruit, which is sold to retailers and exporters on the mainland. Most of this produce is transported from the islands to the mainland in STF's ships. Most islanders are employed in businesses linked to the tourist industry, such as hotel accommodation, catering, retail services and boat hire. However the tourist season currently lasts for only seven months in each year. Even so it has been rumoured that a global company in the tourism business is considering whether to establish operations in the islands, and would probably introduce flights direct from other countries to the main airport on the islands. STF has a good reputation for reliability, safety and passenger care. However, it has been increasing the prices of travel by ship for passengers, although the cost of air travel to and from the islands remains higher. The increase in prices was prompted by narrowing profit margins in the sea services (freight and passenger). Business customers have so far successfully resisted an increase in freight charges. The fruit business on the islands is continuing to grow at a fast rate and it is expected that soon, at some times of the year, one boat will be insufficient to transport all the fruit production from the islands to the mainland. The company has mooring rights on the mainland and the islands for its ships. These are negotiated with the local government authorities for a period of five years, and these rights are due for re- negotiation next year. In the past year, two hotel complexes have been opened on two of the islands, increasing the amount of tourists to the islands. The additional passenger traffic has been accommodated by STF's ships and by an increase in air services, but the new hotel complexes apparently have plans for further expansion. Another developer has just been granted permission by the government to build a large new holiday complex on one of the uninhabited islands. The new complex will accommodate up to 500 customers constantly throughout the year, and the average stay is expected to be for between one and two weeks. This complex will include sailing and sports facilities and also two golf courses. Most of the staff needed to operate the complex will be recruited from the mainland and the islands, and about 400 jobs will be created. This island will not be served by its own airport, and people visiting the island will have to go by sea, either directly from the mainland or from the main island. The developers of the complex have announced that they are considering the negotiation of a ten-year agreement with a transport company for the exclusive rights to transport their customers from the mainland to the island complex. STF has been very profitable, but the owners have been taking out most of the profits as dividends each year, and the company has only limited capital. Requirement Assess the opportunities and threats in STF's external environment, and evaluate its ability to respond to them

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Answer to Interactive question 1 Opportunities There are clear opportunities for business growth. The tourist business on the islands is growing. Two new hotel complexes have opened and a new complex is planned for an uninhabited island. The complex on the uninhabited island will require transport services for its customers and also for its staff, who will have to travel from the other islands by sea. This complex intends to negotiate a ten-year agreement with a transport company. The agriculture business is also growing and the demand for cargo services at certain times of the year should also be expected to grow. However, if STF is to win some or most of the new transport business, it must address its weaknesses (such as insufficient boats or aircraft) and also exploit its competitive advantages. The following advantages or competences seem to exist and the company may be able to exploit them: At the moment, it is the only provider of transport by sea in the area. The complex on the uninhabited island will need sea transport for its customers and staff. Cargo is more likely to be transported by sea to the mainland, since sea transport should be much cheaper than air transport for bulk cargo. The growth in the tourist business generally makes it probable that demand for sea as well as air services will rise in the future. As the only provider of sea transport, STF currently has the advantage of 'monopoly' provider and 'first in the market'. It may be able to exploit this advantage to develop a network of business contacts, and make it difficult for a newcomer to break into the market quickly. STF has mooring rights. These may be the only mooring rights in existence at the moment. If so, renegotiating them next year will give STF an important strategic asset. On the other hand, the government may create and sell additional mooring rights, so the value of mooring rights may be much less than supposed. STF may enjoy the intangible benefits of its acquired experience and knowledge of the islands and local transport. It may be able to succeed because its staff have knowledge that other firms may take a long time to acquire. On the other hand, a rival firm could 'poach' key staff by offering them more money. Therefore, although STF has some competitive advantage at the moment, this may disappear quickly if a rival transport company were to set up in business. STF must plan to expand the capacity of its services so that it can handle the growth in the business. It should also ensure that the general infrastructure of its business is sufficient to provide the standard of service that customers will expect. STF should investigate the requirements of the company that is building the new complex, to establish what it can do to improve its chances of winning the business for the island's transport. STF may also consider splitting its passenger transport and cargo businesses, so that managers can focus on one side of the business. Threats One of the main opportunities for growth is also a threat to STF: the growth in both the agriculture business and the tourist business on the islands. STF will not be able to meet the growth in demand with its existing ships and air fleet; so if STF does not take action to increase its capacity, it is probable that one or more competitors will fill the expanding gap in the market. There is a rumour that a global company in the tourism business may establish an operation in the islands, but it is not clear what activities they would undertake. The global company would only create a threat to STF if it decided to fly tourists direct from other countries to the islands (which may reduce passenger traffic between the islands and the mainland) or if it decided to establish its own transport facilities to take people between the mainland and the islands. Since STF will have to increase the numbers of its ships or aircraft, its lack of capital is likely to be a significant weakness that could affect STF's ability to respond to the opportunities and threats. Without finance it cannot pay for new transport, and banks may be unwilling to lend the money. There is a threat arising from the possibility that STF will be unable to re-negotiate its mooring rights next year. Without mooring rights, STF will be unable to operate its ships. There may be alternative mooring rights that could be obtained. However, at the moment there does not appear to be a rival for the rights, so it is probable that STF will be able to obtain the rights for a further five years, even if it has to pay substantially more for them.

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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?

Answer to Interactive question 2 (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 â&#x20AC;&#x201C; 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 of a 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. What is important for LBG to establish is the relative importance of the movie and theatre industry markets to their competitors. Are they just a sideline, in which case the products may be subsidised by the more profitable main product lines, or are they the main focus of the business? Establishing competitors' assumptions about the industry is essential as this will play a large part in 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 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

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senior managers, this kind of information 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 competencies 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 prospective 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.

Interactive question 3: Product life cycle

[Difficulty level: Intermediate]

3C is a medium-sized pharmaceutical company. In common with other pharmaceutical companies, it has a large number of products in its portfolio, though most of these are still being developed. The success rate of new drugs is very low, as most fail to complete clinical trials or are believed to be uneconomic to launch. However, the rewards to be gained from a successful new drug are so great that it is only necessary to have a few on the market to be very profitable. At present, 3C has 240 drugs at various stages of development; with many still being tested or undergoing clinical trials prior to a decision being made as to whether or not to launch the drug. Currently, 3C has only three products that are actually 'on the market': 

Epsilon is a drug used in the treatment of heart disease. It has been available for eight months and has achieved significant success. Sales of this drug are not expected to increase from their current level.



Alpha is a painkiller. It was launched more than ten years ago, and has become one of the leading drugs in its class. In a few months the patent on this drug will expire, and other manufacturers will be allowed to produce generic copies of it. Alpha is expected to survive a further twelve months after it loses its patent, and will then be withdrawn.



Beta is used in the hospital treatment of serious infections. It is a very specialised drug, and cannot be obtained from a doctor or pharmacist for use outside the hospital environment. It was launched only three months ago, and has yet to generate a significant sales volume.

Requirement Using the product life cycle model, briefly analyse 3C's current product portfolio

Answer to Interactive question 3 The product life cycle (PLC) is a simple model of the way that the sales of a product and the profits earned by it vary from its launch to its exit from the market. The model is crude in that a product's progress through the phases can be heavily influenced by marketing activity and, in any case, many products do not follow the standard pattern. Nevertheless, the concept is a useful tool for basic portfolio analysis. The PLC for current product portfolio can be depicted as follows: £ Epsilon

Alpha

Sales

Beta + –

Time Introduction

Growth

Maturity

Decline

Senility Profit

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(i)

Beta has been positioned in the introduction phase, because it has only recently been launched, and has not yet generated significant sales volume. However, Beta is likely to have a fairly accelerated Introduction stage, as it is a specialised product, for which there is already demand within the hospital market.

(ii)

Epsilon is located at the peak of its cycle. Although it has not been available for long, it has already 'achieved significant success' (and its introduction/growth curve may therefore have been steeper than shown in our 'standard curve' model). Sales are not expected to increase (hence its position at the peak).

(iii) Alpha is currently just at the point of decline. It has been available much longer than the other products, so its maturity stage may have been longer than our 'standard curve' model suggests. However, Alpha is about to enter the 'decline' stage, because of the expiry of the patent and the entry of low-cost generic competitors into the market. The decline/senility stage is then only expected to last a further 12 months. As with any portfolio analysis technique, it is important to look for balance in relation to the PLC. Specifically, this means that a portfolio should include products at several stages in their life cycles, so that as one declines, another is emerging to take its place. 3C's current portfolio seems adequate in this respect, in that while Alpha is expected to enter a rapid decline phase, Epsilon is generating high sales in its maturity phase as an acceptable 'cash cow', and Beta has been launched and still has potential for growth. However, the fact that Beta is unlikely to generate enough sales volume to replace Alpha (because it targets a specialist market niche) is likely to be a concern. Hence, 3C will need to find a 'mass market' product that can act as a successor to Alpha. However, there are currently 240 drugs at various stages of development, so this should increase 3C's chances of continuing the succession into the future.

Interactive question 4: BCG matrix

[Difficulty level: Intermediate]

CPH plc is a diversified conglomerate with business units in four different industries. The original CPH business was a construction company, however, and the construction division remains the largest business within the group. CPH plc's total revenue for the last financial year was $12.9 billion, split across the group's four trading companies as follows: $ Bn 5.4 3.5 2.8 1.2

Construction Engineering Transport Gaming

The following market information has also been produced by the management accountants of each of the four trading companies: Market growth Construction Engineering Transport Gaming

T/O of nearest rival

2% 4% 11% 13%

$3.8Bn $8.7Bn $4.7Bn $0.7Bn

Requirement Evaluate CPH plc's business portfolio, using the BCG matrix

Answer to Interactive question 4 Company

Mkt Growth

Mkt Share

Construction

2% – Low

5.4 / 3.8 = 1.42 High

Cash cow

Engineering

4% – Low

3.5 / 8.7 = 0.40 Low

Dog

Transport

11% – High

2.8 / 4.7 = 0.60 Low

Question mark

Gaming

13% – High

1.2 / 0.7 = 1.71 High

Star

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The portfolio of CPH appears to be well balanced with one trading company in each sector of the matrix. However, we should note that we do not have any information about the profitability of the different trading companies, which would be useful when gauging the strength of CPH's portfolio. Currently, the Gaming business ('Star') has a significant advantage over its nearest rival, which should enable it to build a strong position in the market. However, we do not know what level of investment (eg in marketing and promotions) will be necessary to maintain its market leadership in the future.

Interactive question 5: Value chain

[Difficulty level: Intermediate]

A private college, ABC Ltd, provides training for professional accountancy qualifications. It generates the majority of its funds from employers and self-financing students. For most qualifications there are a number of stages that students need to go through before attaining full accreditation; this can take up to four years. In recent years, the college has placed emphasis on recruiting lecturers, who have achieved success by delivering good academic knowledge of the syllabuses in class. As a result, ABC Ltd's students have had good pass rates. This has led to the college further improving its reputation within the academic community, and applications from prospective students for its courses have increased significantly. The college has good student support facilities, including online learning support, student helpdesks and excellent material. They have recently implemented a sophisticated online student booking system. Courses at the ABC college are administered by well-qualified and trained non-teaching staff who provide non-academic (that is, non learning-related) support to the lecturers and students. The college has had no difficulty in filling its courses. The college has also noted a significant increase in the number of students transferring from other training providers in the last year. Requirement Apply value chain analysis to the college's activities and evaluate how value chain analysis could be used to assess why the rate of transfer to ABC from other providers is increasing.

Answer to Interactive question 5 Value chain analysis (VCA) is a method of reviewing all the activities of an organisation and how they interact with each other. Key linkages are identified and areas that create value are focused upon. VCA is not restricted to just the organisation but also the suppliers and customers. The key 'issue' to address here is identifying which activities in the chain carried out by the college are clearly valued by the students and therefore encourage them to swap to ABC from other training providers. If the college can sustain the elements and linkages in the chain that create value for its students (value drivers) this should help it sustain its competitive advantage over other training providers. Usefulness of the model The value chain model was originally designed for used in the manufacturing sector, whereas ABC College is clearly a service-based business. Some of the 'activities' identified in the VCA (eg outbound logistics) may be more obviously relevant to a manufacturing business than a service one. Nonetheless, value chain analysis will encourage the college's management to think about how and where they add value for their students ('value drivers'). In doing so, they should also consider how ABC College differs from the competition and on what basis it will attract staff and students in the future. In this respect, VCA should help the college to identify its order winners or 'core competences'.

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PRIMARY ACTIVITIES Inbound logistics Operations

Outbound logistics

Marketing and sales

Service

Student supply

Course material production

Lecturing styles and quality

Support functions

Virtual learning development

Provision of material

Marketing mix structure (eg pricing, differentiated product)

Classroom technology

Ease of access to online learning

Staff supply Facilities supply Course selections and flexibility

Social aspects Continuing professional development

Website Promotions (brochures, email)

Structuring of courses

Research Price elasticity SECONDARY ACTIVITIES Procurement

Technology

HRM

Infrastructure

Printed materials

Availability

Staff selection processes

Culture

Building work

Ease of use

Staff turnover rates

Layout of premises

Support staff

Training

Staff training

Organisational structure

Students & staff

Innovation (eg online learning)

Admin and staff processes

Facilities

Knowledge sharing

Planning systems Control systems (professional bodies)

The points shown in each value chain category are a selection of the things that should be looked at within this context. However, it is equally important to consider the processes of the college, and to see how the linkages within the value chain fit together. All that needs to happen for the chain to fail is for one link within it to break.

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Strategic Business Management Chapter-2 Strategic Choice Interactive question 1: Generic strategies

[Difficulty level: Intermediate]

BMK is a small restaurant chain, consisting of eight restaurants, in an attractive part of a European country that is popular with tourists. BMK has been owned by the same family for the previous 15 years and has always traded at a profit. However, a number of factors have meant that BMK is now in danger of making a trading loss. There has been a substantial drop in the number of tourists visiting the region whilst, at the same time, the prices of many of the foodstuffs and drinks used in its restaurants has increased. Added to this, the local economy has shrunk, with several large employers reducing the size of their workforce. The owners of BMK commissioned a restaurant consultant to give them an independent view of their business. The consultant observed that the eight restaurants were all very different in appearance. They also served menus that were very different, for example, one restaurant which was located on a barge in a coastal town specialised in fish dishes, whereas another restaurant 20 miles away had a good reputation as a steak house. The prices varied greatly amongst the restaurants: one restaurant in a historic country house offered 'fine dining' and was extremely expensive; yet another located near a busy railway station served mainly fast food and claimed that its prices were 'the cheapest in town'. Three of BMK's restaurants offered a 'middle of the road' dining experience with conventional menus and average prices. Some of the restaurants had licences that enabled them to serve alcohol with their meals but three restaurants did not have such licences. One restaurant had a good trade in children's birthday parties, whereas the restaurant in the historic country house did not admit diners under the age of 18. The consultant recommended that BMK should examine these differences but did not suggest how. The owners responded that the chain had grown organically over a number of years and that the location, style and pricing decisions made in each restaurant had all been made at different times and depended on trends current at that time. Requirement Advise the owners of BMK how the application of Porter's Three Generic Strategies Model could assist them in maintaining or improving the profitability of their restaurants. Note: You are not required to suggest individual generic strategies for each of BMK's restaurants.

Answer to Interactive question 1 Choosing a competitive strategy Porter's logic behind his generic strategies model is that a firm should follow only one of the generic strategies in order to achieve competitive advantage. According to Porter, if a firm tries to combine more than one of the strategies, it risks becoming 'stuck in the middle' and losing its competitive advantage. Applying these ideas could help the owners of BMK assess whether their restaurants are following a coherent competitive strategy – either individually or as group – or whether they are becoming 'stuck in the middle.' If they are becoming 'stuck' in this way, the lack of a clear strategy might be contributing to the decline in BMK's profits. Generic strategies Porter suggests firms should choose a potential strategy based on one of three generic strategies: cost leadership, differentiation or focus. Cost leadership – If BMK chooses to become a cost leader, it must ensure it has the lowest costs in the industry as a whole. By having a lower cost base than its competitors, BMK could achieve a greater profit than them, even if its sales prices were the same as theirs. Although this aspect of Porter's strategy focuses primarily on cost rather than price, it appears that BMK's restaurant near the railway is pursuing this kind of strategy, since it claims to be 'the cheapest in town.' However, to maintain its profitability, the restaurant must ensure it can continue to keep its cost base lower than any of its competitors' cost bases. Differentiation – If BMK chooses a strategy of differentiation, it must deliver a product or service that

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the industry as a whole believes to be unique. As a result of this uniqueness, BMK will be able charge its customers a premium price. It appears that the extremely expensive 'fine dining' restaurant in the historic country house is charging a premium price in this way. However, to maintain its profitability, the restaurant must ensure it maintains its distinguishing features – be they the quality of the menu; the service, or the ambience. These features are what differentiates the restaurant from others in the industry and make it attractive to customers, even though it is charging a premium price. Focus – A focus strategy will involve segmenting the industry, such that BMK would then pursue a strategy of cost leadership or differentiation within a single segment of the restaurant industry. Three of BMK's restaurants seem to be following this type of strategy and tailoring their offering to a specific market niche: the barge restaurant specialising in fish dishes; the steak house; and the restaurant catering for children's birthday parties. Stuck in the middle – BMK has eight restaurants in total. We have identified five of them as following one or other of Porter's generic strategies, but this means the other three - with conventional menus and average prices – are likely to be stuck in the middle. In this respect, BMK needs to look urgently at finding a way of establishing a competitive advantage for these three restaurants. This should allow them to improve their profitability. Strategy and marketing We do not know whether all the restaurants in the chain are branded unilaterally as BMK restaurants, or whether they have retained their own names as well as their own styles and prices. If BMK is trying to run the restaurants as a single group, under a single brand name, then the analysis of the restaurants' current position, indicates that the group as a whole is at risk of being 'stuck in the middle' due to the diversity of its strategies. In this respect, Porter's generic strategies model suggests that BMK would be best advised to run the restaurants as separate business units, and to develop marketing strategies which support each restaurant's individual characteristics. However, even if BMK chooses to do this, it still needs to consider whether the restaurants' current strategies can deliver a sustainable competitive advantage. For example, the prices of foodstuffs and drinks are rising in BMK's country, which will increase its cost base. So, how sustainable is a cost leadership strategy, particularly as there is little evidence of specific technologies or processes that will allow BMK to sustain a lower cost base than any of its competitors? Given the overall economic context in which BMK is operating, BMK's owners might decide that Porter's focus strategies (either cost-focus, or differentiation-focus) offer them the most practical way of maintaining or improving the profitability of their restaurants.

Interactive question 2: Ansoff's matrix

[Difficulty level: Intermediate]

Sleepway Hotels ('Sleepway') is a family-run business that operates a small chain of nine five-star luxury hotels worldwide. These are located in major cities in the USA, Europe, East Asia and Australia, catering for a mix of business and private customers. The past few years have been difficult for the hotel's business due to the depressed global economy, and profit margins have been low due to relatively low occupancy rates. The company has pursued a long-term strategy of slow growth, opening a new hotel in a city when a suitable opportunity arises. It is now four years since Sleepway opened a hotel, and the CEO believes that an opportunity exists for the company to seek a faster rate of growth. The business has large cash resources, and there are opportunities to borrow for investment at low rates of interest. The CEO has asked the board to consider three strategic options: 1

Opening three new luxury hotels, one in East Asia and two in the USA. Properties have been identified that would be available for purchase.

Opening a small chain of four or five three-star hotels, in cities where the company already has luxury hotels, to attract customers who are increasingly looking for cheaper accommodation than five-star hotels.

Opening two golf and country clubs in Eastern Asia, where economic growth is still strong and demand for recreational facilities is rising, especially among wealthy individuals.

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It is estimated that the time required to implement each of these strategies might be two to three years. By this time, the CEO believes that global economic conditions will have improved and demand for hotel accommodation will be on the increase. The CEO is the grandson of the founder of Sleepway, and took on the role of CEO about one year ago, when his father retired. His father remains as a non-executive director of the company. Requirement Analyse the three options for strategic development in terms of Ansoff's product-market development strategies. Indicate (with brief reasons) which option, if any, you would recommend on the basis of the information available.

Answer to Interactive question 2 Strategy 1 is a strategy of market development, involving the establishment of more luxury hotels in new geographical locations. The cost of investment is likely to be high, and at the moment profit margins in the luxury hotels business are low. The potential return may not justify the risk in the strategy. Strategy 2 is a strategy of either product development â&#x20AC;&#x201C; opening a range of three-star hotels, but targeting the same group of customers as for the five-star hotels â&#x20AC;&#x201C; or diversification â&#x20AC;&#x201C; opening a range of three-star hotels for a new set of target customers. It is probably more likely that the company would need to target a different group of customers from those that use five-star hotels, even though some individuals and businesses may be switching to cheaper hotel accommodation in order to economise. Management has no experience of running three-star hotels, and a diversification strategy could involve excessive risks. Strategy 3 is a diversification strategy. There may be good business opportunities in recreational centres in East Asia, but the management of Sleepway does not appear to have any experience of running any businesses other than hotels. The golf and country clubs may follow a different business model to hotels. Recommendation All three strategies involve risk, and although Strategy 1 is the lowest risk, returns from this strategy may be unsatisfactory. The CEO is expecting economic recovery in the next few years, but opening three new hotels could be a gamble. Without more information it is difficult to make a recommendation, but all three strategies would involve a big expansion of the business for a company that currently has only nine hotels. All three options may well be beyond the resource capabilities of the company, and any strategy for growth should be less ambitious. A more conservative approach of seeking to open one more luxury hotel may be the most appropriate option for this company, but this recommendation should be subject to further analysis.

Interactive question 3: Evaluating strategic options

[Difficulty level: Intermediate]

BBB is a biotechnology company which develops pharmaceutical drugs. It was founded seven years ago by three scientists when they left the university medical school, where they had been senior researchers. The Company employs 10 other scientists who joined from different universities. All of these employees are receiving relatively low salaries but participate in a share option scheme, such that when BBB is successfully floated on the stock exchange, they will receive shares in the company. BBB currently has a number of new, innovative drugs in development, but the earliest any of these drugs might come to market is two years from now. It is expected that there would be one successful drug launched in most years after that for at least six years. However, successful drug launches are never guaranteed, due to the speculative nature of biotechnology and the long period of clinical trials through which any new drug must pass. BBB has to invest a significant amount of resources into the development of each potential drug, whether they are successfully launched or not. Currently, it has 12 drugs in development, a number of which may not make it to market. Due to the speculative nature of the industry, companies such as BBB are unable to obtain bank loans on commercial terms. BBB is funded by an exclusive arrangement with a venture capital company. However, there is only sufficient cash in place to maintain the present level of activity for a further nine months. The venture capital company owns 15% of the equity of the company. The rest is owned by the three founders. It

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has always been the intention of the venture capital company and the founders that, once the company has a sufficient number of drugs in production and on the market, the company would be floated on the stock exchange. This is expected to happen in five years' time. Recently, there have been a number of approaches to BB which might solve its cash flow problems. The three founders have identified the following options: 1

The venture capital company has suggested that it will guarantee the cash flow until the first drug is successfully launched in commercial quantities. However, it would expect its equity holding to rise to 60% once this offer is accepted.

A large pharmaceutical company has offered to buy BBB outright and retain the services of the three founders (in research roles) and a few of the staff.

Another biotechnology company has offered to enter into a merger with BBB. This company has also been established for seven years and has one drug which will be launched in six months. However, of the four other potential drugs it has in development, none are likely to be commercially viable for another five years. This company would expect the three founders to stay with the newly merged company but feels a rationalisation of the combined staff would be needed.

Requirement Using the 'Suitability, Acceptability, Feasibility' framework, evaluate the strategic options identified by the founders.

Answer to Interactive question 3 1

Cash flow guarantee from venture capital company Suitability BBB's main weakness is a shortage of cash, and the guarantee from the venture capitalists will ensure there are sufficient funds to allow BBB to continue until the first drug is successfully launched in commercial quantities. The injection of cash will not, in itself, add to BBB's strengths, but assuming the new drug proves commercially successful the funding could allow BBB a competitive advantage, which it would have otherwise been denied. The venture capitalists have only agreed to guarantee BBB's funding until the first drug is successfully launched, and so there may still be question marks about the longer term funding requirements between that launch and BBB's flotation, unless cash inflows from the launch of that drug are sufficient to support the business' cash needs. However, to the extent that the venture capitalist funding will meet cash needs in the short to medium term and bring at least one new drug to market, this option is suitable. Acceptability Venture capitalists – This plan will see a significant rise in the venture capitalist's shareholder in the company – from 15% to 60%. As the venture capitalists have proposed the plan, we can assume it is acceptable to them. Founders – However, the increase in the venture capitalist's shareholding will mean that the founders' stakes in the company are significantly reduced. This may not be acceptable to the founders, particularly in the context of any profits they might make when the company is floated in five years' time. Employees – Similarly, the plan will not be acceptable to the employees because it will reduce the numbers of shares available to them through their share option scheme. Currently, the employees are prepared to accept relatively low salaries because they will receive shares in the company when it floats. However, if this option is removed, they are likely to either want higher salaries, or will leave the company altogether. If too many employees leave, BBB's ability to develop its new drug may be jeopardised. Feasibility This option does not, in itself, affect the internal resources of the company, so there are no problems about its feasibility.

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Purchase by pharmaceutical company Suitability This option will allow at least some of the drugs that BBB is working on to be brought to market, but not by BBB as a company in its own right. Given the founders' intention to float the company on the stock exchange, it seems likely that one of the strategic goals was to run BBB as an independent company. From that perspective, the outright purchase by another company is not a suitable option. Acceptability Venture capitalists This option is unlikely to be acceptable to the venture capitalists, not least because they have proposed an alternative option. However, possibly more importantly, they are unlikely to be happy that whereas they invested in BBB expecting to see significant returns when it successfully launches its first new drug, they will no longer get the benefit of these returns. We do not know the terms of the deal under which the pharmaceutical company has offered to buy BBB (for cash, or for shares) but either way, it is unlikely that the venture capitalists will receive the same returns as they would if BBB had successfully launched the new drug as an independent company. Founders This option may not be acceptable to the founders either, because while they currently have the independence and status of being their own bosses, under the new structure they will simply be employees (researchers) in a much larger company. If the large company offers the founders a favourable price to acquire BBB now, (rather than them having to wait five years to benefit from the flotation) the relative acceptability of this option may be increased. However, this will probably be unlikely â&#x20AC;&#x201C; especially if the larger company is aware of BBB's cash flow problems. Employees The employees will be concerned about the acquisition because the larger pharmaceutical company only intends to retain 'a few of the staff'. Therefore, there is a risk that some of the current employees will be made redundant, which will not make this an acceptable option for them. The other issue for all the employees to consider is that they will lose the potential benefits accruing from BBB's share option scheme in the event of it floating. However, if the larger company offered them higher base salaries than BBB did, they may be prepared to accept the security of a higher salary instead of the potential benefits of the share option scheme. Feasibility There are no problems with the feasibility of this option.

Merger with another biotechnology company Suitability Because the other biotechnology company's new drug will be launched in six months' time, this will provide a short term cash injection to support BBB until its first new drug is launched. However, whereas BBB is then expecting to launch one new drug in most subsequent years, the other company is not expecting to have any other new drugs commercially available for another five years. Therefore, it is debatable whether the other company has the same strength in developing new drugs as BBB. If the merger effectively means that the other company provides a short-term cash injection in return for piggy-backing on BBB's competences in the longer term, then that is unlikely to be a suitable option for BBB. Acceptability Venture capitalists Again, this option is unlikely to be acceptable to the venture capitalists, because it would mean BBB rejects the option they have proposed. Also the merger would dilute the venture capitalist's share in the new company, which is unlikely to be acceptable.

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Founders As with the acquisition by a larger company, the merger would reduce the founder's independence and autonomy, because the directors of the other company would now be jointly responsible for business decisions and strategy. This change may not be acceptable to BBB's founders. Moreover, there is no indication of how long the founders would be expected to stay with the newly merged company. If they are expected to remain for a long time, they may find this restrictive. Also, there is no indication as to whether the newly merged company would still look to float in five years' time. If it would not, this again may be undesirable for BBB's founders. Employees The merger is very unlikely to be acceptable to the employees, because the rationalisation of the workforce will mean that some employees are made redundant. Also, if the newly merged company does not intend to float, the employees who remain will lose the potential benefits from the share option scheme. It is possible, that they may be offered higher base salaries to compensate for this, but this appears unlikely since the other company has fewer new drugs in the pipeline than BBB and so on-going cash flow could still be a problem for the business. Feasibility The feasibility of this option will depend on how similar the research and development practices of the two companies are. The merger is the only option that will involve the integration of the systems from two different companies. This could mean that there are some significant changes to BBB's operating systems, and the time taken to complete the merger could also be an issue. In addition, BBB's founders have no experience of managing a merger process, which could increase the risk of the merger being unsuccessful.

Interactive question 4: Growth strategies

[Difficulty level: Intermediate]

DD Co (DD) is a manufacturer of specialised electronic tracking equipment used by police forces. The equipment allows the tagging, and tracing, of valuable equipment and also of prisoners. The company, which was only established five years ago, has a virtual monopoly in its own country. However, there are limited opportunities for growth in that country. As in most countries, the police forces in DD's home country are funded by the government. The Board of Directors, which owns the company, wishes to see the same level of growth in revenue and profits continue. DD's equipment, which has been available for five years, is protected by a number of patents and involves some sophisticated technology, both in terms of the manufacturing process and the components that each device contains. Since the equipment is physically robust, there is only a limited replacement market. The external cases, used for carrying the tracking equipment, are bought in from an outside supplier, but most of the other components are manufactured by DD in its own factories. DD's Board of Directors has decided that in order to pursue a growth strategy, it will need to develop an export market. It wants to develop a presence in all major markets in the world within a further five years. The Managing Director has said that he expects the company to grow rapidly into a multinational company, operating in a number of countries. The board has identified a number of countries as possible areas in which DD might operate. However, the board recognises that elements of the political, economic, cultural and legislative environments in those countries differ from those that exist in DD's own country. Requirement Evaluate FOUR market entry strategies that DD could use to develop a market in one of its identified countries.

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Note: You were asked to evaluate four strategies, and the following suggested solution evaluates four strategies involving external partners. However, a fifth alternative you could have suggested would be organic growth in which DD sets up operations of its own in the target countries. 1

Agency agreements DD could continue to manufacture its products in its own factories in its home country, and then export the products to its targets countries. In such a scenario, DD could also use local sales and marketing agents in the target countries to promote demand for its product. Suitability – It is likely that the police forces in DD's target countries will be funded by their governments. Therefore, if DD selects agencies that already have established relationships with the relevant government departments in a country, it could increase its chances of making sales in that country. Acceptability – A potential risk with this approach comes from the level of control DD will have over the agency, and accordingly how much effort the agency puts into selling DD's product. DD will be totally reliant on the agency to generate sales for it, but if the agency doesn't devote much time and effort or resources to promoting DD's product, then this approach will not be able to generate the 'rapid growth' the Managing Director wants. On this basis, an agency agreement may not be an acceptable strategy. Feasibility – This is a relatively simple strategy, and also one that allows DD to maintain control over the manufacturing standards and quality of its product. Low capital requirement – There will be no need for DD to acquire premises or employ staff in the target countries, which could be a particular benefit in the early stages of expansion, before DD establishes how lucrative the market in each country might be. If a market turns out not to be as lucrative as DD had hoped, it can withdraw from that market relatively cheaply because it will not have invested any capital there. Equally, DD will not need to develop any in-depth knowledge of the business practices and customs in its target countries because agents will already have this local knowledge.

