IIA Advanced Diploma Past Paper Pack. Time allowed 3 hours and 10 minutes

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1 IIA Advanced Diploma Past Paper Pack Financial Management M2 Wednesday 5 June 2013 Afternoon session Time allowed 3 hours and 10 minutes DO NOT OPEN THIS PAPER UNTIL INSTRUCTED BY THE INVIGILATOR Candidate information and instructions There is one question in Part A and four questions in Part B. Answer the question in Part A and any three questions in Part B on the answer sheets provided. There are 100 marks available in this paper. Organisations marked with an asterisk, *, are fictitious. No similarity with any real organisation is intended nor should it be inferred. Start each question on a separate answer sheet. Do not identify yourself in answering any questions. Enter your candidate number, the paper number, the question number and the page number within the answer at the top of each answer sheet used. Any plans/notes that are made for each question should only be made on official IIA exam paper. Separate answer sheets should be used for each question plan. Clarity and logic of your answers, effective presentation and good use of English will be taken into account by the examiners when marking this paper. Past Paper Pack Chartered Institute of Internal Auditors 13 Abbeville Mews, 88 Clapham Park Road, London SW4 7BX September 2013

2 PART A There is one compulsory question in this section. QUESTION ONE Nephele Plc* sells luxury goods through stores in major European cities and from its website. It has ample cash for investment but its directors are keen to retain some funds in case of potential losses. With recession in Europe, Nephele is to close its stores in Florence, Barcelona and Nice, and to concentrate operations in capital cities. The directors agree that this will enhance Nephele s brand identity. They also intend to develop Nephele s web presence to ensure it provides a world class online shopping experience, and are considering re-launching their website as Nephele s Pleasureland of Gifts. Basic hardware and software will be needed to develop the website and the supporting IT network, at a cost of 100,000. This expenditure has already been agreed as essential. The board also has two options to address server requirements with additional costs as detailed: Option 1 purchase of new servers Promoted by the head of IT, this option involves the purchase of 40 new servers for 100,000, with installation at 16,000. Further operational costs amount to 90,000 each year for the next three years. Existing IT staff will be able to operate the new system with the minimum of additional training. Option 2 server virtualisation Promoted by the sales director, who has spent 5,000 on a consultant to investigate the need for a new computer system, this option involves spending 50,000 on six internal servers capable of running 40 virtual servers. Installation costs will be 30,000, and further operational costs will be 18,000 each year for the next three years. Server virtualisation will require external IT support at 20,000 per year at current rates. No additional training would be needed for existing staff. Option 2 would release office or storage space at Nephele, the financial benefit of which is yet to be quantified. In addition, Option 2 would offer Nephele disaster recovery software on the virtual servers through off-site locations. The head of IT has expressed concerns about Option 2 and has provided several examples of server virtualisation in other companies where only 20% of their infrastructure proved to be suitable for such a change. He estimates that he will need a budget of 8,000 and two months to investigate server virtualisation fully. The sales director insists further investigation is unnecessary and that Nephele takes action as soon as possible. Regardless of the option chosen, additional sales to be generated have been estimated at: Year 1 100,000 Year 2 150,000 Year 3 160,000 2

3 The following capital investment appraisal information has been calculated: Accounting rate of return (ARR) Required company ARR ARR Option 1 ARR Option 2 40% 80% 247% Payback period (PP) Maximum acceptable company PP PP Option 1 PP Option 2 4 years 2 years 8 months 1 year 3 months The company s rate of return is 8%. Discount factors for 8% are as follows: Discount factors Year Year Year Year Nephele s company policy when making capital expenditure calculations is to assume that all initial capital expenditure is made at the beginning of the financial year and all remaining costs and income take place at the end. a. Explain how capital investment appraisal can be used to add value to an organisation, and illustrate your answer with the capital expenditure decisions faced by Nephele. b. Evaluate the discounted payback period and net present values of Options 1 and 2, and compare your calculations with the capital investment appraisal information provided. c. Evaluate the options available to the Nephele board, discuss the main methods that can be adopted to reflect project risk in capital investment appraisals, and recommend which course of action it should pursue. 6 marks 16 marks 18 marks SYLLABUS REFERENCE 1 The context of financial management 1.1 the main macro-economic variables that can affect organisations, and their likely effects on an organisation, including: inflation trends in national income; growth / recession 10 Capital investment expenditure and appraisal 10.1 the nature, purpose and significance of capital investment appraisal in adding value to an organisation 10.2 the principle of discounting future income streams (cash flows) as being the application of the organisation s overall cost of capital to the evaluation of a specific project 10.3 internal rate of return (IRR) and its relation to net present value 10.4 discounted payback period and its relation to simple payback 10.5 the five main methods of capital investment appraisal and how these can generate apparently contradictory conclusions in respect of a single project 10.6 the effects of inflation on discount rates and consequently on the calculation 3