Licence agreement Note: A Licence agreement would seem to be more appropriate than a franchise agreement in this context, because DD is dealing with a tangible product rather than a business concept. Under a franchising agreement, the franchisor allows the franchisees to use a process or business concept, as well as the franchisor's name, in return for the payment of a franchise fee. However, in DD's case, the agreement is to manufacture specific products rather than to use a business concept, meaning that a licence agreement is more appropriate than a franchise agreement. Under a licensing agreement, a company in the target country could manufacture DD's product using components supplied by DD, and using DD's manufacturing process. Suitability – In order for licensing to be a successful strategy, DD will need to find a suitable company in the target country that could manufacture the product to the appropriate standard, and then market and sell the product effectively. The scenario doesn't give any indication of how easily DD would be able to find such a licence partner, but without one, this strategy would not be viable. However, if DD can select a licensee that already has established relationships with the relevant government departments in a target country, DD's sales opportunities should benefit from this. Feasibility – Assuming that DD can find a suitable company to act as its 'licensee' in a country, then the strategy should be feasible. DD would not need to build its own factory in the target country, nor employ any staff there, so the strategy doesn't impose any resource constraints on DD, and could therefore be implemented relatively quickly. Acceptability – The Board of Directors are keen to see both revenue and profits grow rapidly. A potential drawback of this strategy is that the licensee is likely to require a larger proportion of the profit than an agent would, because the licensee is adding value to the products by manufacturing them. Another concern relates to preserving DD's intellectual property. Not only is DD's equipment

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protected by patents, but its manufacturing process also contains some sophisticated technology. Although DD is likely to require any licensee to sign a confidentiality agreement before a license is granted, there is still a risk that the licensee may be able to use the knowledge it gains about DD's product and processes to develop its own competitor products in time. The emergence of a potential competitor in this way could adversely affect DD's ability to sustain revenue and profit growth. On this basis, even if a suitable licensee company could be found, licensing doesn't appear to be an acceptable strategy. 3

Joint venture DD could establish a joint venture with an existing company in its target markets, and the joint venture would manufacture and market DD's product in those markets. Suitability – A joint venture (JV) arrangement will allow DD to have a much stronger influence over the manufacturing and marketing process than a licensing arrangement because some of DD's own employees will be involved with the JV. DD's greater involvement in the operation will also help it develop its own knowledge of the market in the target country, and in doing so may help DD identify additional new product or market opportunities which may allow further revenue growth. Similarly, DD's active involvement in the JV will help DD to identify problems more quickly than would be the case under an agency or licensing agreement. Acceptability – Profit sharing – DD will have to share the profits from the JV with its venture partner. The percentage split is likely to reflect the division of responsibilities between the venture partners, so if DD's partner takes on the bulk of the responsibility for manufacturing and marketing, that partner might also expect the majority share of the proceeds. This may prove contrary to the aim of maintaining DD's profit growth. Knowledge transfer – The directors may also be concerned about the degree of knowledge transfer about DD's products and processes to the venture partner. As with a licencee, there is a risk that the venture partner could use the JV as a means of finding out about DD's intellectual property and then set itself up as a competitor in future. Feasibility – Capital costs – It is likely that any capital costs (for example, for new plant and equipment) will have to be jointly funded by DD and its venture partner. Therefore, a joint venture is likely to require greater capital investment by DD than either an agency agreement or a licence. Also, if the venture proves unsuccessful, DD would have greater financial exposure to losses than it would have under either of these two methods of expansion.

Acquisition DD may decide that, rather than working in partnership with another company, it would prefer to acquire an existing company in its target country outright and introduce its own manufacturing capability into that company to deal with local demand for its product. Suitability – DD is not working with a JV partner or a licensee so it would retain full control of its technology, thereby reducing the risk of knowledge being transferred out of the company to any potential future competitor. Moreover, DD would retail full control of the manufacturing, quality, marketing and sales processes in the organisation. In this respect, establishing a wholly owned subsidiary in a country could be strategically important. If DD subsequently wants to export in other surrounding countries, this operation would provide a useful base for doing so. Acceptability – Moreover, DD would not have to share any of the proceeds of the business with any other partners. Feasibility – However, there are a number of issues with the feasibility of this strategy: 

Target company – DD would have to identify a suitable target company that was willing to be acquired, and it would then have to manage the acquisition and integration of that company into the 'DD Group'. There is no evidence to suggest that DD has made any acquisitions before, and the company's inexperience will add to the risk involved in this strategy.

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

Cost of acquisition – DD needs to consider the costs involved. If it buys a relatively successful company, then the purchase price is likely to be high. If it buys a less successful firm, the purchase price may be lower but DD is likely then to have to invest further in improving the firm's facilities and premises to bring them up to the standard required to host DD's sophisticated technology.



Political issues – Some countries, and governments, look unfavourably on foreign owned companies and assets. Given that DD's main customers are governments, it cannot afford to pursue an entry strategy which is not politically acceptable to the governments in its target countries.



Investment levels – Making an acquisition is likely to involve a far greater investment by DD than any of the other strategies we have considered so far. However, the size of the potential market (for a specialist product with only a limited replacement market) may not justify the level of investment required.



Barriers to exit – Moreover, if DD does enter a market via an acquisition but the acquisition does not prove successful, there will be significant barriers to exit which could make leaving the market expensive. (For example, if DD closes down the company it had acquired, it could incur significant redundancy costs.)

Alternative suggestion: Build its own plant in target country Rather than entering some kind of partnership with, or acquiring, an existing company in its target countries, DD could set up foreign divisions of its own in those countries. This is likely to involve DD acquiring the necessary land and then building its own manufacturing facility. It is also likely to require DD to develop its own sales and marketing networks in the relevant countries. Suitability – This approach would allow DD to retain control over all aspects of manufacturing and marketing, and to retain all of the profits from the venture. Moreover, DD would have modern, purpose-built factories for its manufacturing operations to use. Acceptability/Feasibility – Building a factory is likely to involve considerable capital investment, yet DD will have no guarantee that the level of future sales it will generate will justify that investment. If the operation provides unsuccessful and DD wants to leave the market, it will then have the additional costs associated with closing the factory, selling the building and laying off the staff who work there. DD's lack of previous experience or contacts in its target countries will make it harder for DD to enter the markets there. For example, DD may be unfamiliar with local customs and business practices; it is unlikely to have any contacts among (buying) decision makers in the government; and it won't have any access to sales and distribution channels. Slow growth – DD's lack of existing contacts and networks, coupled with the time taken to build new premises, will mean that establishing its own operations in its target markets is likely to be a much slower means of growth than partnering with, or acquiring, an existing company. This could be a particular issue here, given the need to build a completely new factory, and therefore the risk of potential delays and problems associated with the construction project (in an unfamiliar country).

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Strategic Business Management Chapter-3 Strategic Implementation Interactive question 1: Due diligence

[Difficulty level: Easy]

Alpha Oil plc has agreed provisional terms with a small industry rival, Beta Extraction plc, for a full takeover. Beta has now agreed to open up its books to Alpha for due diligence purposes. Requirement Advise Alpha as to the types of due diligence its shareholders would expect to see performed before a takeover could proceed.

Answer to Interactive question 1 The shareholders will be assured by the following forms of diligence: 

Review of financial statements for accuracy



Specialist reports on the size of Beta's proven reserves



Actuarial calculations on the state of Beta's pension fund and any shortfalls



An assessment of the value and condition of Beta's assets such as oil rigs and drills



A review of any exploration rights that Beta has acquired and whether these can be transferred upon a takeover to Alpha



An assessment of Beta's legal status: Are there any active legal claims, and the likelihood and impact of losing these?



An environmental audit (think: BP and Deepwater Horizon explosion)

Interactive question 2: Growth strategies

[Difficulty level: Intermediate]

JKL is a small European company. It currently employs 40 people and has an annual revenue of about 11 million euros. One aspect of its recently formulated strategy is an aspiration to expand into a neighbouring country, France, by means of organic growth. The reason that JKL's strategy for expansion is based on organic growth is due to JKL's past experience. Two years ago, the directors of JKL negotiated the purchase of a business, LMN, located in a different region of its home country. At the time of this acquisition, LMN was regarded by JKL as having complementary capabilities and competences. However, within a short time after the acquisition, JKL judged it to have been a failure and LMN was sold back to its original owner at a loss for JKL. JKL employed consultants to analyse the reasons for the failure of the acquisition. The consultants concluded that the failure had happened because: 1

JKL and LMN had very different corporate cultures and this had posed many difficulties, which were not resolved;

JKL and LMN had very different accounting and control systems and these had not been satisfactorily combined;

JKL had used an autocratic management style to manage the acquisition and this had been resented by the employees of both companies.

JKL has learnt that a French competitor company, XYZ, may shortly be up for sale at a price which would be very attractive to JKL. XYZ has a very good reputation in its domestic market for all aspects of its operations and its acquisition would offer JKL the opportunity to widen its skill set. None of JKL's staff speaks fluent French or is able to correspond in French. Requirement Discuss, in the context of JKL, the respective advantages and disadvantages of pursuing a strategy of expansion by:

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(a)

Organic growth

(b)

Acquisition

Answer to Interactive question 2 (a)

Organic growth

Advantages Low risk – Organic growth is generally considered to involve less risk than making an acquisition, and JKL's past experience of its failed acquisition illustrates the risk involved in growing externally. Expanding through organic growth means that JKL can exploit its own strengths whilst maintaining its existing style of management and corporate culture. Also, JKL will not face problems of having to integrate operating systems between different companies. Growth in stages – JKL is a small company and so may only have limited resources. Organic growth is likely to be less onerous on its cash flow than making an acquisition. Organic growth can be managed gradually or in stages, whereas to make an acquisition JKL is likely to have to commit a large amount of funds in one go. Disadvantages Speed of growth – It is likely to take longer for a firm to grow organically, than if it acquires another firm. Organic growth is often achieved by a company reinvesting its profits into its growth. However, this means the speed of growth will be restricted by the level of profits available for reinvestment, and this could be a particular issue for JKL as is it is still a small company. Nature of growth – Organic growth is most suited to situations where a company is growing gradually, and using its existing markets. However, in this case, JKL is looking to break into a new market – in a foreign country (France) – and this represents a more significant change in JKL's strategy. Access – As France is a new market for JKL, it is likely to lack the access to key suppliers and customers that established competitors will already have there. Moreover, none of JKL's staff speak fluent French, which could make it harder to establish contacts in the country. (b) Acquisition In many ways, the advantages and disadvantages of making an acquisition can be seen as a mirror image of those for organic growth: Advantages Speed of growth – Making an acquisition would allow JKL to enter a new market (France) much more quickly than by growing organically. It may even allow JKL to gain access to a market that would otherwise be unattainable (given the absence of any customer contracts, and weak linguistic skills). Acquiring skills – XYZ has a very good reputation in France, and acquisition will offer JKL the opportunity to widen its skill set. One of the criticisms of acquisitions is often that they benefit the company being acquired more than the company making the acquisition. However, in this case, XYZ's reputation and skill set look like it could be valuable for JKL to acquire. Disadvantages Risk – Acquisitions are likely to involve greater risk than organic growth, in particular with respect to the way the post-acquisition integration is managed. Post-integration issues – JKL's experience has highlighted the potential problems involved in trying to integrate different cultures and systems. There could be clashes if the culture and management style of the acquired company is different to the acquiring one, and the likelihood of this happening could be increased by the fact that the company being acquired is in a foreign country. Post-integration problems could mean that the anticipated benefits of the acquisition are not actually realised.

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Interactive question 3: Car manufacturer

[Difficulty level: Intermediate]

Danley Ltd is a car manufacturing company. It commenced business forty years ago and is currently organised along divisional lines. An outline organisation chart is shown below:

Board

Sports cars division

Small and family cars division P

M Pe A

Executive cars division Pu

M Pe A

Key P

Production

Locations

Marketing

Small and family

Luton

Personnel

Sports

Bristol

Accounting

Executive

Newcastle

Purchasing

The company is very keen to cut costs and improve profits before being floated on the Stock Exchange in 20X5. The current organisation structure owes much to history, reflecting the purchase of the sports car and executive car businesses in the past. Each division uses the same suppliers of components for cars and has the same accounting system. Both the small and family cars division and the sports cars division use production line systems, whereas the executive cars division uses a small batch production system. Money is available for investment in new production systems. The following comments have been made to you: 'Because of the slow production system we use where hold-ups between departments occur regularly, we only make two types of executive car, yet we sell all we can make. The marketing department feels that if we could make more types of car, including minor variations around a basic type, we could sell more. I must say that most of my workers seem to get rather bored making the same two cars.' Richard Ingram (Managing director, Danley Ltd) 'My department has been arguing for some time that we're missing out on cost savings by having three purchasing functions. All purchasing can be done by one function. Unfortunately, some of the cost savings will come from redundancies. The best people in the three functions should be put together to form one function in Luton.' Ray Pay (Purchasing manager, Small and family cars division) Requirement Recommend, with reasons, a revised organisation structure that would best suit the circumstances of the firm.

Answer to Interactive question 3 Existing structure The current organisation structure is divisional with the divisions based on type of product. With the decision to close down the sports car division and the necessity to increase profits, a revision of the structure is necessary. Proposed structure It is proposed that the existing divisional structure be maintained with two divisions â&#x20AC;&#x201C; small and family cars, and executive cars. There are two reasons for this. (1) Geography: The two divisions are based in Luton and Newcastle, making control more difficult if a functional structure were to be adopted (eg production under the control of one manager).

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(2) Product type: The products, although similar in some ways (ie cars), are sold in different markets requiring different skills in, for example, marketing and production. The proposed structure is shown below. Board

Production

Ce ntral acco unting

Central purcha sing

Small and family cars division

Executive division

Marketing

Personnel

Production

Marketing

Personnel

All purchasing and accounting functions are provided centrally, rather than having a repetition of functions within each division. The reasons for this are that the same suppliers are used by both divisions for components and both divisions have the same accounting systems. This should reduce costs. Each division has its own personnel function in order that it does not seem too remote from employees, which would be the case if, for example, a central personnel function were established in Luton or Newcastle.

Interactive question 4: Managing change

[Difficulty level: Easy]

After a difficult few years trading, a new chief executive, Brian Parsons, has been appointed to the board of Timbermate Ltd. A large divisionalised company, it specialises in the production of wood-based products, from plywood and chipboard, to kitchens and conservatory windows. In his initial press interview, Parsons stated that the costs incurred by the business were far too high and that efficiency and productivity were unacceptably low. He has made clear his intention to turn the business around. However, there have already been rumblings from the union to which most of the workers belong. They are not prepared to negotiate over wages or working conditions. Timbermate is a major importer of wood. Russian and Scandinavian joinery redwood, together with spruce from North America, make up a high percentage of imports. They also import from the Baltic States. Although sterling is strong against the dollar, it has been struggling lately against the other currencies. There have been signs that some of Timbermate's overseas suppliers are considering expanding into the UK directly. There has also been an increase in the popularity of UPVC alternatives in a number of Timbermate's core business areas. A number of operational issues need addressing. Recently, complaints about quality and product specification have become more common. Additionally, the delivery fleet has become less reliable and several key customers have been let down. However, many of the senior managers do not seem unduly concerned. They often talk of the timber crisis of 1992 and how these problems are just part of the nature of the industry. They rarely stay at their desks after 5pm. There is little in the way of knowledge sharing and it is unusual for staff in any one division to even know the names of staff in the others. One key pillar of Parson's plan is to introduce a fully integrated information system, covering (amongst others) stock control and e-procurement, computer aided design and manufacture, resource planning and management accounting. The system is to operate across all the divisions and allow potential crossselling and better customer management. Requirements (a) Analyse the forces for and against change at Timbermate Ltd. (b) Recommend to Brian Parsons how he might best manage the change process.

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Answer to Interactive question 4 (a)

Forces for and against change

Forces for change The forces for change in Timbermate appear to be both external and internal. External factors would include: 

Overseas competitors: Current suppliers may be able to undercut Timbermate if they set up their own operations in the UK. It will be essential for them to bring down their own cost base to survive.



Exchange rates: Weakening sterling will make imports more expensive, putting up Timbermate's costs still further.



Growth in plastic alternatives may reduce demand in a number of key areas. Unless they can fight back, share will be lost, reducing economies of scale and brand strength.

Internal factors would include: 

Leadership: Brian Parsons' determination to make the changes needed.



Customers: Increasing dissatisfaction with the current standard of service has already given rise to complaint and may, if not addressed, lead to loss of current customers and brand image.



Shareholders: A period of poor results cannot have been satisfactory for the shareholders which is presumably why they have appointed Parsons.

Forces against change 

Attitude of managers: The managers lack a sense of urgency and are therefore likely to resist any major change programme as unnecessarily disruptive.

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Attitude of staff: It is likely that the laid back culture permeates the whole organisation and staff may not understand the need for change. They will undoubtedly also be fearful for their jobs.



Unions have already expressed their intention to resist any changes to wages or working conditions. This could lead to walk-outs and strikes.

(b) Managing change A useful method of managing change was proposed by Lewin. This divides the process of change into three stages, unfreezing, changing and refreezing. Unfreezing The forces for change must be used to encourage the change, and the forces against it must be weakened. Methods might include: 

Carrying out a PEST analysis to identify the exact nature of the threats from the outside environment (issues such as deforestation may also have potential impact and have been overlooked).



These issues and their consequences should then be stressed to the managers. Forecasts of market performance (and its impact on bonuses) if no change is made should be communicated. Workshops to involve senior managers in the process may help them to appreciate the urgency of the situation.



Consultation and negotiation with the unions will have to be entered into. They will need to be persuaded of the importance of change now to protect jobs in the future.

Change The new information system must be introduced. Training in all aspects will be required – not just in how to use the system, but in its potential benefits, so that staff start to identify ways in which it could further improve business. 

New working practices will need to be introduced. Some processes may need re-engineering.



Greater collaboration between different divisions needs to be encouraged.

 Efforts must be made to change the culture of the organisation. Stories about problems being caused Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

by economic cycles that can be ignored, rituals such as leaving work on the dot, and an organisation structure so rigid that there is little or no horizontal communication suggests a 'jobs worth' paradigm where bureaucracy has taken on all its worst characteristics. Whilst education may start the process, it may be necessary to remove those managers who are unwilling or unable to change. Refreezing This is the process of trying to ensure planned changes become the norm. 

Reward systems should be developed to focus on issues such as cost management, customer satisfaction, productivity and innovation.



Continual training: The staff should be given regular training updates to deepen their understanding of the new system.



Communication: Interdivisional meetings should be scheduled on a monthly basis. The agenda should be collaborative problem solving and sharing of best practice. It may be that major customers should be provided with a single point of contact, who will then liaise with all divisions on their behalf (a matrix structure within the divisional one).

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.

Answer to Interactive question 5 (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 the 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 and how these can be implemented. (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.

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(iv) Review job design. Scientific management splits 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 reevaluation 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.

Interactive question 6: Levels of strategy

[Difficulty level: Easy]

Ganymede Co is a company selling widgets. The finance director says: 'We plan to issue more shares to raise money for new plant capacity â&#x20AC;&#x201C; we don't want loan finance â&#x20AC;&#x201C; which will enable us to compete better in the vital and growing widget markets of Latin America. After all, we've promised the shareholders 5% profit growth this year, and trading is tough.' Identify the corporate, business and functional strategies in the above statement.

Answer to Interactive question 6 The corporate objective is profit growth. The corporate strategy is the decision that this will be achieved by entering new markets, rather than producing new products. The business strategy suggests that those markets include Latin America. The operational or functional strategy involves the decision to invest in new plant (the production function) which is to be financed by shares rather than loans (the finance function).

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Strategic Business Management Chapter-4 Strategic Performance Management Interactive question 1: Levels of performance

[Difficulty level: Intermediate]

ST University (STU) is a higher educational institution in a European country, with approximately 8,500 full time students. It employs 360 academic staff and 450 other staff. STU currently receives a significant amount of government funding, which covers its capital budget (for buildings and equipment), teaching, and research. However, a recent visit from government appointed auditors has been critical of STU's performance in a number of areas: 

For the last two financial years, STU has operated at a deficit, with its expenditure being greater than its income.



The percentage of students dropping-out of courses is greatly in excess of the national average, as is the failure rate.



The number of student complaints was very high, and has been increasing over the past five years.



It has had an abnormally high level of staff turnover.



STU's internal control of cash receipts is weak, and in several areas there were discrepancies between the cash actually held and the expected amount.



It also had a large number of debtors (receivables), mainly ex-students, but was not taking any action to collect outstanding debts.



STU could not accurately produce a head-count of the number of students enrolled on its courses.



Overall, the quality of education provided by STU has been graded as 'Poor', which is the lowest possible rating.

Although STU's senior management team were disappointed at the level of the auditors' criticism overall, they were particularly surprised at some comments made about its computing facilities. Over the past two years, STU has made a major capital investment in upgrading all the computing facilities across the university. The auditors' report made reference to this investment, but pointed out that some department faculties are making much better use of them to promote learning than others. Requirement Discuss the extent to which the criticisms made about the University are strategic or operational.

Answer to Interactive question 1 Strategic criticisms – The criticisms are strategic if they relate to aspects of STU which are fundamental to the University and its objectives as a whole, and to its long-term ability to achieve those objectives. The criticism that the overall quality of education is 'Poor' appears to be a strategic criticism, given that one of STU's main purposes will be to provide the highest quality of education that it can to its students. Operational criticisms – By contrast, operational criticisms will relate to weaknesses or problems in the specific, day-to-day activities which STU carries out in order to achieve its financial or operating objectives. In this respect, the fact that STU could not produce a head-count of the number of students enrolled, and the fact that there were discrepancies in cash counts both seem to be operational criticisms. Tactical (or managerial) criticisms – However, a number of the criticisms seem to relate to issues between these two extremes, meaning they are best viewed as tactical or management issues. In other words, they relate to the way that resources are obtained or used to try to achieve STU's objectives as effectively and efficiently as possible.

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For example, the high numbers of students dropping out of their courses, or complaining, suggests that STU is not achieving its educational objectives as well as it could be. Equally, the fact that it is operating at a deficit, and it is not managing its debtors effectively suggests it is unlikely to be performing as well as it could be financially. Computing facilities â&#x20AC;&#x201C; The reference to computing facilities, and the management team's response to it, also gives an indication of the importance of strategic objectives being linked to the tactical and operational level. It is not clear whether STU's intention has simply been to provide more computing facilities or whether it has intended to use computer technologies to enable particular types of learning. However, if there was a particular educational strategy, it seems this has not been communicated clearly to those responsible for implementing it throughout the university (in the different academic departments, or the libraries for example) so consequently STU is not making the best use of the computing facilities it now has.

Interactive question 2: Hotel

[Difficulty level: Easy]

Suggest some suitable performance criteria for a hotel.

Answer to Interactive question 2 Financial performance: Profit and loss per department, variance analysis (eg expenditure on wages, power, catering, bedrooms and so on); revenue per available room. Competitive performance: Market share (room occupied on a total percentage of rooms available locally); competitor occupancy; competitor prices; bookings; vacant rooms as a proportion of the total attitudes of particular market segments. Resource utilisation: Occupancy rate (rooms occupied/rooms available) Quality of service: Complaints, results of room checks, results of questionnaires

Interactive question 3: Training college

[Difficulty level: Intermediate]

Southside College (SC) offers a wide range of courses aimed at vocational and professional qualifications. It has been operating for over 30 years now, and is well-established. It has been accredited as an approved training provider by a number of the qualification-awarding bodies. Although it competes with not-for-profit universities and colleges in some of its markets, SC is a limited company. Throughout its history, SC has always traded profitably. In recent years, there have been a number of new entrants into the professional qualifications market. However, to date, SC has managed to retain the largest market share. SC's students consistently achieve higher pass rates than the national averages for the qualifications they are sitting. SC has always concentrated on the quality of the teaching on its courses and the accompanying study materials. In recent years, however, a number of SC's competitors have begun to offer their students online tutorials to supplement their taught courses and these have proved very popular. SC's customer services team is receiving an increasing number of enquiries from prospective students about whether SC offers similar online tutorials. SC is developing its own online tutorials, but the development process is taking longer than had been hoped. SC's management team have never been convinced of the need for market research or customer research, arguing that the company has always achieved its sales targets and has always been profitable. Similarly, they point out that SC has established a good reputation and a position as a market leader, despite investing relatively little in marketing activities. Historically, SC has had a very low rate of employee turnover, but in recent years this has begun to increase as some of SC's tutors have left to join the new entrants in the market. This increase in employee turnover has concerned SC's management team. Accordingly, SC's management team are keen to identify the critical success factors which will enable SC to maintain its performance levels in the future.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Requirements (a)

Identify four Critical Success Factors that would be appropriate to use at SC.

(b)

For each Critical Success Factor you have identified, recommend, with reasons, two Key Performance Indicators which could be used to support that Critical Success Factor.

Answer to Interactive question 3 Part (a) Four critical success factors which would be appropriate to use at SC are: – – – –

Students' satisfaction with courses and learning materials Staff satisfaction Quality of teaching and materials Reputation and brand image

Part (b) KPIs for each of the CSFs could be: Student satisfaction Student satisfaction rating – At the end of a course, or at the end of a module within a course, students could be asked to complete a questionnaire rating their satisfaction with various aspects of the course (for example, the knowledge levels of the staff, the quality of the supporting materials, and the approachability/availability of staff to ask them questions). If students are happy with the level of tuition they receive, they are more likely to book on subsequent courses with SC than if they are dissatisfied with the courses or the materials. Similarly, they may share their experiences with their peers, in turn influencing their decision about where to book courses. Consequently, SC needs to ensure that student satisfaction levels are maintained as high as possible, particularly with the increasing number of competitors entering the professional qualifications market. In this respect, it is important that TDM knows how its students (its customers) feel about the services it offers so that it can improve any areas where it is not performing well. Percentage of modules with online tutorials available – The online tutorials being offered by SC's competitors appear to be very popular, and may lead students, who would otherwise have studied with SC, to choose one of its competitors instead. If SC cannot offer the online tutorials, it may lead students to think that the level of tuition and service they will receive from SC may be inferior to that offered by the competitors, even though this may not actually be case. Staff satisfaction Staff turnover – The quality of SC's teaching staff is vital in maintaining customer satisfaction, so it is important for SC to retain its best staff. SC has been experiencing an increasing rate of employee turnover, and this could be indicative of dissatisfaction amongst the staff. The management at SC should be keen to prevent this upward trend in staff turnover from increasing, particularly if SC's best staff are leaving to join competitor organisations. The increase in staff turnover is a problem in itself, but even more so if staff are joining direct competitors – making this a crucial measure to look at. Staff absenteeism – High levels of absence are likely to also indicate dissatisfaction among the staff. If absenteeism is rising, in conjunction with employee turnover, then there is a danger that the quality of service provided to students will suffer. For example, if an experienced lecturer phones in 'sick' at short notice, their classes may have to be taken by an inexperienced lecturer who is not such an expert in a subject, meaning the students could receive lower quality tuition. Quality of teaching and materials Market share – SC currently has the largest market share in its sector, despite carrying out relatively little marketing activity, and despite the number of new entrants joining the professional qualifications market in recent years. It will important for SC to monitor its market share, because the share of the market it can capture will have a direct impact on its revenues and consequently, on the wealth of its shareholders. Customers will only continue to use SC if they feel it is providing courses and materials that are high

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quality, and also which offer value for money. If its market share starts to fall, it may be an indication that the students feel SC's competitors are offering courses that are better value for money. Accreditations – SC's courses are accredited by a number of qualification-awarding bodies. SC has always concentrated on the quality of its courses and the accompanying study materials, so external accreditations will provide an independent corroboration of this quality. The quality of course tuition and study materials, in turn, is likely to feed back into the level of customer satisfaction with SC's courses, and the pass rates. The scenario does not indicate what the accrediting bodies think about the use of online tutorials. However, it is possible that, in time, providing some kind of online tutorial support may become one of the conditions for accreditation. Reputation and brand image Brand reputation – SC's management team have never seen the need for market and customer research, given that SC has managed to establish a good reputation and a market-leading position without doing so. However, given the entrance of new competitors into the market, SC will need to ensure that its brand reputation is maintained. This will be very important if SC is to ensure potential customers will choose to come on its courses rather than going to one of its competitors. Equally, SC will need to ensure that the lack of online tutorials does not damage its reputation; for example, if students think that SC is out of touch with current practices and the new developments in the industry. Pass rates – SC's students consistently achieve pass rates that are higher than the national average for the qualifications they are sitting. The level of pass rates achieved could be a key factor in students deciding where to study (or for employers deciding where to send their employees to study). If students, or their employers, think that selecting one college in preference to another can affect their chances of passing their exam, they are likely to select the college with the highest pass rate. Equally, if some of SC's rivals regularly achieve pass rates which are even further above the national average than SC's, the competitors could use this as a marketing message to try to gain market share from SC. Conversely, if SC continues to deliver higher pass rates than its competitors (despite not offering tutorials), this could be an equally powerful marketing message in SC's favour.

Interactive question 4: Reward systems

[Difficulty level: Intermediate]

Stayzee Hotels runs a chain of twenty hotels across the country. Each hotel is wholly owned by the company. Four years ago, the chain was bought by a group of investors who installed a new management team. The new management team introduced a new reward scheme for the hotel managers in an attempt to motivate managers to improve the revenue and profitability of the chain. The salary package devised for each manager comprised: 

A relatively low fixed salary.



A bonus payment based on high room occupancy rate. The occupancy rate is the percentage of usable hotel beds filled every night. Managers who achieved more than 90% occupancy rate receive a significant bonus. This target is aimed at keeping the hotel full.



A smaller bonus payment based on the net profit margin achieved by the hotel. This is aimed at improving the profitability of the hotel.

However, despite these incentives, the overall performance of the company is still declining. Managers are generally achieving a high occupancy rate but are largely failing to deliver higher net margins. It is also clear that some managers have achieved a high occupancy rate by declaring that some bedrooms were unfit for use or were being used as seminar rooms. Also, the pursuit of high occupancy and high net profit appears to be affecting the perceived image of the hotel chain. Once regarded as a mid-market hotel chain, the chain now seems to be perceived as a budget buy. A large percentage of bookings are received through the internet broker lastsecondhotels.com and their view of Stayzee's hotels are given below, together with some visitor quotes from their web site.

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Comments 'Great last minute bargain â&#x20AC;Ś very easy to get rooms at half the advertised rate' 'Full of school children on a trip â&#x20AC;Ś will not be using this chain again' 'No internet connections in the rooms or public areas, very disappointing' 'The bath was cracked and the windows were dirty. Cheap, but badly in need of a clean' 'Receptionists were very off-hand and unable to help. Did not seem to know much about the area surrounding the hotel' 'The staff were surly and uncommunicative. Much worse than last time we visited it. It used to be such a lovely hotel' 'Cheap, but don't eat there. The price for breakfast was extortionate' 'Cheap and cheerful but don't pay the full rate! Always lots of cheap beds available' 'Food was expensive and dull. The serving staff were uncommunicative, the cutlery was dirty and damaged. Staff were more interested in talking to each other than to the customers' 'Restaurant food was very expensive and of poor quality. The two nights I stayed there I was the only customer in the restaurant' Lastsecondhotels.com says: 'Value for money hotels with rooms always available. Perfect for those last minute breaks' Requirement Analyse the unanticipated consequences of the management reward scheme at Stayzee Hotels.

Answer to Interactive question 4 The main focus of the managers' reward scheme is on room occupancy rates. Therefore, the managers are concerned with simply filling rooms, rather than looking at other aspects of performance. They are using a variety of ways to fill rooms, but these are proving damaging to the hotel: Broker sales Elegant, one of the hotels in the Stayzee chain, advertises on online brokerage sites such as lastsecondhotels.com. These sites allow customers to compare prices, so in order to attract guests, Elegant has to offer low prices. The quote on the website, stating that it is a 'value for money hotel', indicates they are doing this. This suggests Elegant will now be making a lower profit margin than it historically did as a mid-market hotel. Customer comments on the lastsecondhotels.com website are also likely to encourage potential guests to wait until the last minute to book, in order to get bargains. If occupancy looks like it will be low, managers will reduce rates as illustrated by the quote, 'very easy to get rooms at half the advertised rate.' Again, this puts downward pressure on the hotels' profit margin. In addition to the lowering of prices, Elegant will also have to pay a commission for guests who have come to them via the brokerage website. This further reduces the profit margin it earns. Group sales Another way Elegant has been increasing occupancy rates is through offering packages for school groups. However, again the profit margins on these will be lower than those earned when the hotel catered for mid-market guests. The use of the hotels by school parties, along with the fact that a large percentage of its bookings are now received through lastsecondhotels.com, has led to a shift in customer perceptions. Elegant are now viewed as a budget hotel rather than a mid-market hotel, which has historically been its market position. The presence of school groups may deter mid-market, higher value customers. Manipulation of rates As the bonus is based on a percentage occupancy rate, the managers have an incentive to reduce the number of beds available for use, as well as get bookings for the rooms. Some managers are declaring rooms unfit for use. If the rooms are not unfit for use, this means the managers are artificially increasing

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their bonus while not generating any revenue by having guests staying in the room. Cutting costs As a result of room rates being offered at a discount, managers need to cut costs even more to make a profit on them. There is evidence that costs are being cut in a number of areas: 

Cheap ingredients: Customer feedback on the website noted that the restaurant food was poor quality, suggesting managers are trying to reduce costs by using cheaper ingredients in the restaurant.



Repairs and maintenance: Customer feedback on the website also noted that, 'The bath was cracked and the windows were dirty.' So it appears that managers are saving money but not arranging repairs when they are needed and by reducing how often the hotels are cleaned.



Low capital investment: Guests have commented that there were no internet connections in the rooms or public areas. This suggests that managers have preferred to save money rather than investing in their hotels. This illustrates a short term focus because it will deter guests in the future.



No investment in staff: Guests have also commented that the staff were not very helpful and were uncommunicative. Again, this suggests that either costs have been cut by hiring cheap, less competent staff, or by not giving staff proper training when they join the hotel. Either way, measures that have been designed to save costs, are leading to a decline in the service being offered to customers.



High prices on ancillary services: The scheme is also leading to inconsistencies in the hotel's strategic approach. Whilst managers are trying to cut costs in a number of areas, they are trying to boost profit by charging high prices on food. This has led to a reduction in demand as guests on cheap, last minute deals are less likely to want to dine in the restaurant, than the guest Elegant traditionally catered for. This is evidenced by the quote 'Cheap, but don't eat there. The price for breakfast was extortionate.'

The conflict between the high prices charged for meals and the poor quality food offered is indicative of a confused strategy. Ultimately, measures to cut cost have led to a decline in levels of customer service and perception of the hotel. However, this is unlikely to change as there is no incentive in the bonus scheme to improve customer service. The management reward scheme has entirely the wrong focus and has led to a severe decline in the reputation and performance of the hotels. Rather than rewarding occupancy rates, the scheme should focus on customer service, quality and providing a good experience for its customers.

Interactive question 5: Managers' performance

[Difficulty level: Intermediate]

TVW is a retail company that has a number of shops across the country in which it is situated. The managers of the individual TVW shops have little authority. Shop budgets are set centrally by the Finance Director and the senior management team, and shop managers are not consulted in the budget-setting process. Inventory purchasing is controlled by a central purchasing team, and brand marketing is controlled by a central marketing team. The head office also manages the rent agreements and other property costs for the shops. However, each shop has a small marketing budget of its own which it can use to run local promotions. TVW produces a standard list of selling prices for all the products it sells, although shop managers do have some scope to change prices, and can vary prices by up to 5% from this standard list. Shop managers also recruit and manage the staff within their shops. However, the wage rates they can offer their staff are fixed by head office, and are not negotiable. The shop managers are paid a basic salary with bonuses of up to 25%. However, in order for a manager to qualify for a bonus, his or her shop's profit has to be above budget. A number of the shop managers have recently complained about this, because they feel that the current remuneration scheme doesn't reflect the effort they are putting in. The manager of one of TVW's largest stores commented: 'The budget that was set was totally unrealistic in the current economic conditions. Although I have run several promotions, which were well received

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by my customers, there was no way I could achieve the sales figure in the budget. The budgeted sales figure for my shop was the same as last year, but this year the industry as a whole has seen a 10% fall in revenues.' The results for the manager's shop for the last year are as follows. These are the figures used as the basis for any bonus calculations: Actual Budget Variance £ £ £ Sales 261,000 287,000 –26,000 Cost of sales 104,400 124,000 –26,600 Gross profit 156,600 172,200 –15,600 Marketing 12,500 13,000 500 Staff costs (manager) 27,500 27,500 0 Part-time staff 36,500 40,000 3,500 Other running costs (eg rent, heat & light) 26,000 25,000 –1,000 Shop profit 54,100 66,700 –12,600 Requirement What are the problems with using this shop performance information as the basis for assessing the manager's performance?

Answer to Interactive question 5 Problems with using shop performance indicators as the basis for assessing shop manager's performance: Accountability – The shop manager should only be held responsible for those aspects of performance he or she can control. However, the branch information used does not appear to distinguish between the factors that the shop managers can control and those which they can't. Controllable and non-controllable costs – A number of non-controllable costs are currently included in the manager's performance assessment. In particular, the shop manager will have very little scope to control property costs, because the rental contract and other contracted costs (such as heat and light) are managed by the head office. The shop managers may have some control over the amount of heat and light that are used in their shops, but not over the unit prices paid for these utilities. Similarly the managers can't control their own wages. However, it is reasonable to classify the part-time staff costs as controllable. The managers manage the staffing for their shops, and so they could save on part-time staff costs by working longer hours themselves. Consequently, a fairer way of assessing the shop managers' performance would be to distinguish costs into two groups: controllable (marketing; part-time staff) and non-controllable (managers' wages; property costs). Budgets – Another problem with TVW's current performance management process is its budgeting process. If the manager's performance is assessed by comparing actual performance to budget, then it is important that the budgets are realistic and achievable. However, the original sales budgeted (which showed the same figure as the previous year) seems unrealistic, given that there has been a 10% fall in sales across the industry as a whole. Consequently, it would be useful to break down the overall profit variance (£15,600) into a planning variance (which adjusts for the 10% drop in industry sales) and an operational variance (showing the variance in the shop's own performance after adjusting for the 10%): £ Planning variance 287,000 Original sales (1) Revenue variance due to economic conditions (10%) (2) 28,700 (A) 17,220 Planning variance (Gross margin 60%) (A) Operational variance Actual sales Revised budgeted sales

Operational variance (Gross margin 60%)

(1) – (2)

261,000 258,300 2,700

(F)

1,620

(A)

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The operational variance more accurately reflects the shop manager's work in promoting sales, and here we can see that the manager's efforts have actually reduced the fall in gross profit by £1,620. The overall gross profit variance (of £15,600, adverse) reflects an adverse planning variance of £17,220 partially offset by a favourable operational variance of £1,620. Controllable profit – Following on from this, we could suggest that TVW should show a controllable profit for each shop, as well as the overall shop profit. The shop manager's performance (and hence their eligibility for any bonuses payments) should then be assessed on the controllable profit performance of their shop only. If we apply this logic to the manager's shop, then instead of the manager facing an adverse variance of £12,600, they would have achieved a positive variance of £5,620, and would therefore have been entitled to a bonus. This helps explain why the manager is so unhappy about the current way performance is being measured:

Original variance (£)

–12,600

Add back: Gross profit planning variance (£) Manager's wages (£) Property costs (£)

17,220 – 1,000 5,620

Discounting – One area where the managers do have a degree of autonomy is in setting prices, because they can vary prices by up to 5% from the standard price list; for example, to reduce prices of a particular product to boost sales of it. Therefore, this is an area of the manager's performance which TVW could justifiably measure; for example, by looking at the sales price and volume for individual product lines, and then looking at the impact of any promotions on gross profit. However, in this case, it appears that the manager has not made any significant use of this authority because the actual gross margin percentage achieved for the year (60%) has remained constant with the budgeted margin of 60%. If the manager had applied any price discounts, this would have led to a reduction in the margin percentage.

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Strategic Business Management Chapter-5 Strategic Marketing & Brand Management Interactive question 1: Competitor analysis

[Difficulty level: Intermediate]

CCC is a manufacturer of specialist portable communications equipment, which is designed for use in hazardous and dangerous conditions. Developments of new technology in recent years, such as wireless mobile telephony, infra-red thermal imaging, and global positioning have allowed CCC to create new products. The market for such equipment has grown significantly over the past five years. The customer base includes fire services, oil and chemical companies and the government. CCC now recognises that, during this period of rapid growth, the market has attracted a number of new entrants and may even be reaching a level of overcapacity. The directors feel that they do not know as much as they should about the existing, and new, companies in the industry. The market is now maturing and, although CCC is managing to maintain its margins and leading market share (45%), it is likely that the characteristics of the industry will change. Requirement Discuss the advantages for CCC of carrying out competitor analysis.

Answer to Interactive question 1 Competitors are one of the main elements in a company's immediate task environment and it is essential that CCC should acquire as much information as possible about them, especially as the market is now maturing. The benefits of undertaking competitor analysis, monitoring and analysing information about competitors are as follows: Understand the basis of competitive advantage If CCC analyses its value chain compared to its competitors', it can assess the ways in which each firm adds value for its customers. Given that the market is becoming increasingly competitive, such analysis will be useful for CCC in determining whether its current competitive strategy is sustainable, and which of its processes will need improving to enhance competitiveness. Understand competitors' strategies If CCC analyses its competitors' current strategies and how they have developed over time, this may give it some insight into its competitors' future strategies. This could help CCC plan how to compete and preserve its market position, rather than simply having to react to its competitors' actions. Identify risk of new entrants As well as using it to analyse current competitors, CCC can also use competitor analysis to identify possible new entrants into the specialist communications equipment market. Given that the market is reaching a level of overcapacity, this could be useful to CCC to assess how barriers to entry could be strengthened to deter the potential new entrants from joining the industry. Develop future strategies CCC can use the information it finds out about its competitors to help determine its own strategy. CCC is currently the market leader and so it needs to develop strategies to maintain its market share in a changing and increasingly competitive industry. For example, could CCC afford to reduce prices in order to increase market share, or are competitors likely to respond in kind, meaning CCC doesn't increase market share, but instead both CCC and its rivals are left with lower margins? Are there certain competitors who are likely to be more aggressive than others, in which case should CCC target growth in specific sectors of the market to avoid those competitors? Competitor analysis could help answer these questions and thereby help CCC determine its business strategy. Improve forecasting By improving CCC's understanding of its competitors' behaviour and how it will affect CCC's sales, competitor analysis will also enable CCC to improve its forecasts and business plans.

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Interactive question 2: Market segmentation

[Difficulty level: Intermediate]

Lucy Brown is a designer and manufacturer of knitwear clothing. She has based her designs on ethnic patterns, inspired by clothing she has seen in Central Asia. She has sourced her products both from these Asian regions â&#x20AC;&#x201C; Uzbekistan and Kazakhstan â&#x20AC;&#x201C; as well as from small factories in parts of the United Kingdom. Her products, though stylish, are relatively cheap, but her marketing strategy is totally passive. She has a website and most of her sales are reactive, responding to orders over the internet. The resultant sales and, in particular, profits have been disappointing and so she has hired a marketing consultant to give her some advice. The following are extracts from the consultant's report. 'Your product, although distinctive, is insufficiently unique. The designs have no patents nor copyright and because the production technology is so simple and inexpensive, there are few barriers to entry. Competition is all too prevalent. Your promotion is too general. It focuses on no specific market. By relying on the internet, your advertising is rather indiscriminate and you have failed to create a loyal following and your image is diffused with little opportunity for building brand awareness. There is a failure within distribution. Most consumers wish to see, handle or try on products before making a purchase, particularly if the products do not already have a well-established reputation and/or a brand name. In your case, the only exposure your products have is via the world-wide web. Your pricing structure is too cost-based. You are able to source your products cheaply but your margins are too low to provide you with the necessary capital to reinvest if the business is to develop profitably in the future. 'You have failed to establish yourself in the market place as a dominant player. Too many of your business decisions are reactive and often too late to have adequate impact. You are following market trends and not attempting to lead them.' Lucy is naturally disturbed by the criticisms which this report has levelled at her company's operations and has decided that she must be more positive in her actions. In particular, she has decided that her marketing efforts must be more focused and she must pursue more proactively her competitive activities. Requirement In order to focus her company's marketing efforts more precisely, Lucy has decided to segment the market for knitwear products. Suggest potential bases for segmenting this knitwear market and discuss the benefits which a more focused segmentation could bring to the company.

Answer to Interactive question 2 Segmentation would be Lucy's first step towards a more active relationship with her existing and potential customers. If she knew who they were in more detail, she could design her market offering in a way that would improve her own efficiency while also providing increased customer satisfaction. The simplest form of segmentation is probably geographical. Lucy's potential market could be very simply split into domestic and overseas, for instance. Indeed, she probably does this already, in a sense, since she must make appropriate arrangements for the extra complications of shipping to foreign customers. Geographical segmentation would be necessary if Lucy wished to sell in other ways than via the internet, perhaps by issuing catalogues, since the styles of knitwear offered would have to appeal to varying local tastes. Geographical segmentation becomes much more useful when it is combined with demographic information. This geo-demographic segmentation would enable Lucy to target segments defined by such variables as place, age, sex, income and social class. A consideration of these variables might, for instance, lead her to concentrate her marketing effort on older, affluent people in specific metropolitan areas. This would have immediate implications for design, quality, promotion, price and distribution. Psychographic segmentation analyses the market according to personality and lifestyle. This might be difficult for Lucy to use, but if she could, perhaps by continuing to employ her marketing consultant, it might offer important advantages in the areas of design and promotion in particular. A further segmentation variable is customer behaviour. This includes such matters as sensitivity to changes in the marketing mix variables, purchase frequency and magnitude and how the product is used. This approach might be useful to Lucy. For example, she might find that some of her designs are frequently bought by women for their partners or families. This might have important implications for design and sizing. The benefit of accurate market segmentation is that it permits a more precise specification of the marketing mix variables, so that they are shaped to conform to the needs of the target segment or segments.

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C H A P T E R

Product. Different segments will probably require different products. When the size of each segment, its product requirements and their costs are known, it will be possible both to estimate the most profitable segment to attack and to specify fairly precisely the nature of the products needed to do so. Lucy might find, for instance, that she needed to adjust her designs to make her range more recognisable and coherent. Price. Pricing decisions are fundamental to trade and very difficult to take. It is very easy to set prices too high, so that customers are put off, or too low, so that potential profit is lost. The problem is compounded by the complex messages about quality, exclusivity and value that can be sent by price levels and changes to them. At the moment, Lucy's products are relatively cheap and this is preventing her from generating the funds needed for expansion: she may find that she can charge more for some of her knitwear. Promotion. Lucy's consultant has identified her promotion efforts as insufficiently focused, which has led to a diffuse image and little brand awareness. Detailed knowledge of the characteristics of her target segments will allow Lucy to develop the accuracy of her promotion. She may find, for example, that a large market exists that is unwilling to use the internet at all, and so remains in ignorance of her products. Place. Lucy's distribution is currently largely via her website. This limits her potential market to those who are both confident in the use of computers and interested in original design knitwear. It is likely that a much larger market could be served through a more traditional approach using prestige clothing outlets. This could be established by careful consideration of the results of the segmentation exercise.

Interactive question 3: Customer profitability

[Difficulty level: Intermediate]

SportyTech (ST) is a company that supplies high specification parts that major international motor manufacturers use in the higher performance versions of their road cars. ST produces a standard range of high-performance parts, including brake sets, turbos and other engine components that can be customised to suit the requirements of a particular car, if required. Total turnover for the coming financial year is forecast to be £135m. The standard pricing policy of ST is based on a simple calculation that delivers a gross profit of 18% excluding any discounts awarded or refunds for faulty goods (ie a part which costs £492 to make would be priced at £600). Faulty goods returned have to be replaced, with the returns scrapped and no resale or scrap value achieved. ST has a fairly stable business, underpinned by three major customers but has become increasingly concerned as it has seen its profitability decline. In response to this, the company paid a management consultant £150,000 for advice on how to arrest this decline in profitability. The main finding of the consultant's report was that the cost of servicing the major customers is much higher than ST had realised. The recommendation of the report was to either cease to supply these customers or preferably, to persuade them to reduce the incidence of cost generating activities (see below). Extracts from the consultant's report: Forecast for coming financial year Sales revenues £m (before discounts/returns) Average discount given Sales visits made Purchase orders processed Customisations requested Faulty products returned (% of sales made) Cost generating activities Making a sales visit Processing a purchase order Design and tooling a customised part

FMC 28 8% 12 48 5 2.1

GMC 14 7% 10 57 7 1.8

HMC 17 5% 14 46 33 3.3 Cost (£) 750 175 26,175

Requirement Calculate the forecast net customer account profitability of each of the three major customers of ST.

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Answer to Interactive question 3 Calculations Sales revenues £m (before discounts/returns)

FMC

GMC

HMC

28,000,000

14,000,000

17,000,000

Forecast margin @ 18%

5,040,000

2,520,000

3,060,000

Discounts

2,240,000

980,000

850,000

9,000

7,500

10,500

Sales visits costs Purchase order costs Customisation cost Replacing Faulty goods (sales returns @ 82% Cost of sales) Actual margin Actual margin %

Interactive question 4: Brand marketing

8,400

9,975

8,050

130,875

183,225

863,775

482,160

206,640

460,020

2,169,565

1,132,660

867,655

7.7%

8.1%

5.1%

[Difficulty level: Easy]

The CPH Group comprises four companies, operating in very different market sectors.    

CPH Construction Ltd (Construction) CPH Engineering Ltd (Engineering) CPH Transport Ltd (Transport) CPH Gaming Ltd (Gaming)

Each of the companies has its own management team, headed by a managing director. Recently, the managing director of CPH Gaming has come under increasing pressure from the board of the CPH Group to justify the comparatively large outlay the business incurs on marketing and advertising, compared to the other three companies. The managing director maintains that Gaming relies more heavily on its brand than the other CPH companies and as such, must invest a much higher proportion of its turnover into marketing and promotion. Requirement Describe how the CEO of Gaming could substantiate assertions about the level of brand investment his business requires.

Answer to Interactive question 4 1

Where there is no physical product, the service may only be differentiated by brand. Whereas construction and engineering have tangible products, gaming is a service business.

In a competitive market, building brand loyalty may help retain customers. It is likely to be very easy for customers to switch between different gaming companies (online) so continuing promotions to retain 'share of mind' are likely to be very important for gaming companies.

A strong brand reduces the risk when launching associated/new services. The gaming industry is likely to be at an earlier stage in its life cycle than the others, so could offer more opportunities for growth (eg through offering new products/services.) A strong brand could help improve CPH's chances of success when introducing any such new products or services.

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Strategic Business Management Chapter-6 Corporate Governance Interactive question 1: Recruitment of non-executives

[Difficulty level: Intermediate]

QP is a major quoted company that manufactures industrial chemicals. The company's board comprises a chief executive and five other executive directors, a non-executive chairman and four non-executive directors. Two of the non-executive directors have served on QP's board for five years. The company has a policy of asking non-executive directors to stand down after six years and so the chairman has established a nominations committee to start the process of selecting replacements. Three replacements have been suggested to the nominations committee. The nominees are: ď&#x201A;ˇ

Adrian, who is on the main board of City Pensions, an investment institution which owns 6% of QP's equity. Adrian has worked for City Pensions for 15 years and has always worked in the management of the company's investments, initially as an analyst and more recently, as director in charge of investments. Before working for City Pensions, Adrian was an investment analyst with an insurance company for 15 years.

ď&#x201A;ˇ

Nicole, who is an ICAEW member, is about to retire from full-time work. Nicole has had a varied career, including acting as a management accountant with an engineering company and finally, as a senior accountant with a commercial bank. Nicole was promoted to the bank's board and has been finance director for seven years.

ď&#x201A;ˇ

Helen, who is a former politician. After a brief career as a journalist, Helen became a member of parliament at the age of 40. After spending 20 years as a politician, including several years as a government minister, Helen has recently retired from politics at the age of 60. Helen already holds two other non-executive directorships in companies that do not compete with, and are not in any way connected to QP.

Requirement Evaluate the suitability of each of the three nominees. Your answer should include arguments for and against each of the nominees.

Answer to Interactive question 1 Adrian Arguments for appointment Knowledge of QP Adrian has exceptionally good long-term knowledge of QP through his involvement with the investment over 15 years. Adrian's knowledge should mean that he can provide expert scrutiny of the performance of executive management. Knowledge of industry As a result of Adrian's long experience as investment analyst, he should have wide knowledge of the industry and economy as well as of QP, although he has not worked in the manufacturing sector. This should mean that he is able to make an informed contribution to board discussions about strategy, and have the weight of knowledge to be able to challenge effectively the plans of executive directors from the perspective of an institutional investor. Arguments against appointment Independence As the representative of a significant institutional investor in QP, Adrian cannot be regarded as an independent non-executive director under governance best practice such as the UK Corporate Governance Code. Adrian has perhaps been suggested because current board members believe, based on their previous dealings with him, that he will be reluctant to challenge their strategies.

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Also Adrian does not appear to be stepping down from the City Pensions' board. If he does not do so, his duties to promote the best interests of City Pensions and QP may conflict. Other significant investors may consider that Adrian's appointment would give City Pensions a privileged position and demand board representation themselves. Lack of fresh perspective Adrian may not be able to bring a fresh perspective to the affairs of QP. As City Pensions' representative, Adrian already has had chances to raise concerns about QP's strategies or how QP is being governed. Possibly, Adrian is unlikely to raise new issues if appointed as a director. Recommendation Adrian's connections mean that he cannot be regarded as an independent non-executive director. This would limit his contribution to the board, as he could not serve on audit or remuneration committees under governance best practice. The board would be some way short of fulfilling the requirement of governance best practice that at least half the board should be independent nonexecutive directors. For this reason, Adrian should not be appointed. Nicole Arguments for appointment ICAEW membership Nicole's membership of ICAEW means that she is subject to ICAEW's ethical code. This should guarantee that she brings to the board essential qualities such as integrity and objectivity. Adherence to ICAEW's continuing professional education requirements will obligate Nicole to make sure that she has the relevant, up-to-date, knowledge needed to contribute effectively as a director. Wide experience Nicole can bring a fresh perspective to the board, based on experience of a number of different sectors. Her experience as finance director on the bank's board, together with ICAEW membership, means that Nicole has the recent financial knowledge, highlighted by governance reports as a requirement for the audit committee. Nicole will also bring contacts in the banking sector, which may be useful when QP is dealing with major lenders. Arguments against appointment Independence Nicole is about to retire. We are not given details of any other sources of income that Nicole has, although Nicole probably has a pension from the bank. Nicole's fees as non-executive director may be a significant proportion of her income going forward. There is the risk that Nicole may be less willing to challenge and upset other directors and jeopardise this source of income. Lack of previous involvement in sector Nicole does not appear to have had previous involvement in this specific sector. Nicole will need to have a more extensive induction programme than Adrian would. Recommendation Nicole should qualify as an independent non-executive director. The benefits that Nicole's ICAEW membership and wider experience will bring should mean that Nicole is offered a directorship. Her role should include chairing the audit committee.

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Helen Arguments for appointment Political knowledge Helen should be able to bring expert knowledge of the political and legal environment to the Board, helping the board assess risks in this area. QP may be able to use the political contacts that Helen has, and use her expertise to lobby against damaging changes to legislation. Other directorships Helen is currently on two other boards. The perspective she gains from serving on these boards may inform her contribution to QP's board. Helen may be able to benchmark what QP is doing against practice elsewhere. She should also have gone through an induction process at these companies and be aware of responsibilities in law and under governance best practice. Arguments against appointment Time Helen is already a director of two other companies and this may limit the time that can be spent as a director of QP to an unacceptably low level. Lack of previous involvement in sector Helen does not appear to have had any previous experience in the chemical sector, unlike Adrian. Helen also appears to lack Nicole's financial knowledge. Recommendation Helen should be considered for one of the vacant directorships. However, before Helen is appointed, the board should obtain guarantees that she will spend sufficient time on QP's affairs.

Interactive question 2: Audit committee

[Difficulty level: Intermediate]

KPN is a major hotel group that will shortly be seeking a flotation on the stock market. At present, the company does not have any non-executive directors or an audit committee. One of KPN's most significant local competitors, NN has recently collapsed; some of the competitor's shareholders have raised issues about the ineffectiveness of the non-executive directors and in particular, the failure of the audit committee to deal with major accounting problems. As this news story is topical, the directors of KPN want to understand why NN's non-executive directors might have failed to exercise sufficient supervision, and how the audit committee that KPN will be required to establish can function effectively. Requirements (a) Explain the limitations of depending on non-executive directors to improve corporate governance. Explain how the effectiveness of audit committees

Answer to Interactive question 2 (a)

The effectiveness of non-executive directors may be limited by the following factors. Having the same perspective as executive directors The corporate governance reports stress the importance of non-executive directors possessing independent judgement and being appointed by a nomination committee. However, the nomination committee may restrict its search to directors who will 'fit in' with the rest of the board, and may be unwilling to recruit from a diversity of backgrounds, for example stakeholders such as employees. In addition, many non-executive directors will only agree to serve on the boards of companies if they admire the company's chairman or its way of operating. Lack of independence In many companies, non-executive directors have been appointed through business or social contacts with directors. It may be difficult to find non-executive directors who fulfill the independence requirements of the corporate governance reports or freedom from any relationship that compromises independence.

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Lack of business knowledge This can be the other side of the coin to the problem of lack of independence. Potential nonexecutive directors who have good knowledge of the business and industry may have gained that knowledge through links with the company in the past. Lack of human resource management Limited time may mean that non-executive directors do not have proper induction into the company, nor proper updating and refreshment of their skills and knowledge of the company. Their performance may not be appraised regularly; it should form part of an annual appraisal of the board's activities. Limited time The most knowledgeable and effective non-executive directors are likely to have other significant demands on their time. As directors, they have to fulfil certain legal requirements. Apart from their contributions to the main board, they will also probably spend time at meetings of board committees such as the audit and remuneration committees. The limited involvement resulting from the lack of time may limit their ability to contribute to board meetings, since they are unable to obtain a broad enough picture of what is happening throughout the organisation. Information available Non-executive directors' contribution will also depend on the information that is readily available to them as directors. This will be influenced by the quality of the organisation's information systems, and also the willingness of executive directors to supply information about their activities. Role of board The corporate governance reports stress the importance of non-executive directors being involved in strategic decisions. If non-executive directors are involved in formulating strategy, they can fulfil their key role, that of warning of potential problems and hence, preventing trouble. However, board meetings may focus almost entirely on current operational matters and shortterm operational results. In addition, a focus at board meetings on short-term results may mean that non-executive directors assess the performance of the organisation using short-term indicators and its management, and do not focus on longer-term issues, such as changes in product mix or re-engineering of the organisation's processes. Inability to resist pressures Non-executive directors have limited options when faced with a united group of executive directors who are determined to push through a policy with which the non-executive directors disagree. Their ultimate weapon is resignation, but if all or a number of non-executive directors resign, they may precipitate a crisis of confidence in the company. Alternatively, they can remain in office, but then if serious problems arise, the executive directors may have to depart from the board, leaving the non-executive directors with the responsibility for 'picking up the pieces'. (b)

The effectiveness of audit committees could be improved in the following ways. Appointment requirements Appointments could be recommended by a vote at the annual general meeting. Alternatively, certain stakeholders, for example, employees could have the right to appoint a member. These measures might improve the independence of committee members. The term of office of committee members could be limited to ensure the committee retained a fresh perspective. When nominating potential members, the selection process could be biased towards recruiting members with financial accounting experience, or experience of large control systems. Members who have accountancy experience will be able to question the judgements that management make when preparing accountancy information.

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Expansion of responsibilities There are various ways in which the committee's remit might be expanded. They could have responsibility for reviewing compliance with laws and regulations such as environmental legislation or ethical codes. Certain transactions could also be referred automatically to them for review. Internal audit As a major function of many audit committees is to oversee the role of internal audit, it follows that a more effective internal audit function will lead to more effective operation of the audit committee, by improving the quality of information that the audit committee review. Statutory backing Audit committees may become more effective if their establishment by certain organisations is made compulsory. The recommendations of internal audit will also be reinforced by stricter accounting and auditing standards. Improvement in operations Changes that might improve the way audit committees operate include the following. (i)

Having clear terms of reference, agreed by the board

(ii)

Establishment of an annual plan, giving details of the areas on which the committee will focus

(iii) Establishment of standards for the frequency of, and form of reporting to, the main board (iv) Regular review of the effectiveness of the audit committee, including whether its recent work has been correctly focused.

Interactive question 3: Internal control review (a)

[Difficulty level: Intermediate]

What sort of information would help the board carry out an effective review of internal control?

(b) What sort of employee attitudes would help or hinder an effective review of internal control?

Answer to Interactive question 3 (a)

The UK's Institute of Internal Auditors suggests that the board needs to consider the following information in order to carry out an effective review. (i)

The organisation's code of business conduct

(ii)

Confirmation that line managers are clear as to their objectives

(iii) The overall results of a control self assessment process by line management or staff (iv) Letters of representation ('comfort letters') on internal control from line management (confirmations about the operation of systems or specific transactions) (v)

A report from the audit committee on the key procedures that are designed to provide effective internal control

(vi) Reports from internal audit on audits performed (vii) The audit committee's assessment of the effectiveness of internal audit (viii) Reports on special reviews commissioned by the audit committee from internal audit or others (ix) Internal audit's overall summary opinion on internal control (x)

The external auditors' report on weaknesses in the accounting and internal control systems and other matters, including errors, identified during the audit

(xi) Intelligence gathered by board members during the year (xii) A report on avoidable losses by the finance director

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(xiii) A report on any material developments since the reporting date and up to the present (xiv) The board's proposed wording of the internal control report for publication (b)

The following employee attitudes will be relevant. Response to management behaviour Employees may not take controls with the same degree of seriousness that management does. They will take into account how strictly controls are applied by senior managers, whether senior managers override controls, and whether follow-up action is taken by management if control weaknesses are identified. Realism of controls If employees see controls as unrealistic because, for example, there is insufficient time to operate them, they may not take management review of controls seriously. Employee collusion If employees do collude, the evidence available to management may be undermined. Collusion may not necessarily be hiding fraud. It could be a shared intention to thwart what is seen as unnecessary bureaucracy. The fact, for example, that there are two signatures on a document does not necessarily mean that it has been checked properly. Focus on certain controls If a lot of emphasis is placed on certain controls, reports on which the annual review is based will stress the operation of those controls and provide less detail of other controls that are also significant. Prioritisation Many employees may feel that controls are bureaucracy and, as such, interfere with more important day-to-day work. This may mean, for example, that controls are not operated when they should be, but some time later, and so the evidence the annual review is relying on may not be as strong as it appears. Reliance on memory Some controls may be dependent on knowledge held in the mind of employees. The employees concerned may be happy about this because it reinforces their position, but it can lead to a lack of clarity about whether controls have operated; and also inconsistency and misunderstanding, when controls depend on the attitudes of the person operating them.

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Strategic Business Management Chapter-7 Business Risk Management 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.)

Answer to Interactive question 1 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.



Impulse buying – A large proportion of confectionery purchases are made on impulse. If economic changes reduced the amount of impulse buying – due to consumers having less money to spend – this could have a major effect on profits.



Supply of raw materials – Sugar is a major raw material used in the manufacture of confectionery 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.



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.

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.

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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, briefly recommend ways in which these risks can be controlled and briefly describe the assurance work that VSYS should carry out on potential suppliers.

Answer to Interactive question 2 Risks 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 the processing and payment of final salaries. 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. Assurance work

460 520



Review financial statements of supplier for evidence of financial health



Discuss with supplier's directors their future plans and forecasts, to see if there is a possibility of future financial problems or whether the supplier is at risk of overtrading

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com



Review ethical code, if supplier has one, and ascertain how the supplier ensures adherence to this code



Review evidence of supplier's employment terms and, if feasible, inspect suppliers' factories for evidence of working conditions



Search for evidence in media or on the internet of whether the supplier has been accused of poor employment practices or unethical behaviour



Review terms of contract and assess strength of guarantees and effectiveness of remedies if supplier fails to perform in accordance with contract



Ensure that contract includes sufficient protection for VSYS's intellectual property



Obtain evidence of supplier's capacity and assess whether supplier may have trouble meeting orders, particularly during periods of peak demand



Examine samples of production to see if supplier reaches required quality standards

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 any potential risk strategies that could be adopted by the airline's management.

Answer to Interactive question 3 

Risk avoidance –



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, establish contacts with a local coach company to ensure transport to hotels if passengers have to spend another night in the country before the plane can take off; negotiate 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 –

460

The airline could abandon plans to offer services to this country

Accept the possibility that airports may not be properly maintained or planes may be grounded, and any accompanying costs

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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. A retail customer of LP's has recently brought legal proceedings against LP for loss of business through one of the chemicals used to waterproof some garments releasing toxic fumes after prolonged exposure to sunlight. The case is due to come to court in two weeks' time but LP's lawyers think that it could be a very lengthy case and believe that LP will eventually lose it. LP's board has made a number of estimates. The directors believe that the best outcome for LP will be damages of ÂŁ300,000 payable in one year's time. The worst possible outcome would be for the case to continue for three years, in which case the estimate of damages and costs is ÂŁ2,500,000, payable in three years' time. A further estimate, between these two extremes, is that damages of ÂŁ900,000 will be payable in two years' time. Management's estimates of probabilities are best outcome 30%, worst case outcome 10% and middle ground outcome 60%. No provision nor any disclosure has been made for this court case in the draft financial statements that are due to be finalised over the next few weeks. Prior to the legal claim being made, LP had already stopped using the chemical in its manufacturing process. Requirements (a)

Explain the business risks facing LP and briefly describe how these risks can be managed.

(b)

Explain how the possible losses arising from the legal claim should be dealt with in LP's financial statements.

Answer to Interactive question 4 Part (a) Business risks These are risks that LP's performance could be better or worse than expected. (i)

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 and 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 the website is capable of coping with anticipated demand. Once the website is operational, LP should monitor the level of sales generated by obtaining customer feedback through the site, and comparing sales generated with the costs of keeping the website updated.

(ii) Product obsolescence 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 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.