4 of net present value, and how to adjust calculations accordingly 10.7 how taxes on profits should be taken into account in calculations of net present value 10.8 the main methods that organisations can adopt in order to reflect project risk in project appraisals 10.9 the circumstances in which either an internal or external capital rationing situation can arise and adapt the basic principles of capital investment decision-making accordingly MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part a. Defining capital investment appraisal and added value 2 explanation at 1 mark Explanation of capital investment appraisal adding value 3 explanations at 1 mark Illustration of adding value in the case of Nephele plc 1 example at 1 mark b. Calculation of discounted payback period and net present value 1 mark per annual cash flow, 1 mark for the total NPV and 1 mark for discounted payback period for each option (12 marks) Comparison of information provided from ARR, payback, discounted payback and NPV 4 reasonable points at 1 mark each c. Evaluation of option 1 in comparison with the maximum figures 1 mark per relevant point, max 3 Evaluation of option 2 in comparison with the maximum figures 1 mark per relevant point, max 3 Evaluation and comparison of options 1 and 2 in respect of drafting a recommendation 1 mark per point, max 5 Remember/ Understand 4 Apply/ Analyse Evaluate/ Create Total marks Recommendation 1 mark 1 1 Methods to reflect project risk 3 methods at 2 marks each 6 6

5 Total a. Adding value through capital investment appraisal Capital investment appraisal comprises a range of techniques used to identify the most appropriate of a number of options. The techniques focus on financial analysis but other considerations are also taken into account. Value is added to inputs of materials, labour and so on through the use of manufacturing expertise, marketing know-how and research and development to generate profits. Value is also added through efficient, up to date equipment and innovative machinery, techniques and a myriad of other forms of investment. Capital investment appraisal assists in adding value through the selection process of investment in capital expenditure. The most cost-effective options will be selected so long as the option selected is also the most effective and efficient. Where capital is rationed as is common, capital investment appraisal helps focus attention on the most cost-effective options available and adds more by way of value than would be possible from options discarded. Some capital expenditure is required, such as the purchase of machine guards to fulfil Health and Safety legislation. Capital investment appraisal provides the opportunity to analyse costs of such obligatory expenditure and ensures that added value is maintained at its highest and not declined significantly. The choice between options 1 and 2 for Nephele plc indicates the most cost effective option of dealing with a single problem and added to value/avoids profits being reduced. b. Discounted cash flows Option 1 Year Cashflow Cumulative cash flow (simple) PV factors 5 Discounted Cash flows Cumulative discounted cash flows 0 (116,000) 1 (116,000) (116,000) (116,000) ½ 1 10,000 ½ (106,000) ,260 (106,740) ½ 2 60,000 ½ (46,000) ,420 (55,320) ½ 3 70,000 ½ 14, , ½ Net present value 260 ½of Discounted payback period 2 years and 55,320 x 12 months 55,580 Hence, rounded to 3 years. 1 Option 2 Year Cashflow Cumulative cash flow (simple) PV factors Discounted Cash flows Cumulative discounted cash flows 0 (80,000) 1 (80,000) (80,000) (80,000) ½ 1 62,000 ½ (28,000) ,412 (22,588) ½

6 2 112,000 ½ 84, ,984 73,396 ½ 3 122,000 ½ 206, , ,264 ½ Net present value 170,264 ½of Discounted payback period 1 year and 22,588 x 12 months 95,984 Hence, 1 years, 3 months. 1 Comparison of information The accounting rate of return (ARR) is a profit based measure whereas the other forms of capital investment appraisal focus on cash flows.. ARR provides a better comparison with RoCE. Net Present Value and Discounted Payback accounts for the time value of money whereas ARR and Simple Payback only consider the value of money at today s date. Simple and Discounted Cash Flow only consider flows of cash until the date of payback. Net Present Value considers the total project. The inclusion of time value of money in calculations allows for the fact that money is worth more today than in several years time. c. Option 1 purchase of servers In financial terms the option falls comfortably within the criteria for ARR and payback, even if discounted payback is used. In the latter case the payback is a year earlier than the maximum acceptable. The NPV is just positive over three years so is regarded as acceptable. However, slight changes in income and costs could turn the NPV negative. This option is promoted by the experienced IT specialist who is aware of the company culture and operations and has presumably kept he company s needs in mind. However, he may be less aware of changes in the industry outside the company unless he has made an effort to stay up to date. This may not be the case as he has asked for a budget and a couple of months to examine virtualisation further. Option 2 server virtualisation In financial terms the second option falls comfortably within the ARR and payback criteria. In addition, the discounted payback is less than half the maximum acceptable simple payback period. And the NPV is significant. Server virtualisation is the best option financially. This option has been promoted by a consultant who presumably has knowledge of the industry although will not be as acquainted with Nephele plc s as the company s IT specialist. There is the additional benefit of disaster recovery software which may/may not place the company in a better position than it is already with provision for business continuity. Comparison of the options The choice between the two options in purely financial terms is straightforward. Option 2 offers a similar facility for fewer funds initially and in terms of flows of funds over three year. This assumes that the information provided is accurate. Option 2 has already cost 5,000 although that was a sunk cost and is not included in the appraisal. Even had that been included, option 2 would still be the best financial option. 6

7 A concern arises about the suitability of both options and, in particular, if Option 2 would actually meet the needs of Nephele plc. Both options have been separated out from the additional purchase of software and hardware and if the decision to make appropriate purchases has not been undertaken perhaps that purchase should also be taken into account in case a wider consideration might lead to a more cost-effective option. The choice of action depends on how the Board of Directors view the two options presented to them. They could either: (i) go ahead with Option 2 if they accept the recommendation of the consultant and the sales director, trusting the information provided (ii) defer the decision pending further investigation and grant the IT specialist the budget requested, or negotiate a different one. (iii) request further investigation to see if there are further options. A deferral may mean sales are lost and possibly closing branches and not developing the website may damage the reputation of the organisation and have an impact on share price. However, if they go ahead with server virtualisation and it proves to be a failure it is likely to involve additional cost and again possible damage to reputation and the share capital. Probably the most prudent option is to grant a budget to the in-house specialist and delay the purchase. Alternatively if the board has concerns about the internal IT specialist it may wish to appoint an independent consultant to review the entire situation. Main methods to reflect project risk There are several methods by which Nephele plc can reflect project risk. Sensitivity analysis o This adjusts factors included in the NPV calculation to identify how much they might deteriorate within the period. o For instance, the current cost of support for server virtualisation is quoted but this may increase over the three year period. o Or, sales levels may not be as high as expected/other costs may be more. o The board will need to make a judgement about the extent to which the actual figures differ from those quoted in calculations. o The impact of other factors will also need to be considered, e.g. benefits fo additional storage/office space and financial implications of this Simulation o The interdependence of various factors needs to be considered such as how well the new hardware and software purchased works with the new servers or server virtualisation. o It would be wise to consider various possible outcomes to assess the impact of varying circumstances. The NPV of the server purchase was low and a small change in circumstances could turn the NPV to negative, for example. o Each simulation will incur costs so the company may wish to limit the number of simulations to most likely, optimistic and pessimistic. 7

8 Adjusting the discount rate o A premium could be added to projects to reflect for additional risk. For instance, a higher discount rate might be used for the potential risks of server virtualisation not be as suitable as projected. o It is difficult to judge the extent of an premium within calculations. o Premiums could also be applied to allow for changes in inflation, the impact of recession on level of sales and so on. The various methods aim to assist in clarifying the overall impact of risk on projects. However, they cannot make the decision. Judgement will still be required by the board. And in this case there is a certain amount of trust to take into account of the judgement of the sales director and the consultant and the IT specialist. EXAMINERS COMMENTS This proved to be a challenging question for candidates. However, many provided well thought out and knowledgeable answers. The choice of figures to use in calculations seemed to present some difficulty but a reasonable number of candidates made the calculations correctly and most others were able to apply the discounting technique to the figures they selected and were rewarded for doing so. As is typical with questions of this nature, there is some analysis of information provided and calculated. Generally, good points were made by candidates although there was a certain amount of repetition in the answers of some candidates. Careful reading of the question is an important technique and may benefit candidates in their effective use of time in future examinations. Answers in general were well balanced, however, and candidates were able to address the various parts of the question and gain credit. In the first part of the question, candidates described what capital investment appraisal was and some wrote at length on the various methods used. However, equating how capital expenditure appraisal added value proved more challenging. Some candidates answered this explicitly and generally wrote well on the topic. Many candidates, though, were far more reticent in directly addressing the idea of value added. However, where their answers touched on the use of capital investment appraisal in a positive way, for example decision making to save costs/increase profit/increase return on capital employed and so on, reward was given. In part (b) there were some good answers which were perfectly correct and well presented. However, even where answers were incorrect answers were provided and candidates are to be congratulated in providing clear and full workings. This excellent technique yielded a number of marks for most candidates. The assessment in the final part of the question was generally answered well. Some candidates who did not identify the methods to adopt to reflect risk in capital investment appraisal wrote instead about the use of a risk register or listed procedures to mitigate against identified risks. Although not strictly what the question was seeking this approach gained some reward in recognising that a risk can be included in the appraisal, implementation of a project or post-appraisal and some effort be made to quantify it. Few answers considered more general economic risks in some depth. Although this was beyond the terms of the question, a few answers worked the argument back to 8