460 520

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LP should monitor the performance of products in detail, and look for evidence of falling sales and other signs 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. (iii) New competition The new company PVO appears to be aggressively attacking LP's market place position. 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 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. Part (b) Provision According to IAS 37, Provisions, Contingent Liabilities and Contingent Assets, a provision shall be recognised when: 

An entity has a present obligation as a result of a past event



It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation



A reliable estimate can be made of the amount of the obligation

If these conditions are met, then a provision must be recognised. The assessment of a provision for a legal claim is always a difficult area as it will be based upon the evidence available but it could also be argued that any provision or disclosure could be prejudicial to the court case itself. In this case, it would appear that the lawyers and management are fairly certain that damages and costs will be payable. The problem is the amount of any provision to be made. As there is a timescale involved here, the first stage will be to calculate the present value of each of the outcomes. Management have also assigned probabilities to each of the three possible outcomes, so a further decision must be made as to whether to calculate an expected value or take the value of the most likely outcome. IAS 37 states that where a single obligation is being measured, the individual most likely outcome may be the best estimate of the liability, although in some circumstances, the range of outcomes may mean that a higher figure is required. Discount factor @ 10%

Outcome Best Most likely Worst

£'000 300 900 2,500

1/1.10 2 1/1.10 3 1/1.10

Present value

Probability

£'000 273 744 1,878

30% 60% 10%

Expected Value £'000 82 446 188 716

IAS 37 requires the estimated value of the provision to be the amount that the entity would rationally pay to settle the obligation. Arguably, in this case that could either be £744,000 as the most likely outcome or £716,000 as the expected value. As the directors are likely to want as low a provision as possible, they are likely to choose the expected value.

460

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Strategic Business Management Chapter-8 Data Analysis Interactive question 1: Treadway

[Difficulty level: Intermediate]

Treadway Stores is a UK-based international supermarket group. The following information has been extracted from an internal report to management on the position of the group within its industry. Currently over two-thirds of its annual revenue comes from the UK, about 15% from the rest of Europe, 15% from Asia and about 1% from the USA, where its business remains unprofitable in spite of large investment. Until last year, the company invested heavily in new store space in all regions. Opening new stores had the advantage of helping the group to increase annual turnover. However, this was at the expense of smaller operating margins. More recently, new investment has slowed down: consumer spending in UK supermarkets is expected to continue to grow over the next few years, but only at the rate of general price inflation. Growth rates in Asia and the rest of Europe are better. In recent years, every £1 spent by the group in Asia has produced annual sales of £0.85, and every £1 spent in Europe outside the UK has produced additional revenue of £0.40. There is strong evidence that consumers have become much more price-conscious. Revenues of discount stores have increased sharply, and Treadway customers are now buying more low-price or discounted products. Treadway has responded to growing competition in the industry by hiring more staff to improve customer service, cut prices and change the products that it sells. Last year, profit margins fell to their lowest level in over 20 years. The UK operation continues to invest in smaller local convenience stores, where average prices are 5% higher than in larger supermarkets, and the group is expanding its online shopping services. Although online sales in food and drinks products have been good, the group is unable to compete successfully with Amazon in online sales of non-food products. With the reduction in capital investment on new superstores, the group is now trying to make its existing stores more effective. A result of the decision to reduce capex is expected to be a significant increase in free cash flow. Treadway also intends to improve return on capital employed. Both ROCE and the company's P/E ratio are below those of major global competitors such as Walmart. Requirements (a)

What do you consider to be the strategic implications of this information?

(b)

What additional information do you think the group should try to obtain in order to carry out a review of current strategy?

Answer to Interactive question 1 Note: The suggested solutions to this question are illustrative and based on the author's assessment. Your views may be different, but they should address the key issues. Here, the condition of the UK industry is almost certainly the key issue because this is currently the source of most of the group's revenue. Part (a) Strategic implications The most significant information in the report is probably that the UK business of the group, which accounts for over two-thirds of total revenue, is under pressure. Customers are more price conscious and discount stores seem to be successful. Treadway has cut prices and hired more staff, but sales are flat in real terms and profit margins are falling. The positive aspects of UK business appear to be the performance of smaller convenience stores and online food shopping, but there is no information on revenues or profit margins for these aspects of operations.

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The management of Treadway needs to consider whether the supermarket industry in the UK may have reached, or be nearing, capacity. If it is, the challenge is to maintain profitability in the UK business until alternative strategies for growth can be developed and implemented. Part (b) Other information to consider Other aspects of the information that should be considered are: 

The potential for growth in either Asia or the rest of Europe. Asia may seem to offer higher growth prospects, but there is insufficient information about conditions or prospects in either of these two regions to make a firm judgement.



The USA accounts for just 1% of group sales globally and is making losses. It would seem appropriate to consider disinvestment and pulling out of the US market. Presumably this would result in write-off costs, but we do not know what these might be, or whether a buyer could be found for the US business.



By cutting back investments in superstores, the group expects to increase free cash flows. What should be done with the money? One option would be to increase annual dividend payouts, which may boost the share price and so the group's P/E ratio.



Lower investment in new stores may improve annual operating margins, by reducing operating costs. Depending on what the group does with its spare cash, there may be prospects for improvements in return on capital.

These judgements have been based on incomplete information and assumptions about future sales growth in the UK that may be too pessimistic. Sales growth may recover and consumer preferences for discount products may be relatively short-term in nature. However, the risk of a long-term slow-down in the supermarket industry in the UK suggests that the group should urgently review its strategy and consider alternative ways of achieving long-term growth. More information is needed about: 

Market conditions and growth prospects in the rest of Europe and Asia



The profitability of online sales and convenience stores in the UK, and prospects for growth



Prospects for the UK supermarkets industry. The forecast of no real growth may be correct, and the switch by consumers to lower-price or discount products may well have occurred. If this is the case, other supermarket groups in the UK should be suffering in the same way as Treadway. Competitor

analysis, and comparisons of performance with other supermarket groups, could provide useful information in support of the assumptions in the report. Interactive question 2: Cook Manor Nursing Homes

[Difficulty level: Intermediate]

Cook Manor Nursing Homes (CMNH) is a company operating residential care homes for the elderly in a developed European country. The residents of CMNH are those elderly people who can no longer care for themselves at home and whose families are unable to look after them. The company runs 785 homes with about 30,000 residents under its care. The company employs approximately 42,500 staff, ranging from head office staff through the home managers to the care staff and cleaners and caterers. CMNH is a private company which aims to make a suitable return to its shareholders. It had revenues of £938m in the last year and is one of the largest providers of residential care places in its country. The company is split into two divisions: General Care (GC), which handles ordinary elderly residents and Special Care (SC), which is a newer operation that handles residents who need intensive care and attention due to physical or mental ailments. The company does not own its homes but rents these from a number of large commercial landlords. It has taken on a large number of new homes recently in order to cope with the expansion of SC, which has proved successful, with 24% pa revenue growth over the last two years. GC is a mature business with little growth in a sector that is now fully supplied. GC has seen volumes and margins falling as it

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faces increasing price pressure from its main customers (public sector health organisations who contract out this part of their care provision). The newly-appointed chief financial officer (CFO) has asked you to analyse the current position of the company. In particular, she has asked you to investigate a problem that CMNH is having with its landlords. The company struggled to meet its most recent quarterly rental payments and the bank eventually agreed to cover them through an increase in overdraft, as CMNH has no cash readily available. The CFO is concerned that the company's chosen strategic measures of performance (growth in earnings per share and operating profit margin) did not identify the difficulties it is currently facing, and she said she felt that gearing needs to be addressed as a key issue. You have been given the outline financial statements to help with this task (see Appendix below). Requirement Discuss why indicators of liquidity and gearing need to be considered in conjunction with profitability at CMNH. Illustrate your answer with suitable calculations. Appendix Outline financial statements for CMNH for the year just ended Summary Income Statements

Revenue Operating costs Homes payroll running Rents Central costs Operating profit Interest Profit before tax Tax Profit for the period

General Care £m 685

Special Care £m

Total £m

253

938

397 86 193 27 (18)

139 24 64 3 23

536 110 257 30 5 5 0 0 0

Special Care

Total

£m

87 47 134

331 64 395

Statement of Financial Position General Care £m Assets Non-current assets Current assets Total assets Equity and Liabilities Share capital Retained earnings reserve Long-term borrowing Current liabilities Total equity and liabilities

244 17 261

165 24 102 104 395

Note: A breakdown of the long-term financing into the two divisions has not been possible.

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Answer to Interactive question 2 Approaching the question: It is important you recognise that the main focus of this requirement is on the value of using different indicators, rather than on CMNH's performance as such. In other words, you need to consider why monitoring liquidity and gearing (in conjunction with profitability) is important; rather than simply looking at CMNH's liquidity and gearing positions. For example, why would it be useful for CMNH to monitor its ability to pay its liabilities when they become due? Although you are asked to 'illustrate your answer with suitable calculations', this does not mean that you should simply calculate a sequence of different ratios. The calculations you perform should be used to support your answer, rather than becoming your answer in their own right. Finally, in relation to gearing – remember that are two aspects of gearing: financial gearing, and operational gearing. The requirement doesn't limit you to dealing with one aspect or the other, and therefore, you should have considered both in your answer. In CMNH's case, the question of monitoring the level of fixed costs compared to variable costs (operational gearing) seems to be particularly important. Profit-based measures – It appears that CMNH's current performance measures (operating profit margin; earnings per share) are primarily focused on the amount of profit the business is generating. However, they have not identified the problems which CMNH is now facing, even though these problems could potentially threaten the survival of the business overall. Profit-based measures can often be insufficient to highlight issues relating to an organisation's survival, either in the long term or the short term. Liquidity Liquidity – CMNH's liquidity relates to the level of funds it has readily available in order to pay its liabilities as they become due; for example, having sufficient cash to pay its rents, or to pay other suppliers. However, CMNH struggled to meet its most recent rental payment, which suggests that it has liquidity problems. CMNH's Liquidity – At the end of the year just ended, CMNH's current assets were £64m, but its current liabilities were £104m. Therefore, its current ratio was 0.62. The fact that this ratio is significantly less than 1 explains why CMNH is having trouble making payments (such as its rental payments) when they are due. Its current liabilities are significantly greater than the funds it has available to pay them. Furthermore, at the end of the year, CMNH has no ready cash . As CMNH is a service company rather than a manufacturing company, it is unlikely to hold a significant level of inventory. Therefore, given that CMNH has no ready cash, it seems likely that the vast majority of CMNH's current assets are receivables. Receivable days – The importance of receivables to CMNH's current assets suggests that receivable days should be a key performance measure for the company. If it can collect the amounts it is owed from residents as quickly as possible, this should help increase the amount of funds it has available to pay for its liabilities. Currently, however, it appears that CMNH may be having some problems collecting the amounts owed to SC. SC's receivable days are 68 [(47/253) × 365], compared to only 9 for GC [(17/685) × 365]. Gearing – Whilst liquidity issues can often be a problem in the short term, looking at gearing can also highlight potential issues in the longer term. In this respect, monitoring its gearing helps an organisation measure risk. Gearing indicates the level of an organisation's fixed regular liabilities compared to the cash generators which will enable that organisation to cover its liabilities. Financial gearing Financial gearing – Financial gearing is measured by the ratio of debt to equity. Debt is a fixed liability for an organisation (for example, the annual interest payments which are due on loans), and equity is the capital equivalent which needs to generate the funds necessary to cover the liability (for example, to pay the interest due).

552

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If the gearing ratio is high, this indicates that an organisation has to cover large fixed liabilities from only a small equity investment. As a result, the business could be at financial risk. As well as looking at the gearing ratio itself, a second indicator, which could be useful in relation to financial gearing, is interest cover. Interest cover compares an organisation's profit before interest to the level of interest payable; again indicating whether it is generating sufficient returns to cover its fixed liabilities. Gearing ratio – CMNH's debt [long term borrowings of £102m] is currently 54% of its equity [share capital + retained earnings: £189m]. A gearing ratio of 54% by itself should not be a particular cause for concern, because it is still relatively low. Interest cover – However, CMNH's interest cover appears to be more of a concern. CMNH's operating profit was the same as the interest CMNH had to pay for the year just ended. CMNH appears still to have a relatively good relationship with its bank, such that the bank agreed to increase CMNH's overdraft facility in order to enable to CMNH to make its most recent rental payments. However, if CMNH doesn't generate sufficient earnings to cover its interest payments, this could be fatal for its relationship with its bank, and will also seriously damage its chances of receiving any further financing. Operational gearing Operational gearing – Operational gearing (or leverage) compares the ratio of fixed costs to variable costs in an organisation, by comparing contribution to operating profit (PBIT). Operational gearing helps to identify the level of business risk in an organisation. If an organisation has high operational gearing, this suggests that it also faces a high level of business risk. High operational gearing means that an organisation's fixed costs, as a large proportion of its total costs, are also high. This is risky because, although variable costs will fall if revenue falls, fixed costs will not. Therefore, an organisation with a high level of operational gearing may find itself unable to cover its fixed costs if its revenue falls. This inability to cover fixed costs appears to explain why the CFO feels that gearing needs to be addressed as a key issue; because it seems likely CMNH has a high level of fixed costs, which in turn means it has a high level of operational gearing. Rent payments are a fixed cost for CMNH, and they alone take up 27% [£257m/£938m] of the company's total revenue. In addition, it seems likely that the central costs and the costs of permanent staff in the care homes will be relatively fixed. The danger for CMNH of having a high level of operational gearing is that if its revenues drop, then it will quickly become loss-making, given that it was only just breaking even at the end of the last year. Again, this reinforces the need to keep a close watch on CMNH's gearing levels. Operational gearing ratio – If we treat rent costs, payroll costs and central costs as all being fixed (or relatively fixed), then the ratio between CMNH's fixed costs and variable costs (running costs) is 7.5:1 [536 + 257 + 30 = 823 : 110]. This ratio is very high, and so should also be viewed as a concern for CMNH. In this respect, it is important for CMNH to see if it can change the nature of any of the costs within its business. In particular, it may be possible to use temporary or contract staff in its homes rather than permanent staff. Such a change would mean that staff costs essentially then become variable costs. However, using temporary staff may also compromise the quality of service CMNH provides to its residents, which would not be acceptable to the residents, or their families.

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553

Interactive question 3: The Eatwell Restaurant

[Difficulty level: Intermediate]

The owners of The Eatwell Restaurant have diversified business interests and operate in a wide range of commercial areas. Since buying the restaurant in 20X0, they have carefully recorded the data below.

Total meals served

20X1

20X2

20X3

20X4

3,750

5,100

6,200

6,700

Regular customers attending weekly

Number of items on offer per day

Reported cases of food poisoning

Special theme evenings introduced

380

307

187

126

Annual operating hours with no customers Proposals submitted to cater for special events

Contracts won to cater for special events

Complimentary letters from satisfied customers

Average number of customers at peak times

Average service delay at peak times (mins)

Maximum seating capacity

Weekly opening hours

570

540

465

187

Written complaints received Idle time New meals introduced during the year Financial data £ Average customer spend on wine Total revenue Revenue from special events Profit Value of food wasted in preparation Total revenue of all restaurants in locality

83,000

124,500

137,000

185,000

2,000

13,000

25,000

55,000

11,600

21,400

43,700

57,200

1,700

1,900

3,600

1,450

895,000

1,234,000

980,000

1,056,000

Requirements

554

(a)

Assess the overall performance of the business and submit your comments to the owners. They wish to compare the performance of the restaurant with their other business interests and require your comments to be grouped into the key areas of performance such as: competitive performance, financial performance, quality of service, flexibility, and resource utilisation.

(b)

Identify any additional information that you would consider of assistance in assessing the performance of The Eatwell Restaurant in comparison with another restaurant. Give reasons for your selection and explain how they would relate to the key performance area categories used in (a)

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Answer to Interactive question 3 Part (a) Competitive performance Over the last four years, market share (the business's share of the revenue of all restaurants in the locality) has increased year on year from 9% in 20X1 to 18% in 20X4.

Market share

20X1

20X2

20X3

20X4

(83/895) 9%

(124.5/1,234) 10%

(137/980) 14%

(185/1,056) 18%

The restaurant is therefore taking an increasing proportion of the area's restaurant business, doubling its market share over the four-year period. The number of proposals submitted to cater for special events has increased dramatically, from 10 proposals submitted in 20X1 to 38 submitted in 20X4, whilst the percentage of contracts won as a percentage of proposals submitted has shown remarkable growth. 20X1 20%

Contracts won as % of proposals submitted

20X2 29%

20X3 52%

20X4 66%

The restaurant appears to be increasingly effective in winning business in this developing area. Financial performance 20X1 Change in revenue Change in profit Profit margin

14%

20X2 +50% +84% 17%

20X3 +10% +104% 32%

20X4 +35% +31% 31%

20X1 â&#x20AC;&#x201C; 20X4 +123% +393%

The analysis above shows continuous growth in revenue and an even stronger growth in profitability. The increase in profit margins may be a result of improved resource utilisation, with fixed costs as a percentage of revenue falling. It is clear that 20X2 was a successful year compared with 20X1, and that 20X3 results were even better. While there was a significant increase in revenue in 20X4, the increase in profitability was less than in previous years and the profit margin fell (admittedly only by 1%). This could indicate the need for tighter cost control. Quality of service Just under 7% ((5 ď&#x201A;´ 52)/3,750) of meals served in 20X1 were to regular customers, compared with over 20% ((26 ď&#x201A;´ 52)/6,700) in 20X4. The business, therefore, has a growing number of regular customers who can be assumed to be happy with the price, level of service, quality of food or, indeed, the total package offered by the restaurant. The data about complimentary letters, written complaints and cases of food poisoning does not paint a clear picture about quality of service as no definitively clear trends are evident, even when the number of meals served is taken into account. Meals served per complimentary letter Meals served per written complaint Meals served per reported case of food poisoning

20X1 3,750 469 938

20X2 1,275 425 1,020

20X3 2,067 443 886

20X4 1,117 479 957

Without a yardstick such as rates achieved by competitors, it is therefore difficult to draw firm conclusions on the quality of service provided by the restaurant, especially as the number of customers almost doubled over the period. More accurate information could possibly be gathered from a large scale customer satisfaction survey. Flexibility One measure of a business's flexibility is how well it copes with varying levels of demand. The restaurant's average service delay at peak times shows no clear trend but has fluctuated widely from 47 minutes in 20X2 to less than a third of that in 20X3. When these figures are analysed in conjunction with the average number of customers at peak times, however, it is clear that performance was particularly poor in 20X2 (with a low level of customers but the longest delay), while performance in 20X3 was better. Overall, however, it is clear that there are problems in flexing resources to meet demand at peak times.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

555

The number of items on offer each day, the new meals introduced during the year, the special theme evenings introduced and the weekly opening hours also indicate improving levels of flexibility, reflecting the increasing choice available to customers. The number of items on offer has more than doubled over the four-year period, from 4 to 9, the number of new meals introduced has varied between 8 and 27, the number of special theme evenings has increased from 0 to 13, and opening hours increased in 20X3. Resource utilisation This is usually measured in terms of productivity (output relative to some form of input). Given the information available and assuming the restaurant is open 52 weeks a year, one measure of productivity is total meals served/opening hours. This ratio has steadily increased from 2 in 20X1 to 3.6 in 20X4. And levels of non-productive time (measured by idle time rates and proportion of operating hours with no customers) declined. Idle hours Opening hours (weekly ď&#x201A;´ 52) Idle time % Operating hours with no customers as % of opening hours

20X1 570 1,872 30%

20X2 540 1,872 29%

20X3 465 2,080 22%

20X4 187 1,872 10%

20%

16%

In conjunction with the increase in the number of meals served (the year-on-year increases being 36%, 22%, and 8%), these measures would tend to indicate overall improvements in resource utilisation. The increase in capacity by 60% in 20X3 allowed more customers to be seated during peak times (although we do not know if this was due to increasing floor space or to seating more customers in the same space), but it was not matched by similar increases in overall activity level, and did in fact correspond with a drop in the number of meals served per seat. Meals served per seat

20X1 150

20X2 204

20X3 155

20X4 168

Weekly opening hours were increased in 20X3, but as the figures above demonstrate, there was no corresponding increase in meals served per seat. Innovation The business appears to have been particularly successful in this area, with attempts at innovative ways of satisfying customer needs including the introduction of special theme evenings, increased items on offer and the successful development of catering for special events. A number of new meals have also been introduced, although the degree of experimentation has varied considerably from year to year. Part (b)

Additional information for assessing performance Competitiveness (i)

Any similar data from one or more restaurants in the locality would enable the business to determine how well it was performing in relation to competitors.

(ii)

It would also be useful to have data about total meals served in all restaurants in the same price band in the locality in order to assess market share in terms of volume.

(iii) More general information about national trends in eating out and restaurant prices, and market research (particularly customer surveys) on similar restaurants would provide a broader context to the performance assessment. (iv) Details of the cost of catering for special events would allow the profitability (or otherwise) of this area of business to be determined. Financial performance

556

(i)

Cost data on labour, food and overheads, which is missing at the moment, would enable a more in-depth profitability analysis.

(ii)

Details of assets would enable the calculation of ROCE.

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Quality of service (i)

Especially useful would be any customer feedback received by or systematically collected by the restaurant (in addition to the complaints and compliments already detailed).

(ii)

Any reviews of the restaurant that might have appeared in guides, newspapers and so on would provide an expert's analysis of the service offered.

(iii) Data on intangible factors, such as the courtesy of staff, ambience of the restaurant, and so on would enable a fuller assessment of the quality of service. Flexibility (i)

Details of the ease with which the restaurant deals with requests for non-menu items (such as those connected with special dietary needs) would give additional information with which to assess this area.

(ii)

It would be useful to know whether any staff training to promote multiskilling (which should improve the business's ability to cope with fluctuations in demand) has ever, or could, take place.

Resource utilisation (i)

A number of useful measures could be calculated if information about staffing levels was provided (eg meals served per hour per member of the waiting staff or revenue per member of staff).

(ii)

If information about floor area was also provided, measures such as revenue per square metre could be calculated.

(iii) It would be useful to know how seat numbers were increased; for example, increasing the restaurant seating space available, or more adding seats in the same space.

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557

Interactive question 4: Company-wide cost control

[Difficulty level: Examination]

You are a trainee ICAEW Chartered Accountant at Miles, Smith and Bowring LLP (MSB), a firm of accountants and business advisers. Along with your manager, you have recently attended a meeting at Hopman Heavies plc (HH), a company operating in the mechanical engineering sector, which manufactures heavy lifting equipment such as cranes, bulldozers and hydraulic elevation platforms. HH is not audited by MSB. During the meeting, the CEO of HH explained that he was concerned about cost control within the company: ‘Costs have been allowed to increase without adequate controls and this must change. For example, a contract with a new supplier of hydraulic systems, Zydrau plc, is being considered, and the method of determining the contract price needs to be reviewed closely, as the hydraulic systems are a key component item for all the types of equipment we manufacture.’ The CEO continued by providing some more details about the contract with Zydrau plc: ‘There has been preliminary agreement by HH on a three-year contract with Zydrau. Given the significance of hydraulics as a component cost for HH, we are anxious not to pay more than is necessary to suppliers. Unfortunately, however, the nature of each piece of hydraulics equipment supplied varies, and so agreeing a fixed price is not possible. A provisional contract has been drawn up using a pricing formula of: direct cost incurred on the contract plus 8%. Direct cost is defined in the provisional contract as the incremental costs to Zydrau caused by supplying equipment to HH.’ The CEO explained that the contract would require independent scrutiny of Zydrau’s management accounts in order to substantiate the amount of direct costs applicable to the contract with HH. He has requested MSB to carry out this engagement, but admitted he is not sure of the most appropriate basis for the engagement. He said the interim Finance Director at HH had suggested that the engagement could be carried out as either an assurance assignment or on an ‘agreed-upon procedures’ basis. However, the CEO admitted he was not sure what this meant. Zydrau has agreed, in principle, to either of these types of arrangement. Requirement Advise the CEO, with reasons, whether: (i) an assurance assignment with a report giving a conclusion; or (ii) an ‘agreed-upon procedures’ assignment, would be more appropriate.

Answer to Interactive question 4 Zydrau contract – assurance or agreed-upon procedures Agreed-upon procedures In an agreed-upon procedures (AUP) engagement, MSB will provide a report of factual findings from the procedures and tests performed, which need to be agreed with both HH and Zydrau. The procedures and tests required should be sufficiently detailed so as to be clear and unambiguous, and discussed and agreed in advance with both HH and Zydrau staff, so that the factual findings are useful and appropriate to the cost plus contract. When performing an agreed-upon procedures engagement on historical financial information MSB, as practitioners, are required, as a minimum, to comply with International Standard on Related Services (ISRS) 4400 Engagements to Perform Agreed-upon Procedures on Financial Information. Our report for an AUP will not express a conclusion and, therefore, it is not an assurance engagement. It will not provide recommendations based on the findings. We would request that HH and Zydrau review the procedures and findings in our report and use the information to draw their own conclusions. The value of an AUP comes from MSB, as practitioners, objectively carrying out procedures and tests with relevant expertise thus avoiding the need for HH to carry out the procedures and tests themselves and therefore it protects confidentiality for Zydrau.

558

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AUP are most effective in situations, such as this, where there is a clear matter to focus on in the form of the costs plus pricing contract. The benefit to HH of agreed upon procedures is therefore that it provides evidence for HH that Zydrau is complying with the terms of the contract in identifying, measuring and allocating only costs appropriate to the pricing contract and consistent with that contract. This prevents excessive, and otherwise unobservable, costs being added by Zydrau thereby increasing the price of goods to HH in a manner that is inconsistent with the contract. Zydrau may be more likely to allow MSB to carry out this task as a professional accountant than perhaps they would with HH, due to the commercial sensitivity of other information that may be obtained in the process. In this context ISRS 4400 requires compliance with the applicable requirements of the Code of Ethics for Professional Accountants. Assurance assignment A key feature that distinguishes an assurance assignment from an AUP assignment is the requirement to express a conclusion. Discussion with both parties when scoping an assurance engagement will be an important part of the process. This will help MSB to obtain a sound understanding of the objectives of the engagement, the nature of the subject matter (cost structure and costing processes of Zydrau), and the requirements of both HH and Zydrau. This understanding will help to plan procedures to gather sufficient and appropriate evidence to support a conclusion that is useful in the light of the needs of the parties involved. It should be possible to obtain the assurance required, provided that the scope of the assurance engagement is in line with the relevant standards; eg, the method of measuring or evaluating the subject matter is appropriate, criteria are suitable, and sufficient and appropriate evidence exists. However, from HHâ&#x20AC;&#x2122;s perspective, an assurance engagement may not represent the optimal approach from a cost benefit perspective as the amount of evidence to support a conclusion may be much greater than for an AUP assignment.

Interactive question 5: 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 varied 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'.

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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. Product development A large proportion of the company's turnover in recent years has been derived from one particular drug. The patent for this drug expires next year and it is expected that its sales at that time will represent no more than 10% of total revenue. Four years ago, the sales of this drug produced almost half the company's entire revenue. A new product, Coffstop, has now completed its rigorous development phases and is being marketed to 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 On the basis of the information in this report, analyse the main issues facing WG.

Answer to Interactive question 5 Suggested approach to a solution An approach to developing a solution is suggested here. You may prefer to take a different approach, but you should be able to consider all the relevant information provided, identify the most important issues, and draw conclusions.

560

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Stage 1: Make notes of the relevant facts Making notes is a method of reviewing the facts. In the table below, the notes are organised according to the checklists suggested in this chapter. In this example, however, issues in the broader business environment do not seem to be a significant issue. External environment Political

–

Economic

–

Social

–

Technological

–

Environmental

–

Legal

Increase in legal actions against drug companies

Industry environment

High R&D costs Patents to protect intellectual property: importance of patent protection for the business of major drugs companies Rigorous development and testing for new products Government and public challenges to high levels of profit National governments and health organisations sponsor most research: donation programmes

Competition

Strong competition between firms, but few firms High barriers to entry No substitute products for patented drugs Peffstill a serious competitor for Coffstop

Internal strengths and weaknesses

Main revenue earning drug: patent ends next year. Loss of up to 10% of revenue? No other major product, apparently. Why is R&D not more effective in producing innovative products? More information needed about patents and product portfolio More spending on R&D than competitors Difficulty in finding retail outlets for Coffstop

Financial

Fall in revenue growth to 5% annually from 15%. Are there any forecasts for future sales? Profit before tax 35% of sales, profit after tax 15%. So tax 20% of sales? This is surprising. Is the data reliable? Fall in revenue but 15% increase in earnings and dividends? How was this achieved? R&D costs = 15% of revenue last year Detailed figures for profitability of Peffstill and Coffstop for retailers: calculations of profitability required.

Operational

Data on performance restricted to financial data, see above

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Deciding the method of analysis The notes should give you some ideas about the approach to take to the analysis. Here, we suggest that the main issue is the need for WG to continue to develop successful new products which can be patented. We know that a 'best seller' will go out of patent next year, so that other companies will be able to make and sell the product, probably more cheaply. Issues such as the performance of R&D and competition will be included in the analysis. A further issue to consider is the financial performance of the company and prospects for the future. Another issue, although perhaps one of lesser importance, may be the risk of action by national governments to reduce the large profits of drugs companies. Calculations Detailed calculations can be produced for the relative profitability of Coffstop and Peffstill. The focus here should be on profitability for retailers, and identifying the key measure of performance. It is not profitability per unit sold. It is the gross profit per week per square centimetre of shelf space.

562

Recommended retail price Bought-in cost Gross contribution per bottle Holding cost per bottle Net contribution per bottle

Coffstop £ 1.50 0.50 1.00 0.40 0.60

Peffstill £ 10.00 7.40 2.60 0.80 1.80

Sales per week (bottles) Total net contribution per week Shelf space per bottle (square centimetres) Contribution per square centimetre of shelf space

120 £72 18 £4.00

20 £36 60 £0.60

= the 1: 2.6 ratio in the data

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Interpretation The 'What-How-Why-When-So What' approach to analysis can be used. 1. Concern about future profitability: need for successful new products WHAT? 2. Possible doubts about future growth in revenue, earnings and dividends HOW?

3. Possible risk of government action to reduce profits 1. Patent of successful product running out Problem with selling Coffstop to retailers 2. Fall in rate of revenue growth, but stronger earnings and dividend growth last year

WHY?

3. Government and public concern about high profit margins: governments are sponsors of R&D 1. Analyse problems of product portfolio and failure of R&D to develop major new drug, in spite of high spending on R&D. Is this a key strategic problem for the company? Failure of company to explain higher profitability of Coffstop to retailers. Need to correct this failing, but why did it happen? 2. In spite of high profit/sales ratio, it is not clear how earnings could increase by 15% when the rate of sale growth slowed to 5%. Is it possible that the company cut R&D spending? Or possibly gains from favourable currency movements? Some discussion of the apparently high rate of tax also appropriate. 3. Governments may be concerned about high profitability of drugs companies. Legislation against patent unlikely. Governments may cut sponsorship of R&D or may ask for better terms in donation programmes. But at the moment, this is not the main problem for the company. Need to keep the matter under review.

WHEN?

Action to promote Coffstop is urgent, especially if it may become a major product for the company. An assessment of future financial prospects and the effectiveness of R&D are also urgently required.

SO WHAT?

The company needs a continual cycle of innovation, product development and successful patenting. Without this, its future financial stability and survival could come into question.

Limitations in the data More information would be useful for analysis: 

A more detailed analysis of revenues and profitability in recent years, including an explanation of tax charges



More information about the company's current product portfolio, sales and profitability of each product (historical and projected) and remaining patent lives



A report from the head of R&D about development projects in hand and an analysis of historical performance – new products developed and product histories. (It is important to establish whether the R&D department is as effective as it should be.)

Conclusion Your views on this example may differ, and you may prefer to approach an answer in a different way. This suggested solution tries to demonstrate, however, the advantages of a structured approach to data analysis.