9 the scenario and were rewarded. For example, inflation affecting interest rates and cost of capital and thus influenced the discount rate. 9

10 PART B There are four questions in this section. Answer any three questions. QUESTION TWO Blue Sky Electronics Plc* (BSE) is a leading manufacturer and supplier of specialist electronic equipment and instrumentation. The company started 20 years ago from a small factory unit and has expanded rapidly to six manufacturing and distribution sites in the north of England. BSE has a growing reputation for being at the leading edge of technology changes, and it aims to offer innovative solutions to customer needs. It has recently developed products to detect counterfeit electronic components. There is a great need for specialist staff training at BSE and the company regularly receives requests for such training from external organisations. Originally staff training and development was provided by salaried trainers employed at each BSE site but the company has recently set up a central training department. Salaried and freelance trainers provide training and development services across the company and to external customers. The training department business unit is required to deliver a profit from external fees and internal charges. BSE has successfully applied for of a one-off development grant to promote training in economically deprived areas. The grant is expected to be received in the first six months of operation of the new training department. A budget has been prepared by the finance department for the first year of operation of the new training department. Monthly budgets have been allocated to reflect the profile of estimated spending patterns through the year. Income has been assumed to flow evenly throughout the year. Year 1 Training department budget, Q1: January March performance ( 000s) Annual budget Q1 budget Q1 actual Income Internal charges External fees Grants Total 1, Expenditure Direct costs Trainers fees and salaries Materials Travel and accommodation Room hire Overheads Office salaries Rent Heat and light Other costs Total expenditure 1,

11 a. Analyse the budget statement for the first three months of operation and discuss the risks and challenges in the budget setting process for the training department of BSE. b. Explain how the training department s budget relates to the strategic plan for this new business unit and assess the potential impact of external factors upon the budget. 12 marks 8 marks SYLLABUS REFERENCE 11.1 Explain how a budget relates to other aspects of the planning process 11.3 Assess the potential impact on a budget of changes in external variables, including macro-economic factors 11.4 Identify and explain the risks involved in the budget setting process MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part Part a Discussion of risks and challenges in budget setting process Analysis of budget and application of figures to discussion Remember/ Understand Apply/ Analyse Evaluate/ Create Total Marks Part b Explanation of link between budget and strategic plan Assessment of external factors on budget Total Outline answer Answers should include analysed data from the given budget information, for example variances. The analysis could be linked to specific risks and challenges as a means of illustration of points made. Another acceptable method of answering the question is to consider the analysis separately from the discussion of risk and challenges. Analysis linking to risks and challenges in the budget setting process: Forecasting external training sales can be difficult for a new training venture because budget figures cannot be based on actual past sales. There is a risk that there has been insufficient market and competitor research to accurately forecast external sales. There is evidence of this in budget performance figures for the first three months as external fee income is much lower than budget (an adverse variance of 56%) It can be difficult to estimate the impact on current business due to a centralisation of service delivery. There is evidence that the company may have overestimated the risk to internal training demand as there is a 11

12 favourable variance of 35% on internal charges income for the first three months Grant income may be difficult to collect as certain criteria have to be met to qualify for grant payments. In budgeting for 50% of grant income to be collected in the first three months, the company may have been over optimistic as actual income received is much lower (adverse variance of 60%). However, there may have been delays in submitting grant claims so this may be just a timing issue There is a risk of setting a budget with unrealistic targets that can be demotivating for staff. It might be argued that the external fees income budget for the first three months was unrealistic in a newly formed business unit. However, allowing too much budgetary slack can produce complacency in budget holders. The favourable variance of 35% on internal charges income may indicate an insufficiently challenging budget target. However there may have been problems in deciding suitable transfer pricing regarding internal charges and this might explain the favourable variance There is a challenge in accurately budgeting for expenditure, particularly as there will be start up costs. There are many adverse variances across expenditure budgets for the first three months, for example adverse variance of 17% on trainers fees and salaries, adverse variance of 21% for materials costs, adverse variance of 52% on travel and accommodation. This may suggest that budgets for expenditure in the first three months are insufficient. There is also some further investigation needed to explain variances, for example why is there a 17% adverse variance on trainers fees when external fee income is less than expected? Has all work undertaken been billed to external customers? The accurate phasing of the annual income and expenditure budgets over the months can be a challenge in a new business venture. For some expenditure heads an attempt has been made to forecast spending patterns, for example only 19% of the annual budget for travel and accommodation has been allocated for the first three months. A 52% adverse variance on this expenditure head suggest phasing may not be realistic Other risks and challenges include: The budget for the new training department has been prepared by the finance department. There is a risk that there has been insufficient involvement of training staff in budget preparation leading to inaccurate budgets, for example inaccurate forecasts of sales of both internal and external training services A lack of involvement of training staff in the budget setting process could lead to a loss of motivation of these staff and a lack of confidence in the budget to reflect the reality of training activity. However there may have been significant time pressure to get the new training department up and running. Any overcomplicated consultation process during budget setting might have caused unwanted delays Part b Relationship of budget to the strategic plan for the new training department: The strategic plan for the training department will be integrated into the overall strategic plan of the company. The training department budget does not operate in isolation but is integrated into the company s financial plans 12

13 The strategic plan for the training department will set out what the department aims to achieve (i.e. its strategic objectives), how it will achieve these objectives and the timing The training strategic plan will be based on information from internal and external sources and will include non financial information. For example, information on competitors and their charges. There is a challenge to successfully integrate non financial information with financial information in the budget The strategic plan decisions will have been taken by senior management and the board. Then the strategy must be converted into action and this involves all levels of management The training department budget is part of operational planning to achieve strategic objectives. Budgets allocate resources to the required outcomes and are directed towards achieving critical success factors There can be a problem linking one year budget plans with the business strategy for the department which will be longer term The potential impact of external factors on the budget includes: Economic downturn can lead to a lower demand for training. Whilst the company can take a decision to maintain the level of internal training, demand from external clients may cause pressure downward pressure on the external fees income budget Increases in inflation rates as measured by CPI/RPI can cause pressure on expenditure budgets. Also decisions by energy supply companies to raise charges above the level of inflation can have an impact on the heat and light budget Changes in government policy can affect the availability of grant income. For example, further grants to boost training in economically deprived areas may be axed by government departments EXAMINERS COMMENTS Overall this was a well-answered question showing a good understanding of the budget setting process and the factors that impact on budgets. In part (a), most candidates were able to point out some general performance issues on analysis of the budget for quarter 1. The shortfalls in income and overspending on certain budget heads were correctly identified. However, budget analysis often lacked precision with some answers not giving any detail of the numerical value of variances. Better answers highlighted favourable and adverse variances quoted as a percentage of figures in the budget. Candidates are advised to use appropriate accounting terminology e.g. variances when answering examination questions. Answers relating to risks and challenges in the budget setting process were often good. Answers could have been enhanced by considering a wider range of risks and challenges and by linking the discussion to risks revealed by the budget analysis as a means of illustration. In part b the potential impact of external factors on the budget was well assessed by many candidates. A good knowledge of appropriate external factors was shown. The link between the training department s budget and the new unit s business plan was not as well explained. For example, the strategic plan will contain non-financial information such as information on competitors so how does this relate to the budget? 13

14 QUESTION THREE In just 12 years, Greenhill Advertising Ltd* has developed from a one person business into a large international advertising agency based in London. It is owned by Robin Greenhill, whose personal leadership and management have resulted in growth into all continents, and high customer satisfaction and loyalty. Robin s success and profit have come without any formal system of performance measurement. However, Robin has just appointed zonal managers (ZMs) in each key market. The ZMs have high levels of autonomy to develop local strategies, conduct market research, make deals, manage customer relations, and plan and run specific campaigns. Robin has asked you, as the new head of internal audit, to present a paper in which you: a. Explain the main arguments for and against systems of quantitative performance measurement as a means of management control and the factors that have led to current trends in this field. b. Describe indicators that can be used by Robin to assess key aspects of performance and explain why each one is appropriate. 6 marks 14 marks SYLLABUS REFERENCE 6.1 Quantitive performance measurement 6.5 Performance indicators in profit seeking organisations MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part (a) Main arguments for systems of quantitative performance measurement as a means of management control. (1 mark per valid point.) Main arguments against systems of quantitative performance measurement as a means of management control. (1 mark per valid point.) Remember/ Understand 2 2 Apply/ Analyse Evaluate/ Create Total marks 2 2 Factors which have led to current trends in this field. (1 mark per valid point.) (b) Describe seven appropriate, specific and measureable indicators that can be used by the