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Strategic Business Management Chapter-9 Information Strategy Interactive question 1: Antiques dealer

[Difficulty level: Intermediate]

GLS is a long-established retailer which specialises in the sale of antiques. GLS is owned by a married couple who both work in the business. They have no employees. Their premises consist of a large modern shop and there is an apartment above this in which the owners live. Over the last five years the local area has become very fashionable and the shop is now surrounded by smart restaurants, cafes and up-market fashion outlets. This area has also become a very popular place to live which has meant that property values have increased substantially. The owners believe that if they disposed of their premises they would make a substantial capital gain. The owners have noticed that the fixed costs of their property, including insurance, local tax, security and maintenance, have risen very sharply during the last five years. Since establishing the business 30 years ago the owners have developed their expertise. They now have a national reputation in the antiques trade and many repeat customers. They traded profitably each year from the start of the business until two years ago, but in the last year have made an operating loss for the first time. The owners are often consulted by other antiques traders and collectors by letter and telephone and they have developed a considerable income stream by charging for their advice. However, they have found that their business location is becoming increasingly problematic. Although the popularity of their area of town has increased and led to many more people living and visiting the area, unfortunately for the owners most of these people are not interested in antiques. They are young people who like the area but do not have the disposable income to spend on antiques. A further problem is that the shop is not situated in a large city and it is very inconvenient for many antiques traders and collectors to visit. The owners believe the location has recently restricted the success of their business. The owners know that a very popular development in the antiques trade has been the establishment of 'Antiques Fairs' where antiques are bought and sold. Some of these have established international reputations and have many thousands of visitors. However, because of GLS's location and the need to keep their shop open, the owners do not attend these. The owners recently set up a website which has basic information about their business on it such as their address, telephone number and the opening times of their shop. The website has received a large number of hits but it does not seem to have increased sales. Requirements (a)

Analyse the strengths and weaknesses of GLS's current business using the value chain model. Note: You are not required to draw a value chain diagram in any part of your answer to this question.

(b)

Evaluate how the introduction of e-commerce could affect GLS's value chain.

Answer to Interactive question 1 Strengths Operations: The owners have developed a considerable income stream by charging for their respected consultancy advice about antiques. Service: The owners have developed a national reputation in the antiques trade and their experience has allowed them to build up a loyal following of repeat customers. Firm infrastructure: The business operates from a large modern shop in a fashionable area, which makes its premises very valuable. If the owners sold the shop they could realise a substantial capital gain. Human resource management: The business is run by the owners, and their experience in the antiques trade, and their reputation as experts, is a valuable asset for GLS. Weaknesses Inbound logistics: The inconvenience of the shop's location may mean that people with antiques to sell may take them to another antiques dealer rather than bringing them to GLS. Operations: The location of the shop is not convenient for potential customers (antique traders and collectors) to visit, and the people who live nearby are not interested in buying antiques. The owners are unable to attend antiques fairs because they need to be physically at the shop to keep it open.

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Outbound logistics: The inconvenience of the location may also be a weakness in relation to customers buying antiques; for example, a collector may choose not to buy an item due to the difficulty of transporting home, or GLS may have to bear the cost of transporting customers' purchases to their homes. Security costs have also increased significantly in recent years, and these costs are presumably related to the cost of storing antiques at the shop. If these security costs continue to rise, storing antiques in the shop may become a weakness. Marketing and sales: The owners themselves believe that the location of the shop restricts the success of the business. However, at the moment GLS's website is very basic, and although a number of people have visited it there is no scope for them to buy anything through the website. Firm infrastructure: The fixed costs relating to the shop premises have increased sharply over the last five years. This is likely to be a contributing factor to the fact that the business made a loss for the first time in the last year. Human resource management: There appear to be no succession plans in place for when the owners retire. Given that they have been running the business for over 30 years it is likely they will be approaching retirement age soon. Technology development The business has only recently set up a very basic website. As we have already noted, it does not have any e-commerce capabilities. (b) Note: A useful way of approaching this question would be to consider how the introduction of ecommerce will help address some of the weaknesses of GLS's operations which were identified in part (a), or to build on some of its existing strengths. However note that, as in part (a), the question requires you to link your answer to the value chain, so it would be sensible to use value chain functions as headings for your answer. Operations – The main impact of introducing e-commerce is that GLS is no longer reliant on its current shop as a physical site for their business. GLS will still need a site where it can store antiques, and it is likely to keep retain some kind of shop or showroom where the owners can make face-to-face sales. However, this can be moved to new, cheaper premises, for example an out-of-town location which should also be easier for antique traders to get to. Outbound logistics – The new location should provide a more convenient base from which to distribute the antiques, and it should also help to reduce the insurance and security costs relating to storing the antiques. Marketing and sales – e-commerce should increase the geographical reach of the business, and so should increase sales. Potential customers who previously couldn't visit GLS's shop (perhaps even international customers) can now search the website to look for items they may want to buy (and then also buy them online if they want to). Firm infrastructure – The reduction in overheads and potential for increased sales should allow GLS to return to profit. The owners will also receive an injection of cash from the proceeds of the sale of the shop, which should cover the costs of the website upgrade. Human resource management – Once the website is running, the owners will be able to reduce the opening hours of their 'bricks and mortar' shop, which will give them more opportunity to attend the antiques fairs which they have previously been unable to attend. Technology – Once the website starts becoming a source of income for the business, then technology becomes a much more important aspect of its value chain. In effect, the website could become GLS's main 'shop'. Procurement – As the website increases the geographical reach of GLS's customers, it may also mean that the supply of antiques into the business also increases as more and more people become aware of it.

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Interactive question 2: 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. Fixed production costs Production Sales

July £110,000 2,000 units 1,500 units

August £110,000 2,500 units 3,000 units

Hamilton Ltd normally expects to produce 2,200 units and fixed production costs were budgeted at £110,000 per month, which are absorbed on a per unit basis. There were no opening inventories in July. Requirements (a)

Determine the profit for each of July and August using:

(b)

(i) Absorption costing and (ii) Marginal costing Demonstrate why the profits under each method are different.

Answer to Interactive question 2 WORKINGS (1) Fixed production costs absorbed per unit

Budgeted fixed production cos ts 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 Actual production Expected production (Under-)/over-production Fixed costs per unit (Under-)/over-absorption

July 2,000 2,200 (200) £50 (£10,000)

August 2,500 2,200 300 £50 £15,000

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Income statements – absorption costing £ Sales (£150 per unit) Cost of sales: Opening inventory Production Less: closing inventory Gross profit (Under-)/over-absorption

670

July £ 225,000

Nil 240,000 (60,000)

August £ 450,000

60,000 300,000 Nil (180,000) 45,000 (10,000) 35,000

(360,000) 90,000 15,000 105,000

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Income statements – marginal costing

Sales Cost of sales Opening inventory Production Less closing inventory

July £ 225,000

£ Nil 140,000 (35,000)

35,000 175,000 Nil (105,000) 120,000 (110,000) 10,000

Contribution Less fixed costs Net profit Difference in profits

August £ 450,000

(210,000) 240,000 (110,000) 130,000

July £ 35,000

August £ 105,000

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

Interactive question 3: Activity Based Costing

[Difficulty level: Easy]

Tammy plc currently makes and sells four products, cost and output details of which are below. Product

Alpha

Bravo

Echo

Oscar

Output (units) Cost per unit (£): Material Labour Activities: Number of set ups Number of times materials handled Number of orders Number of spare parts required

500

300

400

200

60 32

42 20

80 35

100 50

3 11 15

4 12 20

2 16 10

6 25 15

Set up costs Material handling Ordering costs Engineering costs

Total overhead costs (£) 25,000 69,000 32,000 45,000 171,000

Requirements (c) (d)

Using the information given, what is the most suitable cost driver for each overhead cost? Calculate the total product cost for each of the four products, showing all workings.

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Answer to Interactive question 3 (a) Overhead cost Set up costs Materials handling costs Ordering costs Engineering costs

Cost driver Number of set ups Number of times materials handled Number of orders 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 Alpha

[(20 / 100)  25,000] = £10.00/unit 500

Bravo

[(15 / 100)  25,000] = £12.50/unit 300

Echo

[(30 / 100)  25,000] = £18.75/unit 400

Oscar

[(35 / 100)  25,000]

= £43.75/unit

200 Material handling costs per unit =

(Number of times mats handled per product / Total times mats handled)  Total handling cos ts Number of units produced Alpha

[(3 / 15) × 69,000]

= £27.60/unit

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 Number of units produced

[(11/ 64) × 32,000] = £11.00/unit 500

Alpha

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 Number of units produced Alpha

[(15 / 60)  45,000]

= £22.50/unit

500

670

Bravo

= £50.00/unit

Echo

= £18.75/unit

Oscar

= £56.25/unit

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Total cost per unit

Direct costs: Material Labour Other costs: Set-up costs Material handling costs Ordering costs Engineering costs

Alpha £

Bravo £

Echo £

Oscar £

60.00 32.00

42.00 20.00

80.00 35.00

100.00 50.00

10.00 27.60 11.00 22.50 163.10

12.50 61.33 20.00 50.00 205.83

18.75 23.00 20.00 18.75 195.50

43.75 138.00 62.50 56.25 450.50

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.

Interactive question 4: 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: £ 75,000 200,000 150,000

Marketing Salaries Other 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?

Answer to Interactive question 4 Total fixed cos ts

425,000 = =14,167 pairs of roller skates Contribution / unit (55 – 25)

(a)

Break even point =

(b)

Margin of safety = Current sales units – Break even sales units = 20,000 – 14,167 = 5,833 pairs of roller skates (29%)

(c)

Required sales revenue to ensure a profit of £25,000: =

Total fixed costs + Required profit Contribution ratio

where: Contribution ratio =

= =

Contribution per unit Selling price per unit (65 – 25) 65 40 65

Required sales revenue = 465,000  25,000 (40/65) = £ 796,250 672

Interactive question 5: 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 8,000 £ 320,000 176,000 144,000

Sales units Sales revenue Variable costs Contribution Total fixed costs Net profit

Grafassi 6,000 £ 360,000 228,000 132,000

Federdal 4,000 £ 400,000 280,000 120,000

Total £

396,000 306,900 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?

Answer to Interactive question 5 The first step is to calculate contribution per unit: McEnrova 8,000 144,000 £18

Total sales units Total contribution (£) Contribution per unit

Grafassi 6,000 132,000 £22

Federdal 4,000 120,000 £30

The lowest common denominator for the sales mix is 4:3:2. Total contribution for the standard batch is £198 (4  £18 + 3  £22 + 2  £30). Break even point in batches =

306,900

= 1,550 batches

198

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The number of units of each model that must be sold in order to break even is: McEnrova: Grafassi: Federdal:

1,550  4 1,550  3 1,550  2

= 6,200 = 4,650 = 3,100

The break even point in terms of sales revenue is: McEnrova Grafassi Federdal

£ 248,000 279,000 310,000 837,000

(£40  6,200) (£60  4,650) (£100  3,100)

Check: Sales units Contribution per unit Total contribution (£) Total fixed costs (£) Profit/(loss)

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McEnrova 6,200 £18 111,600

Grafassi 4,650 £22 102,300

Federdal 3,100 £30 93,000

Total

306,900 306,900 NIL

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Interactive question 6: Health club

[Difficulty level: Intermediate]

KLL is a large health and fitness complex located in a capital city. Started seven years ago, the business has been profitable. The introduction of a much wider range of activities over the past few years has led to increased complexity of administration and difficulty in interpreting the rapidly growing basic data generated daily. This data remains largely unstructured and this in turn leads to uncertainty in decision making. The present management information system (MIS) is able to produce monthly reports on the performance overall but can only break down the key indicators of revenue and gross profit into six broad categories: water sports, sports hall activities, fitness training, beauty treatments, squash courts and outdoor sports. Thus there is no detail on specific activities such as table tennis, sauna room, badminton or soccer. The managing director and the board cannot distinguish the profitable activities from the unprofitable ones. The managing director tells the board, 'We must have a management information system that can cope with our complex business; there are so many variables it is becoming impossible to make decisions with confidence. Sometimes we have detail we cannot interpret and sometimes we simply do not have enough good information'. The finance director points out that 'the staff are doing their best but they have limited technical knowledge and the software support company is often slow to help'. The board have recognised that it is important to build an MIS to serve the company well into the future, and are currently reviewing various proposals for new systems. Requirement Prepare a memorandum to the board explaining the main purposes of a new MIS and the benefits the company could expect such a system to bring.

Answer to Interactive question 6 MEMORANDUM To:

Board members

From: Accountant Subject: Purposes and benefits of a Management Information System Date:

[today's date]

KLL requires a new Management Information System to provide more detailed information on the various activities of the company. The existing MIS is limited in the information that it can provide, and the directors have identified additional information that would help them control and develop the business. This memo summarises the purposes and benefits that can be obtained from a modern Management Information System. (a)

Purposes of a Management Information System A MIS is a system to convert data from internal and external sources into information and to communicate that information, in an appropriate form, to managers at all levels in all functions to enable them to make timely and effective decisions for planning, directing and controlling the activities for which they are responsible. The MIS is therefore established in a company to satisfy the information needs of management. Within KLL, the directors will already be aware of this objective of a MIS because the company already has a MIS. The limitations of that MIS are now apparent, however, because activities cannot be split between those that are profit making and those that are loss making.

(b) Benefits of a MIS The benefits of a MIS are summarised below, focusing particularly on the requirements of KLL. (i)

Provision of financial information The existing MIS can provide some financial information, although the limitations of this information have been recognised by the directors. This limitation may well be a function of an older MIS being designed to produce specific reports rather than holding the data in some form of database and then different reports being generated from that data as required. A new MIS should store data in a less rigorous format, enabling different reports to be produced as required. Details of profit and loss making sports can therefore be obtained.

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(ii)

Provision of more timely information The current MIS produces reports on a monthly basis. It is not clear whether this is a system limitation or whether reports have not been requested on a more frequent basis. However, monitoring the profitability of individual sports activities may benefit from more frequent provision of information. For example if a competitor starts pricing activities below the price charged by KLL, then an immediate response will be required rather than waiting up to a month to amend prices. A modern MIS should be able to provide information on a daily if not real time basis to enable the directors to make quicker and more effective decisions.

(iii) Provision of summary information The managing director is concerned about the inappropriate level of detail being provided by the MIS. If the detail cannot be interpreted (per the question), then it is likely that the MIS is producing information at an operational level rather than a strategic or tactical level. The detail is available, but this has not been summarised appropriately. It is possible, for example, that income from individual games of squash can be seen, but not the total income for each court or for the sport squash itself for each week or month. The new MIS will provide a summary of income initially, with the ability to provide more operational information as necessary using the 'drill down' ability of many information systems. Focusing the information at the strategic level first, rather than the operational, should provide the managing director with the appropriate level of detail. (iv) 'Better' information The managing director is also concerned about the lack of 'good' information. This appears to be linked to the comment concerning the limited technical knowledge of staff and poor support from the software company. It is therefore possible that staff either have a lack of training in the use of the MIS or they are producing bespoke reports, and are not receiving the support from the supplier to help them do this. The board are not receiving good information because reports are not sufficiently focused on the activities of KLL. Whether the situation actually needs a new MIS to resolve it remains unclear. It is possible that appropriate training or support would enable staff to provide the appropriate reports for the board. Alternatively, more recent MIS programs normally provide an easy-to-use report generator so staff should find it easier to produce the necessary reports. Alternatively, data can be exported into a spreadsheet package for additional analysis and production of visual aids such as charts and graphs as necessary. (v)

Staff morale Providing a new MIS will have other benefits for the company such as increased staff morale and a better working environment. Staff are likely to be more motivated because the company is providing the software that is needed to carry out their job.

Interactive question 7: Data and knowledge

[Difficulty level: Intermediate]

PBB is a UK university. PBB's management board has identified student performance as a Critical Success Factor (CSF). PBB's management board has identified this CSF as it targets an area where it is currently underperforming compared to other UK universities. PBB is aware of a nearby comparable university, KLN, which had considerable success when several of its departments worked together to improve student performance. KLN has a culture of sharing knowledge and a knowledge management strategy. PBB does not have a culture of knowledge sharing. Within PBB, knowledge is regarded as the personal property of the individual and very few of its staff are prepared to share their knowledge with any of their colleagues. PBB has an abnormally high level of staff turnover compared to other universities, nearly twice as high as that of KLN. Student performance Student performance is measured by PBB as the number of students who successfully complete their courses. Those students who do not are described as 'drop-outs'. The number of drop-outs is measured by the drop-out rate. PBB has access to data for all UK universities for student drop-out rates analysed by age and gender. 680

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Drop-out rates vary greatly across PBB's academic departments. In some academic departments the dropout rate is extremely high; in others it is very low, much better than the national average. Where the drop-out rate is much better than the national average, the departments have operated extensive schemes for student support. For example, students with personal problems can seek help from trained counsellors, students with financial problems have been helped to find part-time work and students with academic problems are given extra individual tuition from the academic staff. In the departments where the drop-out rates are extremely high, none of these student support schemes is operating. The departments with the extremely high drop-out rates are not aware of how the departments with the very low drop-out rates support their students. The departments with very low drop-out rates are unwilling to share their knowledge about how to reduce the drop-out rates as they have spent considerable time and effort developing their schemes and regard these as their own property. PBB has not conducted any systematic analysis into its overall drop-out rate. Within its information systems, PBB has the following information about each of its students:       

Name Age Gender Address Educational record prior to joining PBB Educational record within PBB Academic department

PBB is aware that many universities have successfully used data mining to assist them in managing student performance. Requirements (a)

Many organisations integrate their CSFs into their performance management systems by converting them to Key Performance Indicators (KPIs). Briefly explain, using examples, the advantages that PBB would gain by doing the same.

(b)

Advise PBB's management board of three benefits the university and its staff could expect to receive from the implementation of a knowledge management strategy.

(c)

Explain data mining and how the outputs of the analysis could be used by PBB to improve the student drop-out rates.

Answer to Interactive question 7 (a)

CSFs and performance management – PBB's CSFs should identify the areas which are central to its future success and therefore where it needs to perform well if it is to be successful overall. CSFs and KPIs – Once PBB has identified which aspects of performance are crucial to future success, it needs to be able to measure how well it is performing in relation to them. It can use KPIs to measure whether or not its CSFs are being achieved. Examples – So, for example, measuring the number of students who do not complete each year of a course, or measuring the percentage of students who drop out each year, will allow HHH to monitor student performance.

(b)

Improved student performance – One of the aims of PBB's knowledge management strategy should be to gather, organise and share knowledge and experience about areas of its business which will contribute to its future success. In this respect, if the staff in the departments that currently have high student drop-out rates can learn more about how to improve student performance, this should enable them to reduce the drop-out rates. In turn, this should allow the university to improve its performance in this area. Reduce staff turnover – Currently PBB has an abnormally high level of staff turnover. Its staff turnover levels are double those of KLN, which has a culture of knowledge sharing. Although there is no guarantee that introducing a knowledge management system will reduce staff turnover, if sharing knowledge helps improve performance this, in turn, should help improve the motivation and job satisfaction of PBB's staff. If staff value working for PBB because it is a successful organisation, this should help reduce staff turnover levels.

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Increased collaboration between colleagues and departments – Currently very few of PBB's staff share knowledge with any of their colleagues. However, this lack of collaboration is likely to be stifling innovation and creativity within the university. By contrast, if PBB implemented a knowledge management system, this should encourage staff to share ideas and experience with their colleagues, which in turn could lead to new opportunities for collaboration and innovation across the university. These should not only be focused on new opportunities for how to improve student performance, but could also extend into areas of academic research as well. (c)

Data mining – Data mining is concerned with analysing large pools of data to highlight previously unknown patterns and relationships in that data. Predicting future behaviour – One of the key benefits which accrue from data mining is the ability to use the identified patterns and relationships to predict future behaviour. In PBB's case, the aspect of behaviour it wants to be able to predict is students dropping out of their courses. Identify factors affecting drop-out rates – PBB could use data mining software to analyse data to try to identify which factors appear to be influencing student drop-out rates. Because data mining software is designed to analyse large pools of data, PBB shouldn't be restricted to analysing only the performance of its own departments. It could also look at data for students in other UK universities to see what factors appear to be affecting their drop-out rates. Importantly, if PBB can get a better understanding of the issues which are causing students to drop out of their courses, it can then develop plans to address those issues and thereby hopefully improve student retention rates. Preventing drop-outs – If PBB can identify, in advance, the groups of students which are most at risk of dropping out, it can then offer them additional support or guidance to try to prevent them dropping out of their courses. For example, data mining might identify that foreign students who perform poorly in mock exams also fail their end of year exams and therefore cannot continue with their courses. In this case, action could be taken to offer extra tuition to students who fail their mock exams to help them improve their chances of passing their end of year exams.

680

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Strategic Business Management Chapter-10 Human Resource Management Interactive question 1: Scantech

[Difficulty level: Easy]

Scantech is a rapidly growing high-technology company which specialises in producing electronic scanners. It currently has 110 employees, but aims to double in size over the next three years. The company was set up by two researchers from a major university who now act as joint managing directors. However, they intend to leave ScanTech once the growth objectives are achieved and the company is large enough to be sold. The sophisticated imaging devices which ScanTech makes are used by the airline security and health industries. These two markets are very different in terms of customer requirements, although they use the same basic technology. In recent years, Scantech has seen a significant increase in sales from exports, and as a result its strategic plan anticipates a foreign manufacturing plant being set up within the next three years. Scantech's current managers are all staff who joined in the early years of the company, and their primary expertise is in research and development. The future growth of the company will require additional staff in all parts of the business, particularly in manufacturing and sales and marketing. Sue Franklin is HR manager at ScanTech. She is annoyed that HR is the one management function not involved in the strategic planning process shaping the future growth and direction of the company. She feels trapped in a role traditionally given to HR specialists Ěś that of simply reacting to the staffing needs brought about by strategic decisions taken by other parts of the business. However, she feels that HR also has a strategic role to play in helping ScanTech deal with the challenges over the next three years. Requirements Discuss how a Human Resource plan could help support Scantech's growth strategy.

Answer to Interactive question 1 Human resource planning and strategy ScanTech's growth plans envisage the company doubling in size over the next three years. This will require the employment of extra staff, particularly in marketing, sales and manufacturing. The ambitious planned rate of growth and the high technology base of ScanTech's business mean that these extra staff must be of very high quality. Human resource (HR) management is thus an essential component of the company's business strategy and so should be integrated with its development. The alternative is increased potential for serious shortages of staff and mismatches between job requirements and staff availability. The proposed opening of a foreign manufacturing plant will complicate all HR issues significantly and will demand very careful consideration. The following elements of human resource planning could be useful at ScanTech: An audit of existing staff should reveal those with potential for promotion or employability in new specialisations. It would also indicate where shortages already exist. Concurrently, an analysis of likely future staff requirements could be carried out. It seems inevitable that ScanTech will need to employ more staff in the areas already mentioned, but it does not seem to know how many will be required, whether other functions will need to be increased in size, or if more support and administrative staff will be needed. There are also the related and sensitive issues of management succession and internal promotion to consider. In particular, ScanTech needs to consider the eventual replacement of the existing joint Managing Directors, who are expected to leave once the current growth objective has been achieved. These two elements of analysis should help ScanTech to identify the gaps that it will need to fill if it is to have the staff required for its overall growth strategy. Recruitment will be the logical next step once the analysis of resource requirements have been completed â&#x20AC;&#x201C; in the sense of attracting applicants, and selection from within the pool of applicants. Recruitment work is often outsourced (to a recruitment agency) and it will be necessary for ScanTech to decide whether the expertise and economies of scale offered by outsourcing outweigh the need for deep familiarity with our operations on the part of the recruiters.

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Reward policy must be considered. At the moment, ScanTech's staff profile is heavily biased towards people with a background in research and development. Different types of people will be required in the future and their expectations for their rewards and remuneration are likely to vary from those of the existing staff. A doubling in size to, say, 220 employees is likely to take the company into an area of HR complexity in which a formal reward policy and structure is required. Informal decisions about pay and benefits will not be satisfactory. Increasing size is also likely to require the establishment of a policy on appraisal and performance management. This should be linked to a programme of training and development. It is likely that ScanTech will continue to hire well-qualified technical staff, but there will be a need for development of staff in other functions and for management development in particular.

Interactive question 2: Financial Service companies

[Difficulty level: Intermediate]

Since the beginning of the 1990s financial services institutions (eg banks and insurance companies) have pursued the following business strategies: 

Shift to telephone and internet-based servicing of customer accounts, leading to reductions in the total number of High Street branches



Expansion in range of financial products offered at branches



Introduction of 'customer service ethos' with emphasis on providing advice and selling products while increasing reliance on electronic technologies to handle routine transactions



Increasing use of 'off-shore' call centres and transactions processing centres

Requirement What impact would these changes have had for the following factors?    

Forecast human resource demand Forecast human resource supply Training and development External recruitment

Answer to Interactive question 2 Forecast human resource demand 

Reduction in numbers of staff required in the future



Roles – amalgamation up of management roles due to reduction in number of branches



Skills – need for staff with customer skills rather than bureaucratic and professional banking skills



Availability – requirement for more flexible working practices, eg late/weekend opening, 24/7 cover of call centres



Location shift – staff will be required in off-shore centres with reductions in UK centres

Forecast human resource supply 

Potential excess supply of staff internally as internal jobs contract and external opportunities diminish



Increased availability of staff on external labour market due to downsizing by other banks may make this a cheap source of staff – eg on short-term contracts



Need to consider the forecast supply in off-shore locations

Training and development 

Change in the skills and competencies away from professional qualification of Chartered Institute of Bankers or Chartered Insurance Institute



Requirement for some staff to pass compulsory regulatory exams to sell new financial products



Regular updating of staff in new products and legal/regulatory issues

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External recruitment    

Potential for cheaper sources of staff externally than internally Reduction in intake of school-leavers and graduates due to surplus of staff internally Need to access new sources of staff to cover new technologies (eg IT recruitment) Recruitment will also take place off-shore

Interactive question 3: Appraisals

[Difficulty level: Intermediate]

The Jackson Business Centre (JBC) provides professional courses for students of accounting, law and marketing. JBC has operated a formal performance appraisal system, supported by standardised procedures and paperwork, for a number of years. The system has clear organisational objectives, which are based on staff development and improved performance, rather than being a basis for pay reviews or paying individual annual bonuses. However, the scheme is not well regarded by either managers or staff and its objectives are not being met. Senior managers complain about the amount of time that is taken up holding appraisal interviews and then completing the necessary paperwork. Exit interviews are conducted whenever someone leaves JBC, and a review of a sample of recorded comments indicates staff feelings on the scheme very clearly: 'appraisal is just a paper exercise', 'a joke', 'a waste of time and effort'. and its objectives.

Requirement Discuss the possible reasons why the objectives of the formal appraisal system are not being met.

Answer to Interactive question 3 There is only limited information available about JBC's appraisal system. However, it is clear that the organisation has taken a formal approach using standardised forms with clear objectives for staff development and performance improvements. Problems with the system can be considered under two headings – firstly inherent problems with the design and implementation of the system, and secondly problems concerning its operation. Design and implementation problems The system may have been poorly designed in the first place. For example, it may be based on systems used by other organisations and no thought given to whether it is suitable for JBC. The design of the system may have reflected the needs of the organisation at that time but is no longer relevant because the company has 'moved on'. There may have been a lack of consultation and communication with senior managers when the system was being developed. They may view it as being imposed on them and therefore are not interested in making it work. Appraisal schemes should provide benefits which justify the cost and effort put into them. Senior management comments such as 'a waste of time and effort' indicate that there is an imbalance between what is put into the scheme and what comes out – for example, whether or not any staff development needs which are identified during an appraisal are actually subsequently addressed. This imbalance may have been caused by the system being put into place because senior management thought they should be seen to have an appraisal system, rather than it being a genuine method of improving staff development and performance. Operational problems

C H A P T E R

Senior managers may have insufficient time to conduct the appraisal process properly. This may reduce the scheme into a form filling exercise just to meet HR requirements, missing the point of the scheme The scheme focuses on staff development needs. This is likely to involve some additional training costs, and may also reduce the amount of time that academic staff are available for teaching (if they are attending training courses of their own). Therefore, managers may not see it as being in their interest to have staff undergo training. This, of course, is a short-sighted view, as properly structured training

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should improve JBC's performance in the long run. However, managers may not wish to wait for such benefits to materialise, preferring to focus on short-term issues and performance instead. The scheme is not linked to annual bonuses. Employees are likely to act in a manner that maximises their bonus, which may be at odds with the objectives of the appraisal system. Standard procedures indicate a bureaucratic or mechanical approach to appraisals. Senior managers will be faced with a large volume of identical paperwork that needs to be processed in addition to their existing work load. There is likely to be a temptation to rush through the process with not much thought to the objectives. Appraisal schemes often involve subjective judgements and opinions by senior managers over their staff. There is a risk that employees are not assessed correctly or consistently meaning that some staff who do not require training are offered it while others that need help to improve their performance are not.

Interactive question 4: Reward packages

[Difficulty level: Intermediate]

The Superior Business Consultancy (SBC), based in Jayland, provides clients with a range of business consultancy services as well as IT services and support. Currently, SBC pays all its consultants a fixed salary. However, some of the IT consultants are unhappy that their salaries are lower than those earned by the other types of consultant. Recently, four of SBC's longest-serving IT consultants resigned to go and work for rival consultancies. All of them said that the reward packages available had played a significant part in their decisions. The directors are worried about the prospect of more consultants leaving SBC and joining rival consultancies. As a result, the directors are reviewing SBC's reward packages. The directors are aware that all the major software providers in Jayland pay a commission to consultancy firms if the firm recommends their software to a client. Currently, this commission is payable to SBC as a whole, but the directors are considering whether it should be paid to individual consultants. They are also considering a proposal under which the IT consultants would receive a lower basic salary, but would then be entitled to receive any commissions earned from the software providers.

C H A P T E R

Requirement Evaluate the directors' proposal to revise the way SBC's IT consultants are paid.

Answer to Interactive question 4 Staff retention – It appears that SBC's current reward package for its IT consultants is not as competitive as that offered by some of its rivals. If this continues, then SBC's staff turnover could increase further, which is likely to be costly for SBC both in terms of having to recruit and train new staff and also in terms of the loss of knowledge which occurs when consultants leave. If the new proposal means that the overall value of the consultants' salary increases, then this could help to reduce staff turnover which should be beneficial to SBC. Value of commissions – However, it is not clear what impact the proposed changes will have on the consultants' salaries. The scenario does not indicate how much lower the new basic salary will be than the consultants current salaries, nor does it indicate the size of the commissions received from the software companies. It is possible that the proposal could actually end up reducing the consultants' salaries, which will have the opposite effect to what the directors are trying to achieve. will be needed. Local expertise will be necessary in employment law. Impact on SBC's profits – Equally, however, the directors will need to ensure that the changes are not too generous in favour of the consultants because they are likely to reduce SBC's profit margins, for example because the commissions will no longer be income for the company. Moreover, if the commission system doesn't stimulate higher sales revenue, the effect of the commissions will be to reduce profits overall. Therefore, a key issue surrounding the acceptability of the proposal is whether it will result in higher revenues being generated. Other consultants – The directors also need to consider how the other types of consultant will respond. Again, it is not clear how much communication there is between the three types of consultant, but if advertising and recruitment consultants find out the IT consultants have had their rewards schemes revised, they may want something similar themselves.

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Risk to customers â&#x20AC;&#x201C; When SBC's clients are looking to select a new software system, a key factor in their choice should be how well the system fits their requirements. Advice about the suitability of different systems is likely to be one of the key pieces of advice they want from the consultants. However, the new system could compromise the consultants' ability to give this advice impartially. Under the current system, it appears that the consultants have no incentive to recommend one software supplier over another. However, under the proposed new system, consultants may be tempted to advise clients to buy the system that will earn them the highest amount of commission rather than the system which is best for the client. Such practices could be damaging to SBC's reputation and future revenues. If clients install software systems on SBC's advice which do not meet their requirements effectively, then they are unlikely to use SBC in future. Alternative bonus/reward scheme â&#x20AC;&#x201C; It appears that the commission scheme is the only option which the directors have looked at so far. However, rather than only looking at one scheme, they should also consider whether there are any alternative schemes which may be more appropriate. For example, it is not clear whether SBC currently has any kind of performance related pay scheme, or bonus scheme; a scheme which rewards consultants for their performance in relation to a range of targets, linked to SBC's overall objectives, may be more appropriate than the current proposal.

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Strategic Business Management Chapter-11 Finance Awareness Interactive question 1: Financial strategy

[Difficulty level: Intermediate]

As a general illustration of the principles we've just discussed, consider the following outline scenario. Getfitquick operates leisure clubs in a number of countries in Europe. The company is a major presence in the leisure club market, specialising in high care, good facility operations. However, this market is highly competitive and over the last few years a number of chains that have not been growing have been taken over. Getfitquick's performance over the last couple of years has been stagnant, with falling membership in existing clubs and newly-opened clubs taking time to become profitable. The company is listed on a major European stock exchange, with a significant percentage of its shares being held both by its founders and by institutional investors. It also has significant loan finance, with loan creditors holding title deeds to some of the clubs, and in the past some of its loan commitments have had to be rescheduled. Requirements Getfitquick is considering whether to open a number of new clubs over the next few years. Draft notes suggesting how an expansion strategy would be judged against the criteria outlined above.

Answer to Interactive question 1 Factors to consider (a)

Investment, finance and dividends A major investment is planned. There may be financing problems as equity holders may not subscribe if there is a prospect of low dividends.

(b) Profit effects Growth in profit has to be sufficient to meet investor and market expectations. There may be problems initially with new clubs. (c)

Cash effects There will be major expenditure on new clubs, paying finance providers, and possibly refurbishing old clubs. Again new clubs may not generate very much cash flow just after opening.

(d) Shareholders There may be conflicts between initial investors who will accept a long-term return and want to retain active involvement in the business, and institutional shareholders with shorter-term interests who may be willing to accept a reasonably-priced takeover bid. (e)

Other stakeholders Debt holders will be concerned whether investment will generate sufficient returns to guarantee sum lent and income. Managers will be worried about expansion/curtailment of their position. Employees will want to know how operational changes will affect their employment. Customers will be concerned with the fees charged and the services offered.

(f)

Economic and market factors The financial markets are not viewing the sector very positively. Investment in clubs that make initial losses may have an adverse effect on share price, if markets do not take potential long-term revenues into account.

(g)

Restrictions Takeover of another big sports chain may run into difficulties from competition authorities. Existing loan agreements may contain possible restrictions on taking on more debt or opening more clubs.

(h) Risks Downturns in the economy may hit membership of sports clubs if it is perceived as a luxury item. The company may also be vulnerable to changes in property prices if it's investing in new sites, and changes in demand as leisure clubs become less popular. There may be some exposure to foreign exchange risks.

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(i)

Time frame

There's a potential conflict between the need for good short-term profits and cash flows, and longer-term returns. Generating strategy The strategy can be summed up as increasing profits and cash flows by opening X new clubs over the next X years throughout Europe. (a)

Benefits Benefits may accrue to shareholders in terms of dividend and market price appreciation.

(b) Direction Monitoring of investments should be by financial performance indicators for new and existing clubs and overall targets for returns on capital employed. (c)

Resources The company will need to specify sources of finance, amounts expected to be raised, commitments (return to suppliers and security). Also the directors should consider the generation of increased returns from existing operations by increasing membership charges and savings in operating costs.

(d) Environment changes The scale of investment in new clubs should be reconsidered if property prices rise beyond a certain level, or if demand for existing clubs falls beyond a certain level. (e)

Timescale Short-term investments may be limited by current funding problems. Finance may be available on better terms only when the existing network has generated higher returns.

Judging strategy (a)

Suitability A strategy of expansion will maintain the position as a market leader, necessary in a highly competitive market. Merely maintaining current position without any investment may leave the company vulnerable to takeover. However there may be better ways of achieving its goals, taking over existing clubs or diversifying into other less costly areas.

(b) Acceptability Will founder stakeholders maintain sufficient control, or will they prefer any combination of investment and financing to being taken over? Will institutional shareholders be satisfied with resultant dividend levels and movements in market prices? How will creditors view possible threats to their position? Will savings in operating costs adversely affect the service given to customers? (c)

Feasibility Will required finance be available from all sources to support investments, or are the uncertainties or likely restrictions unacceptable? Will existing and new clubs generate enough cash flows to pay providers of finance and make their own contribution to future investment? Does the company have the management, personnel and systems needed to run a much-expanded network of clubs?

Interactive question 2: Developments in financial reporting [Difficulty level: Intermediate] What general impacts might developments in financial reporting have on financial strategy?

Answer to Interactive question 2 General impacts might include: (a)

Relations with stakeholders Companies have to consider how changes in standards will affect the key indicators for various stakeholders. Changes that affect the calculation of profit will influence shareholders if profits become significantly more volatile as a result. Shareholders and lenders who are concerned with financial stability will be influenced by changes in the treatment and classification of capital instruments, for example changes that force companies to include previously off-balance sheet items.

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Other stakeholders may be affected by new forms of accounting or increased disclosures. Employees will be interested in developments in human resource accounting. Pressure groups and other interested stakeholders ('ethical investors') will be interested in how the organisation is reporting its impact upon the natural environment (considered further below). (b) Undertaking and form of transactions Changes in standards may also mean companies do not undertake transactions or stop doing what they previously have been doing. The introduction of more volatility into accounts may make certain transactions less attractive, for example granting of employee share options. Many companies in the United Kingdom have alleged that FRS 17 Retirement benefits, which introduced more onerous rules for accounting for pension liabilities, has forced them to close their final salary pension schemes and offer less generous arrangements instead. However other factors would have had a major influence on this decision as well. Alterations to standards can also affect the form transactions take. There is evidence that some acquisitions in the United Kingdom were structured in a certain way in order to be treated under the (more appealing) merger accounting rules than acquisition accounting rules. Prohibition of the merger accounting treatment removed the incentive to use unusual structuring arrangements. (c)

Investments Having diverse requirements internationally arguably allows companies in some jurisdictions to shelter behind doubtful arrangements. Evidence from the USA suggests that having one set of strict standards forces companies to be more efficient and more competitive. It also lowers the risks of investment, reducing the cost of capital and hence making previously unattractive overseas investments feasible.

(d) Costs of compliance In particular the costs of fundamental changes such as the introduction of international accounting standards may be significant. Not only will this impact upon companies' financial accounting function, but also may affect the management accounting function's work if compatibility between financial and management accounting is to be maintained.

Interactive question 3: Chemical company

[Difficulty level: Intermediate]

Burtchester is a privately-owned company that manufactures chemicals. It is likely to seek a stock market listing in the next two years, and because of the higher profile that it will have once it is listed, its directors feel that the company must have a Corporate Social Responsibility programme. The chairman feels that the programme needs to concentrate in particular on manufacturing processes (which are noisy and smelly and produce a lot of waste), Burtchester's sourcing of raw materials from economically underdeveloped countries, the ethnic diversity of its workforce and compliance with the law. Two years ago Burtchester acquired a manufacturing site, which now houses one of its largest plants. However, unlike its other factories which are situated on industrial estates, this factory is located in the middle of a residential area. Since it opened, there have been complaints from a group of local residents about the noise made by the factory's processes and by lorries loading and unloading at the start and end of the day. Two of the residents wrote to the Chief Executive three months ago to say that they intend to take legal action to stop the noise and claim compensation for distress previously caused. Nothing further has been heard from them since the original letter. Requirements (a)

Advise Burtchester on what the main features of its CSR policy should be, dealing with its manufacturing process, procurement policy, labour force and compliance with the law.

(b)

Briefly describe the contents of an environmental report that would be appropriate for Burtchester and briefly explain the main elements of the assurance work that could be carried out to verify the contents of this report.

(c)

Discuss the corporate reporting implications of the claim by the residents.

Answer to Interactive question 3 (a)

Burtchester's CSR policy needs to deal with the following matters: Manufacturing process

Waste â&#x20AC;&#x201C; The manufacturing process currently produces large quantities of waste, so Burtchester Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

should aim to recycle as much of its waste as possible. However, Burtchester should also try to reduce the levels of waste it produces, for example by making sure its manufacturing processes are as efficient as possible, and by reducing resource usage as far as possible. Noise – The manufacturing process is currently very noisy, so the policy needs to identify how the noise levels may be reduced. In this respect, Burtchester needs to consider both the level of noise pollution for the local neighbourhoods around its manufacturing plants, and also the noise levels within the plants where staff have to work. Smell – The manufacturing process is smelly as well as noisy, so the policy needs to address smell in a similar way to noise. Procurement policy Raw material procurement – As Burtchester sources some of its materials from economically underdeveloped countries, its policy needs to define the basis on which it does business with companies in those countries. In particular, Burtchester needs to highlight the importance of ensuring the price, terms and conditions it negotiates with suppliers are fair. Labour force There are two issues in relation to the workforce which the CSR policy needs to address: Equality – Ensuring that all members of the workforce are treated fairly and equally. Working conditions – Improving the conditions the staff have to work under. As well as the manufacturing process being noisy and smelly, there will also be health and safety requirements. The CSR policy should therefore highlight Burtchester's commitment to workplace safety. Compliance Burtchester has always tried to comply with its country's laws, and it should continue to do so. However, CSR involves more than simply complying with basic legal requirements, so Burtchester's policy should establish its basic principle of complying with the law before going on to highlight the other principles that will enable it to be a good corporate citizen. (b) Reports Reports are often referred to as 'triple bottom line reporting' on the following topics: 

Economic – Information provided should go beyond that required by law. It should demonstrate how Burtchester adds value in a wider sense, eg by creating human capital.



Environmental matters – The report should include information on how Burtchester's activities impact on the environment, eg impact of sourcing chemicals, waste management, noise etc.



Social – Information provided may be on a range of social issues – working hours, rates, policies on child employment, equal opportunities, disablement policies.

A number of companies are following the Global Reporting Initiative (GRI), which aims to deliver transparency, accountability, reporting and sustainable development. Assurance Suitable measures to monitor policies would include checking the appropriate documentation of policies and evidence that they are circulated to staff. The policies should, for example, form part of staff's induction training. Burtchester should initiate internal audit procedures or employ external assurance providers to monitor implementation and check accuracy of reporting mechanisms and key performance indicators. External evidence of, for example, the effectiveness of environmental policies should be obtained from expert third parties where appropriate. (c)

Requirements of IAS 37 Although local residents have given notice that they would be taking legal action against Burtchester no claim appears to have been made. As yet there is no present obligation on Burtchester to make reparations for the disturbance caused and so certainly no provision needs to be made. Whether disclosure is required is questionable. As no notice of a claim has yet been received, the probability of a claim can be regarded as remote and no disclosure required under IAS 37.

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Strategic Business Management Chapter-12 Business and securities valuation 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

(b)

The dividend is expected to grow at a rate of 4% pa into the foreseeable future

(c)

The dividend is expected to grow by 4% per year for the next three years and then to remain constant thereafter.

Answer to Interactive question 1 ke = 12% + 2% = 14% (0.14) (a) P0 =

D0 = £250,000

D0 £250,000 = = £1,785,714 ke 0.14

D (1 g) £250,000(1.04) = (b) P0 = 0 = £2,600,000 g 0.14 – 0.04 ke – (c)

P0 

g = 4% or 0.04

£250,000(1.04)3  1/0.14 £250,000(1.04)  £250,000(1.04)2   (1.14)2 (1.14) (1.14)2

= £228,070 + £208,064 + £1,545,618 = £1,981,752

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: (d) (e)

Bumblebee, which has a P/E ratio of 15, but is a company with very good growth prospects 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? Answer to Interactive question 2 (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 of 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.

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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

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 0 1 2 3 4 5

Cash flow (net of tax) £ (100,000) (80,000) 60,000 100,000 150,000 150,000

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?

Answer to Interactive question 3 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 purchase consideration £ 0 (100,000) 1 (80,000) 2 60,000 3 100,000 4 150,000 5 150,000 Maximum purchase price Year

Discount factor (from tables) 15% 1.000 0.870 0.756 0.658 0.572 0.497

Present value £ (100,000) (69,600) 45,360 65,800 85,800 74,550 101,910

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Interactive question 4: Valuing an acquisition using free cash flow model [Difficulty level: Intermediate]

The management of Atrium, a company in the DIY industry, is considering making a bid for Tetrion, 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 $ 300 2,500 2,600 5,800 750 5,050 10,450 3,600 2,000 4,850 10,450

Cash Receivables Inventory Property, plant & equipment Accum depreciation Net property, plant & equipment Total assets Payables Long-term debt Equity Total liabilities and owners' equity

20X3 $ 100 1,500 1,400 4,000 500 3,500 6,500 2,560 2,000 1,940 6,500

Change $ 200 1,000 1,200 1,800 250 1,550 3,950 1,040 – 2,910 3,950

Statement of profit or loss 20X4 $ 12,000 3,500 3,000 250 6,750 100 5,150 1,236 3,914

Sales Cost of sales Selling: General administrative Depreciation Total expense Interest Income before tax Taxes (24%) Profit for the year Free cash flows Cash flows – Operations Revenue Cash expenses Taxes Total

20X4 $ 12,000 (6,500) (1,236) 4,264

Cash flows – Investments Working capital Non-current assets Total Free cash flow

1,360 1,800 3,160 1,104

The following predictions are made by the management of Atrium for the next five years:

Free cash flows Sales Operating costs excluding depreciation EBDIT Depreciation EBIT Less: tax on EBIT @ 24% Plus depreciation Less: capital expenditure

20X5 $

20X6 $

20X7 $

20X8 $

20X9 $

12,000

15,000

18,750

23,438

29,297

6,500 5,500 250 5,250 1,260 250 1,800

8,125 6,875 300 6,575 1,578 300 2,160

10,156 8,594 360 8,234 1,976 360 2,592

12,696 10,742 432 10,310 2,474 432 3,110

15,869 13,428 519 12,909 3,098 518 3,732

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Less: additions to working capital Free cash flow Terminal value (3,277/0.12) Total free cash flow

20X5 $ 1,360 1,080

20X6 $ 1,700 1,437

20X7 $ 2,125 1,901

20X8 $ 2,656 2,502

20X9 $ 3,320 3,277

1,080

1,437

1,901

2,502

27,308 30,585

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?

Answer to Interactive question 4 First we calculate the PV of the free cash flows over the five year planning horizon.

FCF Discount factor at 12% PV

20X5 $ 1,080 0.893 964

20X6 $ 1,437 0.797 1,145

20X7 $ 1,901 0.712 1,354

20X8 $ 2,502 0.636 1,591

20X9 $ 30,585 0.567 17,342

Total PV = $22,396 PV @ 12% (see above) Less: debt Equity value Shares outstanding Intrinsic value per share

$ 22,396 2,000 20,396 100 $203.96

Market share price

$29.00

Price at which Tetrion shareholders will sell ($29.00 × 120%)

$34.80

Discount of selling price from value

83%

The shareholders of Atrium should buy Tetrion at the offered price.

Interactive question 5 Main plc is considering the acquisition of a profitable unquoted company Peek Limited. The directors of Peek have indicated that they would accept a cash offer of £54 million. (a)

If the acquisition goes ahead, it would be financed entirely by a ten-year loan at 6% interest. The costs of raising this money would be £1 million, so the total amount borrowed will be £55 million.

(b)

It is estimated that the acquisition will increase the operating cash flows of Main plc, net of tax, by £4 million per year in perpetuity.

(c)

The ungeared equity beta that would apply to this investment is 0.80. The risk-free rate of return is 5% and the market rate of return is 8%. Tax is at the rate of 21%.

Requirement Using the APV method of valuation, suggest whether the purchase price demanded by the directors of Peek would be acceptable to Main plc.

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Answer to Interactive question 5 Cost of ungeared equity = 5% + 0.80(8 – 5)% = 7.4% Base case NPV (ignoring the purchase cost of Peek) = £4 million/0.074 = £54.05 million Tax relief on interest Years 1 – 10 = £55 million × 6% × 21% = £0.693m PV of tax relief discounted at risk-free cost of debt 5% = £0.693m × 7.722 = £5.35m Financing costs = £1 million – (£1 million × 21% × 0.952) = say £0.8 million (Note: It is assumed that the costs of the debt issue are allowable for tax purposes.) Ignoring the purchase cost Base case NPV PV of debt financing benefits PV of financing costs APV

£m 54.05 5.35 (0.80) 58.60

This suggests that a purchase price of £54 million would be just acceptable financially, with an APV off + £4.6 million after deducting the purchase cost. However, the directors of Main should try to negotiate a lower price if possible. They should also consider other factors, such as the risk and uncertainty in the estimated cash flows, before making a decision about whether or not to agree to the asking price.

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

Non-current assets (carrying amounts) Land and buildings Plant and equipment Motor vehicles Patents

800 450 55 2 1,307

Current assets Inventory Receivables Cash Current liabilities Payables Taxation

£'000

250 125 8 383 180 50 230 153 1,460

Long-term liability Loan secured on property

Share capital (300,000 ordinary shares of £1) Reserves

400 1,060 300 760 1,060

The profits after tax and interest but before dividends over the last five years have been as follows: Year 1 2 3

£ 90,000 80,000 105,000

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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 noncurrent 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:

Recent year Previous year Three years ago Average

Albatross plc Div. yield P/E ratio % 12 8.5 12 8.0 12 8.5 12 8.33

Bullfinch plc Div. yield P/E ratio % 11.0 9.0 10.6 8.5 9.3 8.0 10.3 8.5

Crow plc Div. yield P/E ratio % 13.0 10.0 12.6 9.5 12.4 9.0 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.

Answer to Interactive question 6 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). (a)

Earnings-basis valuations If the purchaser believes that earnings over the last five years are an appropriate measure for valuation, we could take average earnings in these years, which were: £465,000  £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 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 appropriate figures.)

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P/E ratio 8.5 9.0 10.0 9.167 5.5

Albatross plc Bullfinch plc Crow plc Average Reduce by about 40% to allow for unquoted status

(i) (ii)

Share valuations on a past earnings basis are as follows: P/E ratio (i) (ii)

Earnings £'000 93 93

9.167 5.5

Valuation £'000 852.5 511.5

Number of shares

Value per share

300,000 300,000

£2.84 £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 Year 2 Year 3 Year 4 Year 5 Average

£ 100,000 104,000 108,160 112,486 116,986 108,326.4

(say £108,000)

A share valuation on an expected earnings basis would be as follows: P/E ratio 5.5

Average future earnings £108,000

Valuation £594,000

Value per share £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. 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.

P 0

D0 (1 g) (k g)



45,000(1.04)

 £360,000 or £1.20 per share

(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

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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. Cash flow £'000 120 120 140 70 120

PV of cash flow £'000 1 105.24 2 92.28 3 94.50 4 41.44 5 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. Year

(e)

Discount factor 14% 0.877 0.769 0.675 0.592 0.519

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.

Interactive question 7: Value of redeemable debt

[Difficulty level: Easy]

A company has issued some 9% debentures, which are redeemable at par in three years' time. The most recent interest payment on the debentures has just been made. Investors now require an annual redemption yield of 10%. What will be the current market value of each £100 of debenture: (a)

if interest is paid annually

(b)

if interest is paid six-monthly?

Answer to Interactive question 7 (a) If interest is paid annually: Year 1–3 3

Interest Redemption value

Cash flow £ 9 100

Discount factor 10% 2.487 0.751

Present value £ 22.38 75.10 97.48

Discount factor 5% 5.076 0.746

Present value £ 22.84 74.60 97.44

Each £100 of debenture will have a market value of £97.48. (b) If interest is paid six-monthly: Assumed six-monthly yield = 10%/2 = 5% Period 1–6 6

Interest Redemption value

Cash flow £ 4.5 100

Each £100 of debenture will have a market value of £97.44.

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Strategic Business Management Chapter-13 Financial Instruments and financial markets Interactive question 1: Convertibles

[Difficulty level: Intermediate]

The 10% convertible bonds of Starchwhite are quoted at £142 per £100 nominal. The earliest date for conversion is in four years time, at the rate of 30 ordinary shares per £100 nominal. The share price is currently £4.15. Annual interest on the bonds has just been paid. Required (a)

Calculate the current conversion value.

(b)

Calculate the conversion premium and comment on its meaning.

Answer to Interactive question 1 (a) Conversion ratio is £100 bond = 30 ordinary shares Conversion value = 30  £4.15 = £124.50 (b) Conversion premium = £(142 – 124.50) = £17.50 17.50 or  100% = 14% 124.50 The share price would have to rise by 14% before the conversion rights became attractive.

Interactive question 2: Black-Scholes formula

[Difficulty level: Intermediate]

The current share price of Cathlynn plc is £3.50. Using the Black-Scholes formula, estimate the value of a European call option on the shares of the company that has an exercise price of £3.30 and three months to run before it expires. The risk free rate of interest is 8% and the variance of the rate of return on the share has been 12%.

Answer to Interactive question 2 Find (d1) and (d2) ln(3.50/3.30)  (0.25  0.08) d1 =

0.12 0.25

+ 0.12 0.25

= 0.4552 + 0.0866 = 0.5418 d2 = 0.5418 – (

0.12 0.25)

= 0.5418 – 0.1732 = 0.3686 Find N (d1) and N (d2) using normal distribution tables N (0.5418) = 0.5 + 0.2060 = 0.7060 N (0.3686)

= 0.5 + 0.1438 = 0.6438

Using the Black-Scholes formula C 0= (3.50  0.7060) – ((3.30e

– 0.25  0.08

)  0.6438)

= 2.4710 – 2.0825 = 38.85p

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Interactive question 3 On 1 November 20X5, a company enters into a forward contract with its bank to sell US$750,000 on 1 February 20X6 in exchange for sterling, at a forward rate of $1.50 = £1. The company’s year-end is 31 December. At 31 December 20X5, the $/£ rate has changed to $1.55 and at settlement on 1 February 20X6 the spot exchange rate is $1.60.

How should this forward contract be accounted for by the company? Answer to Interactive question 3 The asset is classified as a financial asset or liability at fair value through profit or loss. On 1 November 20X5 it has no value as an asset or liability. At 31 December 20X5, the financial instrument should be revalued to $750,000/1.55 = £483,871. The company will be receiving £500,000 on 1 February; therefore it has gained from the exchange rate movement. The gain of £16,129 (£500,000 - £483,871) should be recognised in profit for the year to 31 December 20X5. On 1 February 20X6 when the forward contract is settled, the spot value of the dollars that the company must pay to receive £500,000 is now just £468,750 ($750,000/1.60). The total gain on the forward contract has been £31,250. As £16,129 was recognised in profit or loss for 20X5, a further £15,121 will be recognised in profit for the year to 31 December 20X6.

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Strategic Business Management Chapter-14 Financial structure and financial reconstruction 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? Answer to Interactive question 1 Algol:

Rigel:

= rf + e (rm – rf)

= rf + 1.2 (7 – rf)

= rf + 8.4 – 1.2 rf

0.2 rf

= 0.4

= 2 + (7 – 2) 1.8 = 11%

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 Dividend per share, 20X1 Expected growth rate in dividends and earnings Average market return Risk-free rate of return Beta factor of Stilton equity shares

250 pence 3 pence 10% pa 8% 5% 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?

Answer to Interactive question 2 (a) ke

d0 (1 g)

P0 3(1.10) 250

+ 0.10

= 0.1132 or 11.32% (b) ke

= 5 + 1.40 (8 – 5) = 9.2%

Interactive question 3: CAPM and beta factor (a)

What does beta measure, and what do betas of 0.5, 1 and 1.5 mean?

(b)

What factors determine the level of beta that a company may have?

[Difficulty level: Easy]

Answer to Interactive question 3 (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 subdivided 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.

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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 ½ or 1½ 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.

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 ten years Ignore taxation.

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Answer to Interactive question 4 (a) (b)

i The cost of irredeemable debt capital is  P0

£10  100% = 11.1% £90

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

0 1–10 10

Market value Interest Capital repayment

Cash flow £ (90) 10 100

Discount factor 12% 1.000 5.650 0.322

PV £ (90.00) 56.50 32.20 (1.30)

Discount factor 11% 1.000 5.889 0.352

PV £ (90.00) 58.89 35.20 +4.09

The approximate cost of redeemable debt capital (pre-tax) is therefore: k = (11 + d

4.09

 1) = 11.76% (4.09 – 1.30)

Interactive question 5: Cost of debt (with tax)

[Difficulty level: Easy]

(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 as at 28 December 20X2?

(b)

If the cost of debt rose to 12% at the beginning of 20X3, just after the notes had gone ex interest, what effect would this have on the market price?

(c)

If the effective rate of tax was 21% what would be the after-tax cost of debt of the loan notes in (a) above?

Answer to Interactive question 5 (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. Item and date Market value (ex int) Interest Redemption NPV

Year 28.12.X2 31.12.X3 – X5 1.1.X6

0 1–3 3

Cash flow £ (95) 8 100

Discount factor 10% 1.000 2.487 0.751

Present value £ (95.0) 19.9 75.1 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 the debt security rises to 12%, the market price will fall to reflect the new rates required by investors. As the debt is now ex interest, the price will also have fallen by the £8 payment at the end of 20X2. Item and date Interest Redemption NPV

Year 31.12.X3 – X5 1.1.X6

1–3 3

Cash flow £ 8 100

Discount factor 12% 2.402 0.712

Present value £ 19.2 71.2 90.4

The estimated market price would be £90.40 per cent, ex interest.

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(c)

Again we must deduct the current interest payable and use ex interest figures. Item and date Market value (ex int) Interest Redemption NPV

Year

31.12.X3 – X5 1.1.X6

0 1-3 3

Cash flow £ (95.0) 8.0 100.0

PV 10% £ (95.0) 19.9 75.1 0

The estimated after-tax cost of debt is: 10% (1 – 0.21) = 7.9%

Interactive question 6: Weighted average cost of capital

[Difficulty level: Easy]

An entity has the following information in its statement of financial position. Ordinary shares of 50c Debt (12% irredeemable, nominal value)

$'000 2,500 1,000

The ordinary shares are currently quoted at 130 cents each and the loan notes are trading at $72 per $100 nominal. The ordinary dividend of 15c has just been paid with an expected annual growth rate of 10%. Corporate tax is currently 24%. Calculate the weighted average cost of capital for this entity.

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Answer to Interactive question 6 Market values: 2,500

Equity (E):

 1.30

$'000 6,500

0.5 1,000  0.72

Loan notes (D): E+D

720 7,220

Cost of equity:

ke =

1+ g

0.151+ 0.1

+g=

+ 0.1= 0.2269 = 22.69%

1.3

Cost of loan stock:

kd =

i (1– T)

0.12 (1– 0.24)

= 0.1267 = 12.67%

0.72

Weighted average cost of capital: E  D  kd WACC = ke +  E  D   E  D  WACC =

 6,500 

  720   × 22.69% + × 12.67%  = 20.43% + 1.26% = 21.69%        7,220    7,220  

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 have been given.

Answer to Interactive question 7 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 = 10,000 = 20% Thus the project is worthwhile, as expected return exceeds required return.

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Interactive question 8: Dividend policy

[Difficulty level: Intermediate]

Summarised financial data for TYR plc is shown below.

20X0 20X1 20X2 20X3 20X4

Post-tax earnings £ million 86.2 92.4 99.3 134.1 148.6

Year 20X0 20X1 20X2 20X3 20X4

All-share index 2895 3300 2845 2610 2305

Year

Dividends £ million 34.5 36.2 37.6 51.6 53.3

Issued shares million 180 180 180 240 240

Share price pence 360 410 345 459 448

Inflation rate 6% 5% 4% 3% 3%

Requirements Explain, with supporting numerical evidence, the current dividend policy of TYR plc, and briefly discuss whether or not this appears to be successful.

Answer to Interactive question 8

20X0 20X1 20X2 20X3 20X4

Post-tax EPS Pence 47.9 51.3 55.2 55.9 61.9

Growth % – 7.1 7.6 1.3 10.7

Dividend per share Pence 19.2 20.1 20.9 21.5 22.2

Growth % – 4.7 4.0 2.9 3.3

Inflation % – 5 4 3 3

Payout ratio % 40.1 39.2 37.9 38.5 35.9

The data indicates that TYR is paying a constant real dividend per share, the nominal dividend per share being adjusted by the rate of inflation. As a result its payout ratio has declined. Assessment of dividend policy One way in which we can measure the success of the dividend policy is to compare the changes in the share price of TYR with the changes in the market index. FT all share index 20X0 20X1 20X2 20X3 20X4

2895 3300 2845 2610 2305

Growth % – 14.0 (13.8) (8.3) (11.7)

Share price Pence 360 410 345 459 448

Growth % – 13.9 (15.9) 33.0 (2.4)

TYR's shares have out-performed the market over the last two years, so by this measure its dividend policy has been a success, despite the decline in payout ratio. Limitations of analysis However, TYR's share price may be affected by factors other than its dividend policy. Modigliani and Miller suggested that shareholders will be indifferent between dividends and capital gains. Even if this view is not accepted, in a reasonably efficient market shareholders may be influenced by the present value of expected future cash flows rather than present dividend policy. The fact that TYR is retaining a higher proportion of its earnings may signal to shareholders that it has plans for significant investment in profitable opportunities. Other influences on share prices can include rumours of a takeover bid.

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Interactive question 9: Proceeds from liquidation

[Difficulty level: Intermediate]

Ascertain the likely result of Crosby & Dawson Limited (see above) going into liquidation as at 31 March 20X2.

Answer to Interactive question 9 £'000 3,000 1,400 120 800 1,050 6,370

Breakup values of assets at 31 March 20X2 Freehold Plant and machinery Motor vehicles Patents Current assets

Total liabilities at 31 March 20X2 Debentures Other loans Bank overdraft Trade payables

£'000 1,000 3,000 750 1,960 6,710

Thus liabilities exceed assets, and on a liquidation the shareholders would receive nothing.

Interactive question 10: Financial reconstruction

[Difficulty level: Intermediate]

Adrian Walsh produces hand-made furniture. The company has been reorganised twice over the last ten years, but is currently facing financial difficulties which have been made worse by the recent cancellation of three major orders by important customers. The company's overdraft limit of £3 million has been reached and the bank has refused to grant any further credit. No dividends have been paid on the cumulative preference shares for five years, and the shareholders are becoming impatient. The company has just completed a statement of assets and liabilities. STATEMENT OF ASSETS AND LIABILITIES AT 31 DECEMBER 20X9 £'000 Non-current assets Buildings (freehold) Plant and equipment Delivery vehicles Deferred development expenditure Current assets Inventory Trade receivables

Current liabilities Trade payables Bank overdraft

Current assets less current liabilities Non-current liabilities 8% loan (20Y5) secured on buildings Other loans (floating charges)

£'000 11,000 7,750 800 3,150

4,000 2,900 6,900 7,750 3,000 10,750 (3,850) 4,000 12,000 (16,000) 2,850

Ordinary shares of £1 each 7% cumulative preference shares Retained earnings/(deficit)

14,000 4,000 (15,150) 2,850

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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 breakup 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 21%. The company will be preparing full forecasts for profit and financial position over the next few years on the assumption that the reconstruction goes ahead in its proposed form. Requirement Calculate whether the reconstruction scheme is likely to succeed and describe the assurance procedures that an accountant should undertake in order to provide a report on the forecasts for profit and financial position for Adrian Walsh when they have been prepared.

Answer to Interactive question 10 Breakup values of assets at 31 December 20X9 Freehold buildings Liquidation costs Secured loan Plant and equipment Delivery vehicles Sale of patents Current assets Other loans Trade payables and bank overdraft

£'000 11,250 (1,250) (4,000) 6,000 5,000 500 3,125 4,000 18,625 (12,000) 6,625 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.

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Reconstruction scheme Earnings before interest and tax Interest (8%  £3,125,000 + 12%  £8,000,000) Earnings before tax Tax at 21% Earnings after interest and tax P/E ratio (average)

£'000 3,600 1,210 2,390 502 1,888 10.8

Share price = (£1,888,000  10.8) / Number of shares (10,500,000) = £1.94 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 it had previously and the yield on the loan remains the same (8%). If the company went into liquidation it would receive the full amount of the money owing to it. Other loans The loan provider will receive £8,000,000 secured loan plus £4,125,000 worth of shares (£1.50  2,750,000). This is more than it 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 if reconstruction took place Cash from new share issue to equity holders Repayment of overdraft Available cash

£'000 5,000 3,000 2,000

The reconstruction scheme may not be acceptable to all interested parties. In particular, the providers of 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 unavoidable. Assurance procedures Applicable to all Prospective Financial Information (PFI) 

Discuss with management the way in which the PFI is prepared.



Compare the actual results of previous restructurings with forecasts to determine overall level of accuracy of PFI.



Determine who specifically is responsible for the preparation of the PFI and assess their experience and expertise.



Assess the role of internal audit and other control procedures over the preparation of PFI.



Check the accounting policies normally adopted by the company. These should have been consistently applied in the preparation of the PFI.

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

Check the arithmetical accuracy of the PFI by making clerical checks such as re-computation. Internal consistency should also be assessed through the use of analytical procedures.



Obtain written representations from management regarding the intended use of the prospective financial information, the completeness of significant management assumptions and management's acceptance of its responsibility for the prospective financial information.

Profit forecasts 

Discuss with management the means by which they have predicted expected revenues/profits. For example, extrapolation of historical data may be inappropriate due to the restructuring.



Check that any assumptions made are consistent with one another. For example, if revenue is expected to grow certain costs would also be expected to increase (although not necessarily in direct correlation). Assess the assertion by the business that the restructuring will result in a lower cost base.



Compare assumptions made for forecast purposes with other internal information produced by the business. For example, expected sales growth can be compared to sales and marketing plans.



Compare assumptions made with general industry data and trends particularly in respect of the building systems market.



Compare predicted costs against actual costs incurred. Clarify the rationale behind any significant cost savings.

Forecast statements of financial position 

Perform analytical review comparing key ratios including ROCE, current ratio and gearing, based on the forecast information with the most recent results.



Agree proposed additions to tangible assets to capital expenditure budgets. Ensure assumptions regarding depreciation are consistent with the profit forecast. (This would also apply to intangibles.)