15 owner to assess key aspects of performance. 14 Explain, for each one, how due 7 account has been taken of what is known of the organisation s objectives, strategy and operations in selecting them. Totals (a) Main arguments for systems of quantitative performance measurement as a means of management control include the following: It provides a measure of progress to achievement of organisational strategy Can be linked to the achievement of specific targets that can be expressed in numerical terms Provides a measure of objectivity in performance measurement and achievement People have confidence it and can use it is a basis for working activity Clear processes can be established to collect and evaluate quantitative measures Facilitates comparisons to be made between individuals Main arguments against systems of quantitative performance measurement as a means of management control. Placing processes in place to facilitate measurement can present significant technical challenges, and there are risks of inadequate resources and support, Staff can have difficulties in determining the right data to collect and how it should be gathered. Those setting measures may not have and necessary abilities and skills to do or to properly interpret results. Over emphasis on quantitative analysis is a common problem. There may be excessive costs in operating the system. Mistaken belief that quantitative measurement is the only type of measurement and that qualitative measurement is either not considered or is often wrongly seen to be inferior. A related risk is the lack of fit between the measure of performance and what is/should be being measured Factors which have led to current trends in this field The methodology is well known and can be applied to most if not all situations (environmental assessment, goal identification, resource alignment, implementation of activities and programs, measurement of performance, with appropriate monitoring corrective action and process review leading to targets/goals being met.) Assessing performance objectively and effectively is a necessary aspect of effective management and control of organisations. Targets and related quantative performance measurement is valued by organisational theorists, academics, organisations and managers. Managers see it as a clear means by which to be effective in their roles 15

16 It is easier than qualitative measurement which involves more complex evaluations and judgements. (b) Describe appropriate, specific and measureable indicators that can be used by the owner to assess key aspects of performance. Explain, for each one, how due account has been taken of what is known of the organisation s objectives, strategy and operations in selecting them. Number of contracts with new companies entered into by region per financial quarter This is relevant and important because it shows growth of the business across the world in terms of new customers and winning entry to new markets, with comparisons between regions and zonal managers performance. Number of contracts with existing customers that are renewed into by region per financial quarter. This is relevant and important because it shows ability to retain customers and so is a measure of quality of service provided and strength of relationships built up by zonal managers, with comparisons between regions and zonal managers performance. Financial value of contracts with new companies entered into by region each financial quarter. This is relevant and important because it shows growth of the business across the world in terms of value of business acquired, with comparisons between regions and zonal managers. Financial value of contracts with existing customers entered into by region each financial quarter performance. This is relevant and important because it shows growth of the business across the world in terms of retained value of business and also provides and indicator as to how well established clients businesses are performing and the extent to which the firm can share in that success with larger repeat contracts, with comparisons between regions and zonal managers. Annual / end of contract customer satisfaction surveys including overall levels of satisfaction expressed in numerical terms for example out of 10 by region each financial quarter. This allows due account to be taken of the detailed views of clients and this can be provided directly the owner Sidney Greenhill, over the heads of the zonal managers, and can include the private views of senior management and their direct contact details so the owner van directly take up any issues of concern on a priority basis. Comparisons of total value of revenues generated by individual clients from the same product before and after relevant advertising campaigns by region each financial quarter. This provides a basis for Sidney to review in depth the impact of campaigns on products on a before and after comparison basis, and may help him to review zonal manager performance in considerable depth. Comparisons of total numbers of units sold after advertising campaigns by region each financial quarter. This provides a basis for Sidney to 16

17 review in depth the impact of campaigns on products on a before and after comparison basis, and may help him to review zonal manager performance in considerable depth. This measure has to be used in conjunction with the similar measure on revenues as demand for the product may be price sensitive and this may have been adjusted by the client Total gross revenue by region per quarter generated for Greenhill Advertising Ltd by each Zonal Manager. This shows the revenue generating capacity of each region and can also be used as a control total to reconcile with figures for new and existing contract by region. Total costs incurred by region per quarter generated for Greenhill Advertising Ltd by each Zonal Manager. This useful measure allows analysis of costs and may throw light on how efficiently each zonal manager controls them locally, but also whether higher costs can be justified - if expenditure, including hospitality costs and quality of service earns commensurate rewards in terms of new contracts and renewals. Net profit generated by region per quarter for Greenhill Advertising Ltd by each Zonal Manager. This measure shows the net contribution by each region to total net profitability and provides a headline of regional success of the business. Percentage Share of total profits for Greenhill Advertising Ltd generated by each Zonal Manager by region per quarter. This represents the measure of profit by region and indicates success by each region as a proportion. This can be used in performance discussions with zonal managers, as the owner will have clear views on which regions should be performing best and indicates clearly if zonal managers are making the contribution to overall performance and profitability he expects. EXAMINERS COMMENTS Most candidates performed well in response to this relatively straightforward question. In answers to part (a) good arguments we put forward by nearly all candidates both for and against the use of quantitative performance measurement as a means of management control, and most scored well in this section. In part (b) some answers lacked the necessary depth, breadth and quality. Some focused very narrowly on typical financial accounting performance measures and largely ignored the other critical areas of performance, and therefore did not fully address the range of key aspects expected from strong candidates; many however understood the full context required by the question and provided the necessary range and breadth needed. As so often some wasted valuable time with over lengthy introductions, for which it was often not possible to give credit, as these did not address the matters under examination. Others dwelt at length on the balanced scorecard and/or benchmarking instead of focusing on the specific requirements of the question. On balance however, most demonstrated the expected level of knowledge and understanding. 17