Agree cash balance to other forecast information, e.g. cash flow.



Determine the level of provisions made in respect of discontinued activities and assess whether they seem reasonable.



Compare predicted movements in loans to cash flow.



Analyse movement on reserves (i.e. is movement on revenue reserve equal to forecast profit? If not what do the other movements represent?).

Interactive question 11: SME finance

[Difficulty level: Intermediate]

DF is a manufacturer of sports equipment. All of the shares of DF are held by the Wong family. The company has recently won a major three-year contract to supply FF with a range of sports equipment. FF is a large company with over 100 sports shops. The contract may be renewed after three years. 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 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 ten days rather than the normal 90 days.

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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:    

(b)

Bank loan Overdraft Debt factoring Invoice discounting

Discuss the factors that a venture capital organisation will take into account when deciding whether to invest in DF.

Answer to Interactive question 11 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 market prospects of a company, 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.

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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 As already stated, the main drawback to using an overdraft is that it is repayable on demand. 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: (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 (i)

The level of finance is geared to the level of sales. In other words, finance lags sales. In practice, DF will need finance ahead of sales in order to build up sufficient inventories to meet demand.

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(ii)

Factoring may be more expensive than bank finance. Service charges are generally around 2% of total invoice value, in addition to finance charges at levels comparable to bank overdraft rates.

(iii) The fact that accounts receivable will be making payments direct to the factor may present a 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. 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. It 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. The debenture holders may require security that the company is unable to provide.

(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, 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.

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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 setting out 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, as bearing part of the risk will provide an incentive 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.

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Strategic Business Management Chapter-15 Financial Risk Management 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 settlement/delivery date is 20 December 20X6. On 22 November the future is trading at 94.63. On 24 November 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?

Answer to Interactive question 1 The asset underlying the future is a notional three-month deposit of £500,000. In the example, the price of the future alters by 0.10% (94.63 – 94.53), or ten ticks. The value per tick is £500,000 × 0.0001 × 3/12 = $12.50. So the profit on each contract would be: £12.50 × 10 ticks = £125

Interactive question 2: Interest rate futures

[Difficulty level: Intermediate]

Rumble Inc will shortly be making a short-term investment and wants to borrow $4 million for three months, starting in three months' time. However, interest rates are currently volatile and it is worried about adverse movements in these rates before it takes out the loan. Rumble Inc is considering using interest rate futures to hedge the $4 million loan. It is now 1 March and the current futures prices are (for standard $1 million three-month contracts): March delivery June delivery September delivery

96.00 96.10 96.20

These contracts will expire at the end of the quoted months. The spot three-month LIBOR rate is 3.5% and Rumble can borrow at a rate of approximately LIBOR + 1%. At 1 June, the price of the June futures contract is 95.07 and the price of the September futures contract is 95.10. Requirement Assuming that Rumble takes out a loan at a rate of LIBOR + 1% on 1 June, illustrate the outcome of hedging with the futures contract if LIBOR at that date is 4%.

Answer to Interactive question 2 Set up Sell futures to hedge against the risk of an increase in the interest rate. Choose the futures contract with the next delivery date/settlement date following the date when it is intended to close the position. In this case the company should sell June futures on 1 March. (a)

How many contracts?

Exposure

= Contract size ($4m/$1m)  (3/3) = 4 contracts an period Length of contract

Closing the position on 1 June Original sale price on 1 March Buying price to close the position on 1 June Gain per contract

96.10 95.07 1.03

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Total gain on futures = 103 ticks × $25 per tick × 4 contracts = $10,300. Gain per contract 0.35 % Interest cost on loan (LIBOR + 1%) 5.00 ($4,000,000 × 5% × 3/12) Gain on futures contract (1.03) Net cost 3.97

Interactive question 3: Exchange-traded options

$ 50,000 (10,300) 39,700

[Difficulty level: Intermediate]

Rumble (see Interactive question 2) is considering using options to hedge against interest rate movements on its $4 million loan. It is now 1 March and LIBOR remains at 3.5%. Rumble Inc will be able to borrow on 1 June at LIBOR + 1%. Options on three-month futures ($1,000,000 contract size, premium cost in %) are as follows.

9600 9625 9650

Calls June 0.195 0.075 0.085

March 0.120 0.015 0

September 0.270 0.155 0.085

Puts June 0.085 0.255 0.480

March 0.020 0.165 0.400

September 0.180 0.335 0.555

Rumble chooses to trade in options on futures with an exercise price of 96.25. Requirement Illustrate the effect of using options to hedge against the risk of a rise in interest rates with an option hedge at 3.75% and assuming that on 1 June (a) (b)

three-month LIBOR is 4% and the June futures price is 95.90 three-month LIBOR is 2% and the June futures price is 97.95..

Answer to Interactive question 3 Set up Buy put options on June futures at a price of (100 – 3.75) 96.25. Exposure

How many contracts? 

= ($4m/$1m)  Contract size (3/3) = 4 contracts

an period Length of contract (e)

Premium = 0.255%



Total premium cost: Contracts  premium  



  Outcome

Buy put options On 1 June Sell at Closing by buying at

 

Size of contract 12 months



= 4  0.00255  [$4m/(12/3)] = $10,200

  Length of contract 

  LIBOR 4% Futures price 95.90

Exercise options to sell futures at 96.25 96.25 95.90

LIBOR 2% Futures price 97.95 Do not exercise options

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C H A P T E R

1037

Total gain on futures (35 ticks × $25 × 4 contracts) Borrow at LIBOR + 1% (= 5% or 3%): interest cost Option premium Net cost

(3,500) 50,000 10,200 56,700

– 30,000 10,200 40,200

In this example, the high cost of the option premiums means that hedging with options would not have been financially worthwhile without a much more substantial increase in the LIBOR rate between 1 March and 1 June.

Interactive question 4: FRA settlement value

[Difficulty level: Intermediate]

Suppose a 4 v 10 US$10 million FRA is transacted with an FRA rate of 3.5%. The four-month forward period starts on the spot date and extends to the settlement date. For this FRA, the reference rate is sixmonth US$ LIBOR. Suppose the reference rate is 3.8% on the fixing date. What is the settlement amount? (The US$ money market uses a 360-day basis for calculating interest, not a 365-day basis.)

Answer to Interactive question 4 On the settlement date, the borrower will receive the following amount from the lender: (0.038 – 0.035) × (180 / 360) S = $10 million ×

1+ (0.038 × (180 / 360)) S = $14,720.

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1037

Interactive question 5: Interest rate swap

[Difficulty level: Intermediate]

Seeler Muller, a German company, wishes to borrow US$300 million for five years at a floating rate to finance an investment project in California. The cheapest rate at which it can raise such a loan is US dollar LIBOR + 0.75%. Seeler Muller can issue a fixed interest five-year bond at 9% per annum interest. Another German company, Overath Maier, needs a five-year fixed interest loan at $300 million. The cheapest rate at which it can arrange the loan is 10.5% per annum. It could, however, borrow in US dollars at the floating rate of US dollar LIBOR + 1.5%. Both companies have approached the same bank that deals in interest rate swaps. The bank is currently offering the following five-year swap rates against US dollar LIBOR: 8.78% – 8.48%. Seeler Muller can issue a fixed interest five-year dollar bond at 9% per annum interest. The bank would charge a swap arrangement fee of 0.15% per year to both parties. You are required to devise a swap by which both parties can benefit. You are also required to explain why the companies would prefer to arrange a swap through their bank rather than directly with each other

Answer to Interactive question 5 Company wants Would pay (no swap) With a swap Borrow at Swap with bank Pay Receive Net cost

Seeler Muller Floating (LIBOR + 0.75%)

Overath Maier Fixed (10.5%)

(9.00)%

(LIBOR + 1.5)%

(LIBOR)% 8.48% (LIBOR + 0.52%)

(8.78)% LIBOR (10.28)%

0.23%

0.22%

Net benefit from swap

Both companies make a net gain by arranging a swap, and the bank would make a profit from the difference of 0.3% between its fixed pay rate and fixed receive rate for the five-year swaps. The swap arrangements would be as follows.

Step 1

Seeler Muller borrows $300 million for five years at a fixed interest rate of 9%, possibly by issuing a bond.

Step 2

Overath Maier borrows $300 million for five years at a floating rate of LIBOR + 1.5%, possibly as a bank loan or a syndicated bank loan.

Step 3

Each company enters into a separate five year swap deal with their bank. In its swap Seeler Muller pays ‘interest’ at US dollar LIBOR to the bank and receives in return ‘interest’ at 8.48%. Taking the loan and the swap together, its net interest cost is LIBOR + 0.52%. This is 0.23% less than it would pay if it had borrowed directly at LIBOR + 0.75%. In its swap Overath Maier receives ‘interest’ at US dollar LIBOR from the bank and in return pays ‘interest’ at 8.78%. Taking the loan and the swap together, its net interest cost is 10.28%. This is 0.22% less than it would pay if it had borrowed directly at a fixed rate of 10.5%. The exchange of ‘interest’ payments in the swaps could be timed to coincide with the payments by the companies on their direct loans.

Step 4

C H A P T E R

At the end of five years the companies repay their loans at 9% fixed (Seeler Muller) and LIBOR + 1.5% (Overath Maier), and their swap arrangements terminate.

With these swap arrangements the bank profits by 0.30%, the difference between its pay and receive rates on five-year swaps. In theory, the two companies would therefore benefit jointly by 0.3% if they arranged their swaps directly with each other. In practice this does not happen, for three reasons:

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1049



It is a straightforward task to approach a bank to arrange a swap. It is much more difficult to find another company that has matching but opposite borrowing and interest payment requirements.



Banks that arrange swaps do not need to match different requirements of their customers. They can deal separately and individually with each customer, quoting their swap rates.



The credit risk (counterparty risk) is much lower when dealing with a bank than when dealing with another non-bank corporate.

Interactive question 6: Northland and Southland

[Difficulty level: Intermediate]

The spot exchange rate between two currencies, the Northland florin (NF) and the Southland dollar (S$) is NF4.7250 = S$1. It is expected that 12-month interest rates will be 6% in Northland and 9% in Southland for each of the next three years. Using interest rate parity theory, predict the spot exchange rate at the end of each of the next three years.

Answer to Interactive question 6 At end of Year 1

4.7250 × (1.06/1.09) = 4.5950

At end of Year 2

4.7250 × (1.06/1.09) = 4.4685

At end of Year 3 4.7250 × (1.06/1.09) = 4.3455 These are predictions of future spot rates. However the one-year forward rate for NF/S$ will be close to 4.5950, due to the differences in interest rates. (Forward contracts with settlement dates beyond 12 months exist only for a limited number of currency pairs.)

Interactive question 7: Forecasting exchange rates

[Difficulty level: Easy]

Assume that the $/£ exchange rate is currently $1.7/£, expected inflation in the UK is 4% and the expected inflation rate in the US is 5%. What is the expected exchange rate in one year's time according to the PPP?

Answer to Interactive question 7 The exchange rate will be: Future spot rate  1.7 

1.05

 1.716

1.04 That is the dollar is expected to depreciate relative to the pound by $0.016 or 0.9%.

Interactive question 8: International Fisher effect 1

[Difficulty level: Easy]

Suppose that the nominal interest rate in the UK is 6% and the expected rate of inflation is 4%. If the expected rate of inflation in the US is 5% what is the nominal interest rate in the US? What is the real interest rate in each country?

Answer to Interactive question 8 The nominal interest rate in the US is:

1 ic



1 hc

1 ib

1 hb 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%.

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C H A P

1050

The real interest rate in both countries is approximately 2% (the difference between the nominal interest rate and the inflation rate for each country). Interactive question 9: International Fisher effect 2

[Difficulty level: Easy]

Suppose that the nominal interest rate in the UK is 6% and the nominal interest rate in the US is 7%. What is the expected change in the dollar/sterling exchange rate over a year?

Answer to Interactive question 9 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%.

Interactive question 10: Forward contract

[Difficulty level: Easy]

A German exporter will receive an amount of $1,500,000 from a US customer in three months' time. He can arrange a forward exchange contract to cover this transaction. The current spot rate is $1 = €0.7810 – 0.7840 and the three month forward rate is quoted at 0.0005 – 0.0003 premium. Requirement

C H A P

Calculate how much the exporter will receive under the terms of the forward contract. T E

Answer to Interactive question 10 The German bank will buy $ at the lower rate 0.7810. The premium should be deducted from this rate 0.7810 – 0.0005 = 0.7805. As the $ is the base currency, multiply the amount in $ by the forward rate: 1,500,000 × 0.7805 = €1,170,750

Interactive question 11: Money market hedging

[Difficulty level: Intermediate]

Nicole, a French company, has made a large sale worth $5,000,000 to a US company, Sims Inc. Sims Inc is due to settle the amount it owes to Nicole in three months' time, on 15 December. Currency market rates Spot rate $ per €1

1.5904 – 1.5912

Money Market Rates pa Euro US

2.6% 1.6%

Demonstrate how Nicole can use the money market to hedge the foreign currency receipt.

Answer to Interactive question 11 We need to borrow now to match the receipt we shall obtain. France €3,129,764

Now

@ 1.0065** 3 months 3

12 3

€3,150,107

@ 1.5912

US $4,980,080

@ 1.004* $5,000,000

× 1.6% = 0.4% × 2.6% = 0.65%

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1051



Borrow an amount in US which will be repaid in three months, so that principal and interest will equal $5,000,000 (1.6% pa = 0.4% for three months). Total paid off by $ receipt in three months' time



Convert principal in $ to € at spot (€1 = $1.5912)



Invest € in money market (2.6% pa = 0.65% for three months)



The deposit will grow to €3,150,107

Interactive question 12: Currency futures

[Difficulty level: Intermediate]

Allbrit plc, a company based in the UK, imports and exports to the USA. On 1 May it signs three agreements, all of which are to be settled on 31 October. (a) (b) (c)

A sale to a US customer of goods for $205,500 A sale to another US customer for £550,000 A purchase from a US supplier for $875,000

On 1 June the spot rate is £1 = 1.5500 – 1.5520 $ and the October forward rate is at a premium of 4.00 – 3.95 cents per pound. Sterling futures contracts are trading at the following prices: Sterling futures (IMM) Contract size £62,500 Contract settlement date Jun Sep Dec

Contract price $ per £1 1.5370 1.5180 1.4970

Requirements (a)

Calculate the net amount receivable or payable in pounds if the transactions are covered on the forward market.

(b)

Demonstrate how a futures hedge could be set up and calculate the result of the futures hedge if, by 31 October, the spot market price for dollars has moved to 1.5800 – 1.5820 and the sterling futures price has moved to 1.5650.

Answer to Interactive question 12 (a)

Before covering any transactions with forward or futures contracts, match receipts against payments. The sterling receipt does not need to be hedged. The dollar receipt can be matched against the payment giving a net payment of $669,500 on 31 October. The appropriate spot rate for buying dollars on 1 May (bank sells low) is 1.5500. The forward rate for October is spot – premium = 1.5500 – 0.0400 = 1.5100. Using a forward contract, the sterling cost of the dollar payment will be 669,500/1.5100 = £443,377. The net cash received on October 31 will therefore be £550,000 – 443,377 = £106,623.

(b) Set up

Step 1

(a) Which contract December contracts (b) Type of contract Sell sterling futures in May, we sell the sterling in order to buy the $ that we need (c)

Number of contracts Here we need to convert the dollar payment to £ as contracts are in £ Using December futures price: 669,500

= £447,228

1.4970

£447,228 No of contracts = 62,500 = 7.16 contracts, round to 7

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1052

Step 2

Closing futures price 1.5650

Step 3

Result of futures market Value per tick (in US dollars) = £62,500 × 0.0001 = $6.25. (a) Futures market outcome Opening futures price Closing futures price Movement Futures market loss = 680 ticks × $6.25 × 7 = $29,750

1.4970 Sell 1.5650 Buy 0.0680 Loss

(b) Net outcome Spot market payment Futures market loss

$ (669,500) (29,750) (699,250)

Translated at closing spot rate The bank sells low hence we use the rate of 1.5800

Interactive question 13: OTC option

1.5800 £442,563 [Difficulty level: Easy]

Edted is a UK company that has purchased goods worth $2,000,000 from an American supplier. Edted is due to make payment in three months' time. Edted's treasury department is looking to hedge the risk using an over-the-counter option, A three-month dollar call option has a price of 1.4800. Requirement Ignoring premium costs, calculate the cost to Edted if the exchange rate at the time of payment is: (a) £1 = $1.4600 (b) £1 = $1.5000

Answer to Interactive question 13 As the option is an over-the-counter option, it is possible to have a dollar call option and to cover the exact amount. (a)

If the exchange rate is 1.4600, the option will be exercised and the cost will be: 2,000,000 = £1,351,351 1.4800

(b)

If the exchange rate is 1.5000, the option will not be exercised, and the cost will be: 2,000,000 = £1,333,333 1.5000

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C H A P T E

1063

Interactive question 14: Traded option

[Difficulty level: Intermediate]

Vinnick, an American company, purchases goods from Santos, a Spanish company, on 15 May on three months' credit for €600,000. Vinnick is unsure in which direction exchange rates will move so has decided to buy options to hedge the contract at a rate of €1 = $1.2950. The details for €10,000 options at 1.2950 are as follows. Calls

Puts

July

August

September

July

August

September

2.55

3.57

4.01

1.25

2.31

2.90

The current spot rate is 1.2821. Requirement Calculate the dollar cost of the transaction if the spot rate in August is: (a) 1.3330 (b) 1.2500

Answer to Interactive question 14

Step 1

Set up the hedge (a)

Which date contract? August

(b)

Put or call? Call, we need to buy euros

(c)

Which strike price? 1.2950

(d)

How many contracts 600,000 = 60 10,000

(e)

Step 2

Use August call figure of 3.57. Remember it has to be multiplied by 0.01. Premium

= (3.57  0.01)  Contract size  Number of contracts

Premium

= 0.0357  10,000  60 = $21,420

Closing spot and futures prices Case (a) 1.3330 Case (b) 1.2500 Assume here the price to use for options calculation is the same as the closing spot rate.

Step 3

Outcome (a) Options market outcome Strike price call Closing price Exercise? Outcome of options position

1.2950 1.3330 Yes €600,000

1.2950 1.2500 No –

(b) Net outcome Spot market outcome translated at closing spot rate 600,000 × 1.2500 Options position 600,000 × 1.2950 Premium

– (770,000) (21,420) (798,420)

(750,000) – (21,420) (771,420)

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Interactive question 15: 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.

Answer to Interactive question 15 The following forex 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.

Interactive question 16: El Dorado part 2

[Difficulty level: Intermediate]

Look again at El Dorado part 1. Assume that the currency spot rate is 100 rupees/£ and the Sri Lankan government has offered a forex swap at that rate. The estimated spot rate in one year's time (when the government will pay for the theme park ride) is 180 rupees/£. The current UK borrowing rate is 8%. Requirement Should El Dorado hedge the exposure using the swap or should it just do nothing? Show all workings to support your answer.

Answer to Interactive question 16 With the swap Year 0 £m Buy 500 million rupees (spot rate = 100) Swap 500 million rupees back (spot rate 100) Sell 400 million rupees at 180/£ Interest on sterling loan (£5 million × 8%)

Year 1 £m

(5.0)

5.00 2.22 (0.40) 6.82

Net outcome is a net receipt of £1.82 million. Do nothing

Buy 500 million rupees (spot rate = 100) Sell 900 million rupees (spot rate = 180) Interest on sterling loan (£5 million × 8%)

Year 0

Year 1

£m

(5.0)

5.0 (0.4) 4.6

Net outcome is a net payment of £0.4 million. El Dorado is better off undertaking the swap.

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1071

Interactive question 17: 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) $/£ 1.7106 – 1.7140 0.82 – 0.77 cents premium 1.39 – 1.34 cents premium

Spot Three months forward Six months forward Interest rates Three months or six months Sterling Dollars

Borrowing 12.5% 9%

Lending 9.5% 6%

Foreign currency option prices (New York market) Prices are cents per £, contract size £12,500

Exercise price ($) 1.60 1.70 1.80

March – 5.65 1.70

Calls June 15.20 7.75 3.60

Sept – – 7.90

March – – –

Puts June – 3.45 9.32

Sept 2.75 6.40 15.35

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.

C H A P T E R

Requirements (i)

Calculate the net sterling receipts and payments that Fidden might expect for both its threeand six-month transactions if the company hedges foreign exchange risk on:  

The forward foreign exchange market The money market

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1071

(ii)

(c)

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.

PRW appears to have hedged a large foreign currency payment due on 30 April 20X8 with a foreign currency transaction that it entered into in October 20X7 and has accounted for this hedge using cash flow hedging. It is currently 31 March 20X8 and you are involved in the audit of PRW for the year ended 28 February 20X8. There has been a large fair value loss on the hedging arrangement as calculated at 28 February 20X8. The documentation connected with the hedging was not given to you until some days after you requested it, and you are suspicious that it may not have been prepared until after you asked to see it. Requirement Explain the corporate reporting issues and assurance risks that arise as a result of your suspicions about the hedging documentation, and describe the assurance work you would carry out on the hedging arrangements.

Answer to Interactive question 17 (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)

Forward exchange market The rates are: Spot 3 months' forward 6 months' forward

$/£ 1.7106 – 1.7140 1.7024 – 1.7063 1.6967 – 1.7006

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C H A P T E R

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 $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:

1  (1 (0.095  3 ))  £924 12 1 (0.09  3 ) 1.7140 $197,000

£116,000

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. The sterling payment six months hence is therefore: 293,000 1   (1  0.125  6 )  £176,690 6 12 1.7106 1  0.06  12

(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 £). Using options at $1.70 gives the following results. $293,000

= £172,353

1.70$ / £ Contracts required =

£172,353

= 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. The overall cost is £175,000 +

$293,000 + $6,038 $297,500

= £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$/ £ Contracts required =

£162,778

 14 (to next whole number)

£12,500 Cost of options = 14  12,500  9.32 cents = $16,310

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14 contracts will provide, for £12,500  14 = £175,000, 175,000  1.80 = $315,000. The overall cost is £175,000 +

$293,000 + $16,310 $315,000

= £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. (c)

Financial reporting issues To be eligible for hedge accounting the hedge documentation must be in place at the inception of the hedge relationship. Until the necessary documentation is in place hedge accounting cannot be applied even if the underlying hedging activity is valid. There can be no retrospective designation of a hedge relationship. If the hedge documentation is ultimately determined to be valid, then IAS 39 permits a foreign currency hedge of a firm commitment to be treated either as a fair value hedge or a cash flow hedge. If the hedge to be validly designated as a cash flow hedge, then the fair value loss can be recognised in other comprehensive income in accordance with the directors' wishes. It then needs to be reclassified into profit or loss in the year ending 28 February 20X9 when the underlying transaction takes place. Assurance risks The key risk is that this is not a valid hedge because the hedge documentation was not in place at the date of inception of the hedge, but was only drawn up later when the hedge instrument made a loss. Also, the forecast purchase after the year-end needs to be 'highly probable' or hedge accounting is not permitted. If it is not a valid cash flow hedge then the reduction in fair value would be recognised in profit or loss rather than in other comprehensive income. This would not affect overall comprehensive income, but it would affect profit for the period. Assurance procedures 

Examine documentation that evidences that the purchase transaction will take place with a high degree of probability, or has already taken place (eg correspondence with suppliers, contracts).



Review hedge documentation for evidence of completeness (describing hedge relationship, risk management objective, identification of hedge instrument and hedge item, nature of risk being hedged, assessment of effectiveness).



Look for any evidence of a date on which the documentation was drawn up (eg reference to events after October).



Speak to the author of the documentation and question them about the hedge and when they prepared documentation. Question other personnel for consistency of the story.

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1085

Strategic Business Management Chapter-16 International Financial Management Interactive question 1: International investment decisions

[Difficulty level: Intermediate]

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 (a)

Discuss factors that Tiger should take into consideration when deciding which, if any, African countries it should invest in.

(b)

How might Tiger handle political risk if it invested in Africa?

(c)

What ethical issues might have to be taken into consideration as part of Tiger's overall overseas investment strategy?

Answer to Interactive question 1 (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.

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(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, it 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 Tiger obtains 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. The laws of developed countries have progressively reflected voters' concerns on ethical issues by banning activities considered harmful to society (eg drug dealing) or to the economy (eg corruption) and by developing numerous constraints on the behaviour by companies towards employees, the local community and the environment. These are intended to give companies a level playing field on which they can compete vigorously. Adverse publicity Where potentially unethical activities are not banned by law, companies need to make difficult 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: (i) (ii) (iii) (iv) (v) (vi)

Provision of proper safety equipment and working conditions for employees Use of child labour Wage rates below subsistence level Discrimination against women, ethnic minorities, and so on Pollution of the environment '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.

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Interactive question 2: Overseas investment

[Difficulty level: Intermediate]

Watson 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 mobile phone, which is currently manufactured in Watson's home country, Eardisland. If the Buzzlandian investment project was undertaken the existing Eardisland factory would either be closed down or downsized. Watson hopes to become more competitive by shifting production from Eardisland. Additional information: (i)

Corporate tax in Eardisland is at the rate of 24% 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 Eardisland.

(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 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 Eardisland.

(xi) If the Eardisland 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.

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(xii) If Watson decides to downsize rather than close its home country 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 Eardisland if downsizing does not occur. (xiii) The estimated beta of the Buzzland investment is 1.5 and of the existing Eardisland 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: Year 1 Year 2 Year 3 Year 4 Year 5

Eardisland and the EU 2% 3% 3% 3% 3%

Buzzland 20% 15% 10% 10% 10%

(xvii) Spot exchange rates: Buzzland francs/$ 36.85 Buzzland francs/Euros 23.32 Requirements (a)

Should Watson undertake the proposed investment in Buzzland and consequently close or downsize its Eardisland 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 the final decision as to whether to invest in Buzzland?

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Answer to Interactive question 2 (a)

Eardisland investment Cost of closing Eardisland factory = 35 (1 – 0.24) – 20 = $6.6 million Cost of downsizing = 20 (1 – 0.24) – 10 = $5.2 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 – 0.24) × Inflation factor (1.02 Year 1, 1.02 × 1.03 Year 2 etc) 0 $m (5.2)

Net downsizing costs Post-tax cash flows

(5.2) Discount factor 12% 1.000 (5.2) Net present value = $4.7million

1 $m

2 $m

3 $m

4 $m

3.1 3.1 0.893 2.8

3.2 3.2 0.797 2.6

3.3 3.3 0.712 2.3

3.4 3.4 0.636 2.2

Buzzland investment 0 Fm

WORKING Sales German comp. Labour Local comp. Sales and distrib. Fixed costs Tax allow. deprec. Taxable profit Tax at 20% Tax allow. deprec. Investment Working capital Remittable cash flows Fm Exch. rate Remittable cash flows $m Add: Eardisland tax Net cash flows Disc. factor Disc. cash flows

(2) (3) (4) (5) (6) (7) (8)

(9)

(1)

(580) (170) (750)

2 Fm 735 (47) (262) (104) (23) (58) (109) 132 (26) 109

3 Fm 785 (52) (288) (114) (25) (63) (82) 161 (32) 82

(34) 179

(31) 184

(23) 188

4 Fm 839 (57) (317) (125) (28) (70) (94) 148 (30) 94 150 258 620

36.85 (20.4)

43.35 4.1

48.40 3.8

51.69 3.6

55.20 11.2

(20.4) 1.000 (20.4)

(0.1) 4.0 0.870 3.5

(0.1) 3.7 0.756 2.8

(0.1) 3.5 0.658 2.3

(0.1) 11.1 0.572 6.3

(10) (11)

1 Fm 659 (41) (228) (90) (20) (50) (145) 85 (17) 145

Net present value = $ (5.5) million Present value overall = 4.7 – 5.5 = $ (0.8) million On these figures, the reorganisation does not appear to be worthwhile.

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WORKINGS (1) Exchange rates Year

PP factor

Buzzland francs/$

Buzzland francs/euro

36.85

23.32

43.35

27.44

48.40

30.64

51.69

32.72

55.20

34.94

0 1 2 3 4

1.20 1.02 1.15 1.03 1.10 1.03 1.10 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

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(4) Labour Incremental cost of employing 50 extra workers 50,000 × 3,800 × (50/250) = F38 million This is less than the F75 million a year factory rental, so the extra workers are employed. Costs 50,000 × 3,800 × (300/250) × Inflation factor Inflation factor 1.15 Yr 2, 1.15 × 1.1 Yr 3, etc (5) Local components 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 Fm

0 1 2 3 4

145 109 82 94

Tax written-down value Fm 580 435 326 244 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) Eardisland tax Taxable profits × (0.24 – 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.

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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 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).

Interactive question 3: Transfer pricing

[Difficulty level: Intermediate]

An MNC based in Beeland has subsidiary companies in Ceeland and in the UK. The UK subsidiary manufactures machinery parts which are sold to the Ceeland subsidiary for a unit price of B$420 (420 Beeland dollars), where the parts are assembled. The UK subsidiary shows a profit of B$80 per unit; 200,000 units are sold annually. The Ceeland subsidiary incurs further costs of B$400 per unit and sells the finished goods on for an equivalent of B$1,050. All of the profits from the foreign subsidiaries are remitted to the parent company as dividends. Double taxation treaties between Beeland, Ceeland and the UK allow companies to set foreign tax liabilities against their domestic tax liability. The following rates of taxation apply. Tax on company profits Withholding tax on dividends

UK 25% â&#x20AC;&#x201C;

Beeland 35% 12%

Ceeland 40% 10%

Requirements Show the tax effect of increasing the transfer price between the UK and Ceeland subsidiaries by 25%.

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Answer to Interactive question 3 The current position is as follows. UK company B$'000

Ceeland company B$'000

Total B$'000

84,000 (68,000) 16,000 (4,000) 12,000 0

210,000 (164,000) 46,000 (18,400) 27,600 2,760

294,000 (232,000) 62,000 (22,400) 39,600 2,760

Revenues and taxes in Beeland Dividend Add back foreign tax paid Taxable income

12,000 4,000 16,000

27,600 18,400 46,000

39,600 22,400 62,000

Foreign tax credit Tax paid in Beeland (3)

5,600 (4,000) 1,600

16,100 (16,100) â&#x20AC;&#x201C;

21,700 (20,100) 1,600

Total tax (1) + (2) + (3)

5,600

21,160

26,760

Revenues and taxes in the local country Sales Production expenses Taxable profit Tax (1) Dividends to Beeland Withholding tax (2)

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An increase of 25% in the transfer price would have the following effect. UK company B$'000

Ceeland company B$'000

Total B$'000

105,000 (68,000) 37,000 (9,250) 27,750 0

210,000 (185,000) 25,000 (10,000) 15,000 1,500

315,000 (253,000) 62,000 (19,250) 42,750 1,500

Revenues and taxes in Beeland Dividend Add back foreign tax paid Taxable income

27,750 9,250 37,000

15,000 10,000 25,000

42,750 19,250 62,000

Beeland tax due Foreign tax credit Tax paid in Beeland (3)

12,950 (9,250) 3,700

Total tax (1) + (2) + (3)

12,950

Revenues and taxes in the local country Sales Production expenses Taxable profit Tax (1) Dividends to Beeland Withholding tax (2)

8,750 (8,750) â&#x20AC;&#x201C; 11,500

21,700 (18,000) 3,700 24,450

The total tax payable by the company is therefore reduced by B$2,310,000 to B$24,450,000.

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Strategic Business Management Chapter-17 Investment Appraisal 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) (ii) (iii) (iv)

Payback period Accounting Rate of Return Net Present Value Internal Rate of Return

Answer to Interactive question 1 Note: The exploratory work of £15,000 is a sunk cost and is therefore not relevant when appraising the project. Payback period In this case, the payback period will be the amount of time it will take Robbie plc to earn £500,000. Year

Cash flow £ 200,000 200,000 200,000

1 2 3

Cumulative cash flow £ 200,000 400,000 600,000

Payback is therefore 2 years + (100,000/200,000) = 2.5 years Accounting rate of return (ARR) ARR =

Average Accounting Profit Average Investment

Accounting Profit = Cash flow Depreciation Depreciation =

Cost Resale value Useful life =

500,000 50,000 4

= £112,500 pa Average profit per annum

= £200,000

112,500

= £87,500 Average investment

Cost + Resale value 2

ARR 

500,000  50,000 = £275,000 2

87,500 = 31.8% 275,000

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Net present value

Initial investment Cash flow Resale proceeds Net cash flow Discount factor (10%) Discounted cash flow

Year 0 £ (500,000)

(500,000) 1.000 (500,000)

Year 1 £

Year 2 £

Year 3 £

Year 4 £

200,000 – 200,000 0.909 181,800

200,000 – 200,000 0.826 165,200

200,000 – 200,000 0.751 150,200

200,000 50,000 250,000 0.683 170,750

NPV = £167,950

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

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). IRR = 10 +

167,950 (167,950  49,300)

 (30 – 10)

IRR = 25.5%

Interactive question 2: NPV with inflation and taxation

[Difficulty level: Intermediate]

Bazza 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. Corporate tax rate is 24% 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 on whether the project should be undertaken.