18 QUESTION FOUR Grand Central Plc*, a leading consumer beauty products group, has been criticised by industry analysts for not creating sufficient value from the assets and technology it has at its disposal. Despite the advantages of its products over those of its competitors, Grand Central is ranked third on performance on average in the markets it serves. Although projections by the management team for the next three years show growth, the board is concerned that the projections will not satisfy market concerns. The board has asked you for an independent review of the projections: Investor Relations and Finance teams projections data Projections NOPAT per annum 300m 350m 400m Free cash flow per annum 100m 120m 160m WACC 10% 10% 10% Interest rate 5% 8% 10% Projected net assets 1,000m 1,100m 1,200m NB Expected annual inflation of 5% is excluded from the figures. Prepare a briefing note for the board in which you: a. Explain the concept of business value as the sum of discounted future income streams and illustrate how it can be calculated in the case of Grand Central. b. Explain how conventional accounting principles can be inconsistent with value measurement. c. Explain the concept of value drivers and list the alternative ways Grand Central could be adding or losing value for its shareholders. 10 marks 5 marks 5 marks SYLLABUS REFERENCE Section 3 Value 3.1 Value and income stream 3.3 Conventional accounting versus value 3.5 Value drivers MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part Remember/ Understand Apply/ Analyse Evaluate/ Create Total marks 18

19 a. Explains the concept of business value as the sum of discounted future income streams and illustrate how it can be calculated in the case of Grand Central b. Explains how conventional accounting principles can be inconsistent with the value measurement of the company c. Explains the concept of value drivers and lists the alternative ways the company could be adding or losing value for its shareholders Total Outline Answer Part a General points Business value is based on future income streams versus accounting nest asset values. This a key difference in approach between Corporate Finance and Financial Reporting. Discounted future income streams represent today s value or present value of future income. The discount factor is the rate used to compute the present value Two methods are Income streams can be measured based on Free Cash Flow - Profit after Interest and Tax - Less Capital Expenditure - Add Depreciation - = Free Cash flow The duration of the Free Cash Flow will determine the Business Value. Additionally; Where Free Cash is expected to continue, it may be considered Perpetuity. In such cases the Free Cash Flow divided by the discount rate delivers the Business Value. If an annual growth is assumed, the discount factor is reduced by the growth rate. 19

20 Alternative approaches use the expected future stream Dividends as the method of valuing a Business (so called Dividend Valuation Model). As Grand Central does not pay dividends this is not available. Calculations Projections (in m unless stated otherwise) Total A Profit after interest and tax B Capital Spend C Depreciation D E (changes in D) Working Capital ( 25m in 2012) Working Capital Movement F Projected Net Assets G (A- Free Cash Flow (FCF) B+C-E) H WACC% 10% 10% 10% I(1+H) Discount Factor J(G/I) Discounted FCF K (J/3) Equivalent annual Value 141 J Perpetuity value 1414 Starting Net Asset K(F-B+C) Value 800 Additional Data Market Capitalisation 1200 ( 1.20x 1Bn) EPS in pence 0.3 P/E Ratio 4.0 Part b General points Corporate Finance uses future estimate data. Specific points The syllabus for 3.2 specifically mentions three areas; revenue recognition, expense matching, and asset recognition. Discussion points under these three headings:- Revenue recognition The company valuation could be based on a multiple of future earnings 20