Answer to Interactive question 2 WORKINGS (all figures in $) (1) Tax writing-down allowances (WDA) Year 20X0 WDA (20%) 20X1 WDA 20X2 WDA 20X3 WDA 20X4 WDA 20X5 Proceeds Balancing all

WDA/Written-down value

Tax saved at 24%

350,000 (70,000) 280,000 (56,000) 224,000 (44,800) 179,200 (35,840) 143,360 (28,672) 114,688 (60,000) 54,688

16,800 13,440 10,752 8,602 6,881

13,125

(2) Inflation computations Net cash inflows

20X1 95,000

20X2 98,800

20X3 102,752

20X4 106,862

20X5 111,136

20X1

20X2

20X3

20X4

20X5

22,800

23,712

24,660

25,647

26,673

(3) Tax computations Tax at 24% of net cash inflows

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

NPV calculation Initial investment Cash (net) Tax (24%) WDA/Bal. all Sale Disc. factor DCF

20X0 (350,000)

20X1

20X2

20X3

20X4

16,800

95,000 (22,800) 13,440

98,800 (23,712) 10,752

102,752 (24,660) 8,602

106,862 (25,647) 6,881

(333,200) 1.000 (333,200)

85,640 0.893 76,477

85,840 0.797 68,414

86,694 0.712 61,726

88,096 0.636 56,029

20X5 111,136 (26,673) 13,125 60,000 157,588 0.567 89,352

NPV = $18,798 As NPV is positive, the project is feasible and should be undertaken.

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. Corporate tax is 24% 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.

Interactive question 4: Modified IRR

[Difficulty level: Easy]

The following cash flows are relevant for a project: Year 0 –10,000 0

Cash outflows (£) Cash inflows (£)

Year 1 0 3,000

Year 2 0 5,000

Year 3 0 7,000

If the discount rate is 10% what is the modified internal rate of return?

Answer to Interactive question 3

Step 1

Calculate NPV of the project with the original cost of equity with no gearing. Ungeared beta ße = ßa (1 +

D(1 T) ) E

1.178 = ßa (1 + (1 × ((1 – 0.24)/3))) ßa = 0.94 Ungeared cost of equity (using CAPM) = Rf + ßa × Market premium = 7 + 0.94 × 6 = 12.6% (say 13%) Discounted cash flow using 13% as the discount rate Year Initial investment Annual cash flow

0 $m (8) –

1 $m – 2.5

2 $m – 2.5

3 $m – 2.5

4 $m – 2.5

5 $m – 2.5

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

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 × 24% = $0.192m Discount at cost of debt (8%) over 5 years

= $0.192 × 3.993 = $0.767m

Step 3

Issue costs = $300,000 APV = $0.79m – $0.3m + $0.77m = $1.26m As APV is positive, the project should be undertaken with the proposed method of financing.

Interactive question 4: Modified IRR

[Difficulty level: Easy]

The following cash flows are relevant for a project: Year 0 –10,000 0

Cash outflows (£) Cash inflows (£)

Year 1 0 3,000

Year 2 0 5,000

Year 3 0 7,000

If the discount rate is 10% what is the modified internal rate of return?

Answer to Interactive question 4 PVOUTFLOWS = £10,000 Value of inflows if reinvested at the 10% cost of capital Year 1 2 3

MIRR =

Interest rate multiplier

Cash inflows £ 3,000 5,000 7,000

1.21 1.1 1.0

Amount when reinvested £ 3,630 5,500 7,000 16,130

(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.)

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' cash flows. Year 0 1 2

Purchase of plant £ (7,000)

Running costs £

Cost savings £

2,000 2,500

6,000 7,000

Requirement Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and savings.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Answer to Interactive question 5 The PVs of the cash flows are as follows. Year

Discount factor 8%

0 1 2

1.000 0.926 0.857

PV of plant cost £ (7,000)

(7,000)

PV of running costs £

PV of savings

(1,852) (2,143) (3,995)

5,556 5,999 11,555

PV of net cash flow £ (7,000) 3,704 3,856 560

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. (a)

Plant costs sensitivity

(b)

Running costs sensitivity =

(c)

Savings sensitivity

560

 100  8% 7,000

560

 100  14% 3,995

560

 100  4.8% 11,555

Interactive question 6: International investment appraisal

[Difficulty level: Easy]

A UK company is considering an investment in a foreign country, Marshland. The investment would last for four years and would cost £500,000. At the end of the four years, the investment would have no residual value. Annual cash flows in Marshland dollars (M$) are expected to be: 

Revenue M$2 million



Operating costs: M$1 million



Tax on net operating cash flows: 25%. Tax is payable in the same year as the operating profit to which it relates. However revenues are expected to increase with inflation by 5% in each year and operating costs are expected to increase by 8% per year. The general rate of inflation is expected to be 4% each year in the UK and 6% in each year in Marshland. Assume that all after-tax cash flows are remitted to the UK in the year that they arise. No further tax will be payable in the UK. Ignore capital allowances. Use PPP theory to estimate the exchange rate for each year. The current spot exchange rate is M$4 to the £. The company will apply a cost of capital of 10% to the project. Requirement Calculate an NPV for this project.

Answer to Interactive question 6 Cash flows should be adjusted for expected inflation. The exchange rate each year, according to PPP theory, will change by a factor of × 1.06/1.04 Year

1 M$ m 2.100 1.080 1.020 0.255 0.765 4.077

£'000 (500.0) 1.000 (500.0) +92.7

£'000 187.6 0.909 170.5

Revenue Operating costs Tax at 25% Net cash flow Exchange rate in M$ Cash flow in £ Discount factor at 10% PV NPV

2 M$ m 2.205 1.166 1.039 0.260 0.779 4.155 £'000 187.5 0.826 154.9

3 M$ m 2.315 1.260 1.055 0.264 0.791 4.235 £'000 186.8 0.751 140.3

4 M$ m 2.431 1.360 1.071 0.268 0.803 4.317 £'000 186.0 0.683 127.0

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Interactive question 7: International investment appraisal

[Difficulty level: Intermediate]

Donegal, a company based in the country of Earland which has the Franc (F) as its currency, 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 F100,000 per annum will be incurred each year in Earland over the expected life of the project. The Earland taxation rate on Earland income and expenditure is 24%, payable one year in arrears. Assume there is full double taxation relief in operation between Earland and Ruritania. The Ruritanian $:F exchange rate is 5:1. The company's cost of capital for the project is 10%. Requirement Calculate the NPV of the project.

Answer to Interactive question 7 Time 0 $'000 cash flows Sales receipts Costs Tax allowable depreciation (brought in to calculate taxable profit) $ taxable profit Taxation Add back tax allowable depreciation (as not a cash flow) Capital expenditure Scrap value Tax on scrap value (W1) Terminal value Tax on terminal value Working capital Exchange rates

1,600 (1,000)

(400) 200

(400) 200 (70)

400

(70)

(2,000) 800 (140) 500 (175) (400) (2,400) 5:1

600 5:1

530 5:1

400 2,230 5:1

(385) 5:1

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Time 0 F'000 cash flows From/(to) Ruritania Additional Earland expenses/income Earland tax effect of Earland expenses/income Net sterling cash flows Earland discount factors Present values

(480)

(480) 1 (480)

120 (100)

106 (100)

446 (100)

(77)

24 30 0.826 24.8

24 30 0.751 22.5

24 370 0.683 252.7

24 (53) 0.621 (32.9)

20 0.909 18.2

NPV = F (195,000), 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

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

. Strategic Business Management Chapter-18 Treasury and working capital management Interactive question 1: 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?

Answer to Interactive question 1 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 can 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.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Interactive question 2: Global treasury

[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.

(b)

How the company proposes to minimise any potential problems for the subsidiaries that might arise as a result of treasury centralisation.

Answer to Interactive question 2 Memorandum To: From: Date:

Directors of all foreign subsidiaries Consultant 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 intercompany goods and services centrally. The potential benefits The main benefits are: (a) (b) (c)

Cost savings resulting from reduction of unnecessary banking charges. Reduction of the Group's total taxation charge. Enhanced control over financial risk.

Reduction in banking charges will result from: (a)

Netting-off intercompany debts before settlement. At the moment, we are spending too much on foreign exchange commission by settling intercompany debts in a wide range of currencies through the banking system.

(b)

Knowledge of total Group currency exposure from transactions. Amounts receivable in one subsidiary can hedge payables in another, eliminating unnecessary hedging by subsidiaries.

(c)

Knowledge of the Group's total cash resources and borrowing requirement. This will reduce the incidence of one company lending cash while a fellow subsidiary borrows at a higher interest rate and will also eliminate unnecessary interest rate hedging. It will also facilitate higher deposit rates and lower borrowing rates.

Reduction in the Group's tax charge will be made possible by a comprehensive centrally-set transfer pricing policy. 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.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

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.

Interactive question 3: Treasury matters

[Difficulty level: Intermediate]

The board of SFR has agreed to establish a corporate treasury department, with a full-time Treasurer who will be appointed to deal with the cash flows, supported by a small staff who will undertake the associated administration. None of SFR's existing employees are suitably qualified for any of these posts and so all will have to be appointed externally. The Chief Accountant is concerned that this team of new employees will have a great deal of discretion over making payments which will increase the risk of fraud. The Finance Director feels that the Internal Audit department can monitor the Treasury department on a day-to-day basis. The Finance Director also feels that the new Treasury department will give SFR the opportunity to profit from currency movements by actively taking positions in currencies that are going to appreciate in value. Requirements (a)

Discuss the merits of the suggestion that SFR should control its planned Treasury department by having the Internal Audit department monitor its routine activities.

(b) Discuss the merits of SFR attempting to earn profit from speculating on currency movements.

Answer to Interactive question 3 (a)

Responsibilities The responsibilities of operational managers of the treasury department should include management of risk. This should mean that they are responsible for day-to-day monitoring. The Finance Director and Chief Accountant should be responsible for overseeing the treasury department, rather than delegating this role to internal audit. Internal auditors should provide assurance and review of the treasury department's activities. They should observe the control systems rather than be part of them. Involvement in commercial decisions By being involved in day-to-day operations, there is a risk that internal auditors will have some responsibility for approving commercial decisions. This goes against the principle that internal audit should not be involved in operational decision-making. Expertise Internal audit may not have the expertise required to carry out the day-to-day review of complex treasury transactions. Independence and familiarity If internal auditors become involved with the treasury department, there is a risk that they become too friendly with members of the department. This could mean that they become too willing to take on trust explanations from treasury staff rather than verifying them.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Self-review Part of internal audit's brief ought to be reviewing the effectiveness of day-to-day monitoring of the treasury department. However, their position will be compromised if they themselves are carrying out the monitoring, since they will be reviewing their own work. Other priorities Day-to-day monitoring of the treasury department may mean that internal audit has insufficient time and resources to carry out other audit work. There may be other risky areas of the business that require substantial internal audit work. (b) Strategic objectives SFR's main strategic objective is to develop its retail activities. Its main strategic risks will be linked to that objective. The company's strategy is not to speculate on the foreign exchange markets. Instead, it should be using the markets to reduce the risks of the commercial transactions it undertakes. Profits available The markets for major currencies are generally efficient. It is therefore difficult to make profits over time by anticipating the market. SFR may have to invest substantial resources to gain the market intelligence it needs to have a chance of outperforming the market. SFR may have greater opportunities for speculation in the currencies of developing economies, since the markets for these are less mature, and SFR's commercial activities may give it the insights it needs to gain an advantage in these currencies. However, this speculation may carry greater risks than dealing in more stable major currencies. Risk appetite Speculating on the treasury markets may involve a higher degree of risk than SFR's current activities. These risks may be higher than SFR's board or shareholders wish to tolerate. There is no certainty that the currencies in which SFR's treasury function takes positions will appreciate in value. Motivation of team members Involving the treasury department in speculative activities may mean that SFR attracts individuals who are seeking to take high risks in return for high returns. However, SFR's main purpose in setting up the treasury department is not to seek high returns, but to improve the efficiency of its cash management.

Interactive question 4: Working capital management

[Difficulty level: Intermediate]

It is currently May 20X6. MNO is a private toy distributor situated in the United States of America (US) with a US customer base and local suppliers. There is a central manufacturing base and several marketing units spread across the US. The marketing units are encouraged to adapt to local market conditions, largely acting independently and free from central control. These units are responsible for all aspects of local sales, including collecting sales revenues, which are paid across to Head Office on a monthly basis. Funding is provided by Head Office as required. Figures for last year to 31 December 20X5 were: Revenue

$10 million

Gross profit margin

40% of revenue

Accounts receivable days minimum 20, maximum 30 days Accounts payable days minimum 40, maximum 50 days Inventories

minimum 50, maximum 80 days

Non-current assets

$8 million

Accounts receivable, accounts payable and inventories can all be assumed to be the same on both 31 December 20X4 and 31 December 20X5, but fluctuate between those dates.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

The Financial Controller is carrying out an analysis of MNO's working capital levels, as requested by the Treasurer. He is assuming that the peak period for accounts receivable coincides with the peak period for inventories and the lowest level of accounts payable. MNO is currently in consultation with a potentially significant new supplier in Asia, that will demand payment in its local currency. Requirements (a)

Calculate the minimum and maximum working capital levels based on the Financial Controller's assumption regarding the timing of peaks and troughs in working capital variables and discuss the validity of that assumption.

(b)

Discuss the advantages and disadvantages of an aggressive financing policy and advise whether or not such a policy would be appropriate for MNO.

Answer to Interactive question 4 (a) Workings Accounts receivable Accounts payable (Cost of sales 60%  10 = 6) Inventories

Minimum ($m) 20/365  10 = 0.55 40/365  6 = 0.66 50/365  6 = 0.82

Maximum ($m) 30/365  10 = 0.82 50/365  6 = 0.82 80/365  6 = 1.32

Max level of working capital = Peak accounts receivable + Peak inventories – Lowest accounts payable = 0.82 + 1.32 – 0.66 = $1.48m Min level of working capital = Lowest accounts receivable + Lowest inventories – Peak accounts payable = 0.55 + 0.82 – 0.82 = $0.55m The Financial Controller has assumed that the peak period for accounts receivable coincides with the peak period for inventories and the lowest level of accounts payable. However, if sales have been particularly high resulting in accounts receivable peaking, it is likely that inventories will be lower. If inventories are high it is likely that there has been increased spending on purchases and accounts payable will be higher. Working capital levels will be affected by many factors and monitoring the fluctuations over a year in order to identify any relationships and cyclical patterns would produce a more accurate forecast. (b) The advantages of an aggressive financing policy are that it carries the greatest returns. It aims to reduce the financing costs, as short-term financing is cheaper than long-term, and to increase profitability by cutting inventories, speeding up collections from customers and delaying payments to suppliers. It also enables greater flexibility in financing. However, there is an increased risk of illiquidity and managers will need to spend a significant amount of time managing and renewing short-term sources of finance. Short-term finance may not always be easily available. MNO is likely to have large fluctuations in its levels of working capital requirements and would therefore find the flexibility of an aggressive financing policy beneficial.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Strategic Business Management Chapter-19 Ethics Interactive question 1: Ethics and CSR

[Difficulty level: Intermediate]

Briefly explain the differences between business ethics and corporate social responsibility (CSR).

Answer to Interactive question 1 The notion of corporate social responsibility (CSR) is often interlinked with ethical issues, but increasingly the term CSR is being used interchangeably (in general parlance) with the concepts of ethics. However, the two are not the same. Business ethics can be defined as behaviour which supports justice, integrity, honesty and goodness, and is guided by ethical theory. In this respect, the primary goal of ethics can be seen as 'preventing harm.' Corporate social responsibility (CSR) is a broader concept. It includes a commitment for businesses to act ethically, but also to act in a way that provides benefits to society. This benefit to society can be related partly to economic development, but CSR also extends to look at the ways companies deliver environmental improvements, community projects, or any other measures to improve quality of life. Therefore, the primary goal of CSR could be seen as 'doing good' (in contrast to the ethics, whose primary focus is on 'preventing harm'). In this context, we can see that business ethics only forms one part of corporate social responsibility. A company also has economic and legal duties, in addition to its ethical duties. However, the major value of corporate social responsibility is that it encourages companies to take account of social costs and benefits when they are fulfilling their economic duties.

Interactive question 2: Ashdene Homes

[Difficulty level: Intermediate]

Ashdene Homes is a regional house builder, having considerable knowledge and experience in the South of England where the current UK housing shortage is centred. The company caters for the mid to lower end of the market, with prices normally below ÂŁ500,000, on relatively small and individual sites which tend to be too large for the resources of local builders but too small for the high volume national house builders. Any mass release of land for development in the South East due to government initiatives is likely to be centred in one area. The development of any such land would take many years given delays within the planning process. The company, worth ÂŁ67 million has looked like a takeover target for a while but, unfortunately, the company's reputation for internal control has been damaged somewhat by a qualified audit statement last year (over issues of compliance with financial standards) and an unfortunate internal incident which concerned an employee expressing concern about the compliance of one of the company's products with an international standard on fire safety. She raised the issue with her immediate manager but when she failed to obtain a response, she decided to report the lack of compliance to the press. This significantly embarrassed the company and led to a substantial deterioration in its reputation, especially as there have been more press releases about the company's failure to adhere to the high welfare, health and safety, financial, marketing and ethical standards that the founder practiced when he started Ashdene Homes. Requirement Explain, with reference to Ashdene Homes as appropriate, the ethical responsibilities of an accountant both as an employee and as a professional.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Answer to Interactive question 2 A professional accountant has two 'directions' of responsibility: one to their employer and another to the highest standards of professionalism. Many companies provide a Code of Ethics that all employees are expected to follow in order to maintain a culture of corporate ethics. Issues which could be included in such a Code of Ethics are: 

Avoiding conflicts of interest.



Compliance with laws and regulations.

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Rules about disclosure or avoidance of opportunities for personal gain through use of company property or position in the company.

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Confidentiality – extending to absolute discretion of all sensitive matters both during and after the period of employment.

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Fair dealing with customers, suppliers, employees and competitors.

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Encouragement to report illegal and unethical behaviour.

The responsibilities also include the expectation that the accountant will act in shareholders' interests as far as possible, and that they will show loyalty within the bounds of legal and ethical good practice. In addition to an accountant's responsibilities to their employer, there is a further set of expectations arising from their membership of the accounting profession. In the first instance, professional accountants are expected to observe the letter and spirit of the law in detail and of professional ethical codes where applicable (depending on country of residence, qualifying body, etc). In any professional or ethical situation where codes do not clearly apply, a professional accountant should apply 'principles-based' ethical standards (such as integrity, objectivity and professional competence) such that they would be happy to account for their behaviour if so required. Finally, and in common with members of other professions, accountants are required to act in the public interest and that may involve reporting an errant employer to the relevant authorities. This may be the situation that an accountant may find themself in at Ashdene Homes. It would clearly be unacceptable to be involved in any form of deceit and it would be the accountant's duty to help to correct such malpractice if at all possible.

Interactive question 3: MSA – company relocation

[Difficulty level: Intermediate]

MSA is a public company that has its corporate headquarters in Asia. It is listed on the London Stock Exchange. Its latest annual report was criticised in a leading international financial newspaper because of its 'exclusive focus on the interests of shareholders which ignored any other interested parties'. MSA was established over 150 years ago, and, at that time, its purpose was importing and exporting commodities between the UK and a number of Asian countries. Since then, the nature of MSA's business has changed radically and it is now a property company with investments in many countries. In the last financial year, MSA managed properties valued at £800 million. MSA does not have a mission statement. MSA's Financial Director is an ICAEW member. He has suggested that the corporate headquarters be moved from Asia to London for the following reasons. 

London is a major international financial centre whereas its current host country is not. It would be easier for MSA to arrange finance from a London base and some of its transactions costs would be cheaper.



MSA's business takes place in 28 different countries. None of these countries contributes more than a 5% share of MSA's business and there is no particular reason for MSA to be based in one of them.

The board has agreed to this proposal and is considering using a change agent to help it in this process. MSA has decided that when the corporate headquarters is moved to London – within the next 12 months – 80 employees in Asia would lose their jobs. Their prospects for finding a replacement job are not good.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Requirement Assess whether the Finance Director's suggestion to move the corporate headquarters is a breach of ICAEW's Code of Ethics.

Answer to Interactive question 3 Code of Ethics – ICAEW's Code of Ethics highlights five fundamental principles dealing with: integrity; objectivity; professional competence and due care; confidentiality; and professional behaviour. The Finance Director's suggestion will only constitute a breach of ICAEW's Code if it contravenes one of these principles. Although the decision to move the headquarters has been agreed by the Board of MSA as a whole, the Finance Director must take some responsibility for it: partly because he made the original decision, and partly because, as a member of the Board, he shares in the collective responsibility of the Board. Redundancies – The relocation of MSA's headquarters to London will mean that 80 employees in Asia lose their jobs, and they are unlikely to be able to find replacement employment. Consequently, the decision to relocate is likely to have an adverse impact on these 80 employees. However, the fact that people are being made redundant does not necessarily make the decision to relocate MSA's headquarters unethical. Sometimes difficult decisions have to be made in the best interests of an organisation. Fiduciary responsibility – The directors are obliged to act in a way which is most likely to promote the success of the company for the benefit of its shareholders. In this case, it appears that there are genuine business reasons to relocate to London: for example, finance can be arranged more cheaply, and some of MSA's transactions costs would be lower. Given this, it seems that the Finance Director is simply carrying out his fiduciary duty to the shareholders by suggesting the relocation. Objective decision – There is no indication that the director was forced to suggest London as an alternative site for the headquarters, nor that he has any self-interest in doing so. Given that MSA's business is spread relatively thinly across 28 different countries, there is no apparent reason why a location in any of those countries would necessarily be more suitable for the headquarters than London. Therefore, the decision to move to London appears to be made for objective business reasons: driven by lower financing costs. Consequently, although the suggestion will have adverse consequences for the 80 employees who will lose their jobs, the suggestion does not appear to constitute a breach of ICAEW's Code of Ethics. Nonetheless, the directors need to ensure that when the relocation does occur, the employees losing their jobs are treated fairly and in accordance with legal requirements; for example, in relation to the notice periods they are granted and the level of redundancy pay they receive.

Interactive question 4: DEF Airport

[Difficulty level: Intermediate]

DEF Airport is a regional airport in country D, which is a European country. DEF's mission statement says: 'At DEF Airport we aim to outperform all other regional airports in Europe by ensuring that we offer our customers a range of services that are of the highest quality, provided by the best people, and that conform to the highest ethical standards. We aim to be a good corporate citizen in everything we do.' In recent months, there has been increasing concern that passenger numbers are less than forecast and that DEF will fail to reach the revenue figure which had been forecast for the current year. The Chief Executive is concerned about DEF's future strategy because he feels that, in general, airlines and their passengers are putting increased emphasis on lower costs and lower prices rather than quality, and DEF is no longer offering terms which are as competitive as some of its rivals. However, the Commercial Director argues this pessimism is unjustified. He is currently at an advanced stage of negotiations with a large low-priced airline which is keen to use DEF as an entry point into country D. The airline does not currently operate any flights to and from the country, but feels country D offers it significant scope for growth.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

The Commercial Director argues that if a deal with the airline can be signed this is likely to make good the shortfall in passenger numbers, and bring revenues at least back in line with forecast, if not ahead of forecast. DEF's Director of Facilities Management pointed out that the airport has always sought to compete on the basis of the quality of the services it offers its customers. She expressed concern that if DEF starts hosting more low-priced airlines, and shifts its focus to minimising costs rather than upholding quality, this will change the whole culture of the organisation. She pointed out that DEF's mission statement specifically referred to its commitment to providing the highest quality and employing the best people. However, the Commercial Director replied that the mission statement also said DEF would aim to outperform its competitors, and he believed its current performance suggested it wasn't doing this. Furthermore, he argued that if beneficial commercial opportunities became available DEF should take advantage of them, rather than letting the mission statement become some kind of 'business prevention' exercise. The Chief Executive feels that both directors are making valid points, and points out it may be necessary for DEF to critically evaluate a number of different strategic options in the coming years in order to meet its strategic objectives. However, the Chief Executive also highlighted the assertion in DEF's mission statement that it will aim to outperform all other regional airports. He questioned what analysis DEF is currently doing to assess whether it is outperforming the other airports, and what aspects of performance have been measured. He reported that at a recent industry forum, the Chief Executive of one of the other regional airports in D argued that short-term metrics (such as revenue per passenger) are important, but airports cannot afford to overlook issues surrounding the environment and sustainability. Requirement Evaluate the extent to which DEF's mission statement encourages it to develop a sustainable business model.

Answer to Interactive question 4 Sustainability and the long term – Sustainability refers to the social, economic and environmental concerns of a business that aims to thrive in the long term. However, increasingly sustainability is also being linked to ethics, encouraging businesses to appreciate that a socially and environmentally ethical approach increases their ability to be successful in the long term. Measuring success – DEF's mission statement clearly expresses an aim to be successful (by outperforming all other regional airports), but there is no indication whether this success is to be measured in the short or the long term. In the context of a sustainable business model, performance should not simply be measured in relation to the annual accounts, but should consider, for example, the effects that an investment project could have on profits in the longer term. Ethical standards – The mission statement states that DEF aims to conform to the highest ethical standards, and to be a good corporate citizen. This expressed desire to follow an ethical approach suggests DEF should consider the impact which ethics can have on its brand and on how it is perceived, but in practice, it is not clear how far ethics will be embedded in its strategy and decision-making process. The Commercial Director's attitude that DEF needs to be quick to take advantage of commercial opportunities when they become available suggests that he may be motivated more by short-term profit rather than promoting a sustainable business model. If DEF is going to develop a sustainable business model, then the decision about whether to pursue any of these 'commercial opportunities' must be made with a view to longer-term consequences as well as any possible short-term gains. Investment appraisal – A sustainable business model implies a holistic view of investment appraisal in which the wellbeing of society (social, environmental and ethical factors) are considered as well as maximising shareholder's wealth. The fact that DEF's mission statement expresses the desire to be a good corporate citizen, suggests it has recognised this balance between its own financial performance and the wellbeing of society. DEF's strategic objectives also reiterate this balance: highlighting the need for financial security but also the need to minimise pollution and to reduce the audible and visual impact of the airport's operations.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Again, DEF is most likely to achieve its social and environmental goals if these are measured alongside other aspects of performance. Although the mission statement refers to outperforming other airports and offering customers high quality services, there could be a danger that performance against these aims is measured in the short term and in financially-oriented terms; for example, simply focussing on increasing passenger numbers in the short term rather than looking at the longer term, and, for example, looking at the environmental costs of the services being provided.

Interactive question 5: Electrical manufacturer

[Difficulty level: Intermediate]

RRR Co manufactures electrical products. It is based in Erewhon, a European country, with a welldeveloped economy. In the last four years, RRR has suffered from decreasing profits due to increased competition from imported products. These imports have reduced its market share. RRR has always stressed that it has an 'ethical business' policy which is based on the following aspects: 

All of RRR's products are sourced and made exclusively within Erewhon.



RRR sells all its output within Erewhon.

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RRR pays high regard to its employees' working conditions and strictly adheres to all legislative requirements.



RRR has stated its commitment to the principles of fair trade although it does not currently trade with any developing economies.

Market research indicates that RRR's customers and shareholders value its ethical business policy. RRR's procurement manager has identified several suppliers in country Y, which is a developing economy. Suppliers from country Y could supply components to RRR at a price which would undercut its existing domestic suppliers within Erewhon by 40%. If RRR bought from the suppliers in Y, it would enable it to significantly reduce its product costs and compete on price against the imported products which have been reducing its market share. RRR's procurement manager believes the reasons for the low prices of the suppliers based in Y are: 1

Y's labour costs are 60% lower than those in Erewhon. Y's labour laws allow children from 11 years of age upwards to work in factories whereas in Erewhon, no one under the age of 16 can work in a factory. Y has a national minimum wage for adults which is only 15% of the national minimum wage for adults in Erewhon. Y has no national minimum wage for people under the age of 18.

Erewhon has extensive health and safety legislation which, it is estimated by RRR's Management Accountant, adds approximately 20% to its products' costs. Y has little health and safety legislation.

Requirement Advise RRR whether the four aspects of its 'ethical business policy' could cause concerns for its shareholders. (Assume that the components are not sourced from suppliers in Y when answering this question.)

Answer to Interaction question 5 All of RRR's products are sourced and made exclusively within Erewhon Cheaper suppliers – RRR's procurement manager has identified several suppliers in country Y who could supply components at a price which is 40% lower than that RRR pays to its current, domestic suppliers. If RRR continues to source all the components for its products domestically, its costs will be higher than if it sourced them from the suppliers in Y. In turn, this suggests that RRR's profits are likely to be lower than they would be if it used components imported from Y. It could also mean that RRR might lose sales, if customers choose to buy cheaper imported rival products instead of RRR's. Therefore, this aspect of the ethical business policy could cause concerns for RRR's shareholders, because it conflicts with the aim of maximising shareholder wealth.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com

Customer preference – However, market research has also shown that RRR's customers value its ethical business policy. This means that RRR's customers may be prepared to pay more for its products, on account of its ethical business policy. Although it is unlikely that the extra amount that customers are prepared to pay will cover the 40% difference in cost, RRR should consider its customers' attitudes before making any change to the policy. For example, if there is a danger that customers will stop buying RRR's products if it discontinues its ethical business policy, then such a change will also concern the shareholders because it will again conflict with the aim of maximising shareholder wealth. RRR sells all its output within Erewhon Restricting growth – Although RRR's share of the market has been reduced in the face of competition from imported products, this restriction on its market development imposed by the ethical business policy prevents RRR from trying to replace any losses of revenue by expanding into foreign markets. In this respect, if the policy prevents growth – or even RRR's ability to maintain its existing revenues – then it could cause concern because, again, it conflicts with the aim of maximising shareholder wealth. Conversely, the policy could reduce risk, by avoiding exposure to the risk of foreign trade. Exporting and fair trade – If RRR were to start exporting to developing economies, a Fair Trade policy might imply that it should sell its exports to those economies at more favourable terms than those which it would offer to developed countries. In this respect, the combination of exporting to developing economies and a Fair Trade policy could again conflict with the idea of shareholder wealth maximisation. Employees' working conditions and adherence to legislative requirements Adherence to legislative requirements – The element of the policy which states that RRR adheres to all legislative requirements should not cause any concerns for the shareholders. RRR, like all other companies operating within Erewhon, has to comply with all relevant laws, and therefore RRR's competitiveness shouldn't suffer as a result of complying with the law. Equally importantly, if RRR doesn't adhere to legislative requirements it could be fined, or may even be preventing from operating – both of which outcomes would be detrimental to the aim of maximising shareholders' wealth. Nonetheless, adhering to the law could still leave RRR exposed to international competitors who practice 'social dumping,' by selling products from countries which do not have equivalent labour protection laws. High regard to employees' working conditions – It is not clear how far the 'high regard' which RRR gives to employees' working conditions extends beyond its legal requirements, and what the cost implications of providing these favourable working conditions are. If RRR's policy simply means that it takes care to ensure that its working conditions comply with all legislative requirements, then this should not cause concern for its shareholders. However, if RRR's working conditions exceed legal requirements – for example, by providing very generous wages and benefits – then this could be a concern for the shareholders. The shareholders might feel that RRR is incurring unnecessary costs (by providing favourable working conditions above the legal requirements) which could be seen as conflicting with shareholder wealth maximisation. Commitment to the principles of fair trade Paying a fair price for components – 'Fair trade' principles would oblige RRR to pay a fair price for any inputs or components it sources from a developing economy. However, because all of RRR's inputs currently come from within Erewhon, they will not be affected by a 'fair trade' policy. Therefore, this aspect of the policy should not currently cause any concerns for RRR's shareholders. Overall impact of the policy Customer values – The shareholders' concerns with the policy are likely to arise if they feel it is making RRR's products more expensive than competitors' products, thereby leading to reduced margins. Basis of differentiation – As the market research has indicated, RRR's customers value its ethical business policy. This could mean that some customers buy RRR's products because they share the values of the ethical business policy. In this respect, the policy may provide RRR with a means of differentiating itself from other manufacturers. As such, the shareholders should consider the extent to which the policy might actually increase their wealth rather than reducing it.

Courtesy: Saiful Islam Mozumder, Shiraz Khan Basak & Co, Cell-01515653940 Email:simbd@outlook.com