21 Sales recorded in accounts are based on historical data. In the case of Grand Central market sentiment would seem to discount the share price of Grand Central and may not believe management projections. Expense matching Potential liabilities are not included in historical costs. They may be included by way of note (contingent liabilities). For valuation purposes however the market will incorporate risk of additional liability in the share price as impairment on future earnings. Asset Recognition Conventional accounting places limits on accounting for intangible assets such as goodwill. Whilst goodwill on purchase is recognised it will not be re-valued upwards. Increases in Intellectual capital, human capital, and brand value are not recognised. The firms real options are also not recognised in the accounts. However if the market sees value in these it will be reflected in the share price. Part c General Points Value drivers can be come from a number sources including; product leadership and innovation (e.g. Apple), customer loyalty or intimacy (e.g.m&s) and operational excellence (e.g. Walmart). The route to market leadership to redefine the meaning of value to customers in the markets serve (e.g. men s cosmetic market development). Specific Points - Value add sources could include ; o Better alignment of physical and intangible assets (Strategy, People, Assets, Capabilities) o R&D process investment o Strategic alliances with firms who are more effective in complementary areas (e.g. distribution) o Acquisitions - Value Erosion could come from the opposite above o Failure to capitalise on a leading technology in time o Marketing failure - Comments on Grand Central s predicament o Grand Central s product leadership means that it has a strategic emphasis on innovation. o Grand Central ranked as third indicates it is not leading their sector. There may be niche areas where Grand Central is leading which might held it to drive value in different ways. o Of most concern is that the market does not believe in Grand Central s customer value proposition as indicated by a low PE ratio. EXAMINERS COMMENTS The question tested the area of Value on the syllabus. It asked for knowledge of accounting and corporate finance and the relationship between the two areas. Approximately half the candidates attempted this question. Those who performed well understood key corporate finance concepts and were able to apply these to the company scenario. In part (a), candidates were required to explain the concept of business value and illustrate their answer with regard to the scenario presented in the question. Whilst candidates were generally able to explain the concept many struggled to apply their knowledge to the particular circumstances presented. 21

22 In part (b), candidates were asked to explain how conventional accounting methods could be inconsistent with value measurement. This should have offered straightforward marks but the relatively poor standard of answers suggested that this was not a part of the syllabus particularly well understood. Similarly in part (c), the concept of value drivers was not well explained by candidates indicating a general lack of knowledge of the syllabus in this area. QUESTION FIVE AAA Healthcare Plc* provides healthcare services to a number of primary care trusts and private clients. It runs a number of residential homes under contract and provides home help to those eligible for similar care at home under the National Health Service. It also provides home help to a small number of private individuals. Funding from the Department of Health forms 90% of the company s income. In a very competitive market, and with increasing pressure on public sector finances, the board of AAA needs to decide whether a benchmarking exercise should be undertaken to identify where improvements to the business may be possible. As head of internal audit you have been asked to: a. Identify how benchmarking could benefit AAA and analyse the different types of benchmarking that could be undertaken. b. Explain the benchmarking process that would need to be undertaken and propose appropriate performance measures. 12 marks 8 marks SYLLABUS REFERENCE Section 5.6 Benchmarking MARK SCHEME Mark schemes are not definitive and valid relevant points not listed will receive equal credit. Question/Part b. Definition Identify benefits of benchmarking Types of benchmarking b. Process Performance measures Remember/ Understand Apply/ Analyse 5 Evaluate/ Create 3 Total marks Total a. Definition of benchmarking and its objectives. Benchmarking establishes, through data gathering, of targets and comparators. Relative levels of performance can be 22

23 identified (particularly areas of underperformance). By adopting best practice it is anticipated that performance will improve and compliance with standards and regulations maintained. Reasons for benchmarking include: Identification of the need for change. Learn from others in order to improve performance. Keep performance measures current and relevant Gain a competitive edge Improve services Different types of benchmarking Selection of types of benchmarking is determined by the availability of information, its accessibility and where it can be obtained. Public sector information will be more readily available in the form of Departmental Accounts and associated notes, Press releases and industry articles and information on future government legislative changes. Private sector information may not be so readily available. Internal benchmarking. Other units or departments within the same organisation can be used to benchmark against each other Competitive benchmarking (External). Use most successful competitors as a benchmark Industry Averages Horizontal and Vertical benchmarking Functional benchmarking. Comparisons made with similar functions such as ordering or stock holdings Strategic benchmarking. Form of competitive benchmarking. Aimed at reaching decisions for strategic action and organisational change. b. Benchmarking process. The benchmarking process should consist of the following elements: Identify the gaps in performance through comparisons with other organisations Seek a fresh approach to achieve an improvement in performance that exploits the gaps identified Implement the improvements and changes identified Monitor progress of implementation and impact on business (turnover, efficiency, effectiveness) Repeat the process. Benchmarking should be a continual process, not a one off exercise. Performance measures identified will vary but could include: A combination of measures to provide the relevant information. They should be key and critical to the success of the business Can be financial or non-financial depending on what aspects are identified for improvement Should be quantifiable and measurable as further comparisons may be necessary Co-operative benchmarking which could provide more extensive knowledge 23