The Institute of Chartered Accountants in England and Wales

BUSINESS ANALYSIS
Advanced Stage Technical Integration Level

For exams in 2014

Study Manual

www.icaew.com

Business Analysis
The Institute of Chartered Accountants in England and Wales

ISBN: 978-0-85760-870-3
Previous ISBN: 978-0-85760-473-6
First edition 2007
Seventh edition 2013

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any
form or by any means, electronic, mechanical, photocopying or otherwise, without the prior written permission of
the publisher.

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© The Institute of Chartered Accountants in England and Wales

Welcome to ICAEW
I am delighted to welcome you as a student studying our chartered accountancy qualification, the ACA.

The ACA will open doors to a highly rewarding career as a financial expert or business leader. Once you
are an ICAEW member, you will join over 138,000 others around the world who work at the highest
levels across all industry sectors, providing valuable financial and business advice. Some of our earlier
members formed today's global Big Four firms, and you can find an ICAEW Chartered Accountant on
the boards of 80% of the UK FTSE 100 companies.

We are here to help you every step of the way. As part of a worldwide network of over 19,000 students,
you will have access to a range of resources including the online student community, where you can
interact with fellow students, and our student support team. Take a look at the key resources on page ix.

I wish you the very best of luck with your studies and look forward to supporting you throughout your
career.

Michael Izza
Chief Executive
ICAEW

iii

iv

Contents

 Introduction vii
 Business Analysis viii
 Key resources ix
 Skills assessment guide x
 Faculties and Special Interest Groups xviii

 ICAEW publications for further reading xix

1 Strategic analysis 1

2 Business risk management 71

3 Cost analysis and control 123

4 Investment appraisal 157

5 Business and securities valuation 193

6 Cost of capital and financial structuring 237

7 Financial engineering 311

8 International financial management 363
 Mathematical tables 391
 Index 397

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vi

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

The knowledge level
The Business and Finance paper provides an introduction to how a business is managed and financed,
and the external environment that it faces. It also explains the role of the professional accountant. The
Management Information paper introduces costing and budgeting, and also looks at working capital
and performance management.
Progression to ACA application level
The knowledge base that is put into place here will be taken further in two application stage modules.
The Business Strategy paper looks at how businesses develop their strategies for products, markets and
management of internal resources and risks. The Financial Management paper examines the key
financial decisions that businesses take, relating to investment, financing and dividend payments, and
also how businesses manage their financial risks.
Progression to ACA Advanced Stage
The Advanced Stage papers – Business Reporting (BR) and Business Change (BC) – then take things
further again. The aims of BR are to ensure that students can apply analysis techniques, technical
knowledge and professional skills to resolve real-life compliance issues faced by businesses. In the BC
paper the aim is to ensure that students can provide technical advice in respect of issues arising in
business transformations eg mergers and acquisitions.
The above illustrates how the knowledge base of accounting gives a platform from which a progression
of skills and technical expertise is developed.

Introduction vii

2 Business Analysis
2.1 Module aim
The aim of the Business Reporting paper is:
To ensure that candidates can apply analysis techniques, technical knowledge and professional
skills to resolve real-life compliance issues faced by businesses.
Candidates may be put, for example, in the role of a preparer of financial statements, or other corporate
reports such as on sustainability and corporate responsibility, an advisor or in an assurance role facing
business issues where there are reporting implications. Compliance issues relating to taxation will also
feature in this module.
Candidates will be required to use professional judgement to identify and evaluate alternatives and
determine the appropriate solution(s) to compliance issues, giving due consideration to the commercial
impact of their recommendations.
The aim of the Business Change paper is:
To ensure that candidates can provide technical advice in respect of issues arising in business
transformations, mergers, acquisitions, alliances and disposals.
Candidates will be required to analyse and interpret both external and internal financial and non-
financial data in order to plan for change and provide advice. In undertaking this analysis candidates will
be expected to evaluate the impact of stakeholder influences on the data, including the impact of
choice of reporting policies.
Taxation and practical business techniques are particularly important in this module, where business
techniques include aspects of business strategy, business finance, performance management and
costing. There will also be financial reporting, assurance, ethical and legal implications to be considered
when developing and assessing strategic and business plans.

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

viii Business Analysis

3 Key Resources
STUDENT SUPPORT TEAM
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E studentsupport@icaew.com
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icaew.com/students student homepage
icaew.com/exams exam applications, deadlines, regulations and more
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icaew.com/examresources examiners comments, syllabus, past papers, study guides and more
icaew.com/examresults exam results
TUITION
If you are receiving structured tuition, make sure you know how and when you can contact your tutors
for extra help.
If you aren't receiving structured tuition and are interested in classroom, online or distance learning
tuition, take a look at our tuition providers in your area on icaew.com/exams
ONLINE STUDENT COMMUNITY
The online student community allows you to ask questions, gain study and exam advice from fellow
ACA and CFAB students and access our free webinars. There are also regular Ask an Expert and Ask a
Tutor sessions to help you with key technical topics and exam papers. Access the community at
icaew.com/studentcommunity
THE LIBRARY & INFORMATION SERVICES (LIS)
The Library and Information Service (LIS) is ICAEW's world-leading accountancy and business library.
You have access to a range of resources free of charge via the library website, including the catalogue,
LibCat. icaew.com/library

Introduction ix

The work experience framework is built around five key skills:  Business awareness – being aware of the internal and external issues and pressure for change facing an organisation and assessing an organisation's performance.2 Assessing your professional skills Initial Professional Development BR BC Advance Stage TAX FR technical integration FA A&A Professional Stage application level ETHICS Case Study FM Technical Professional Stage BS knowledge level Skills The work experience requirements for students provide a framework to develop appropriate work experience. completion of which is essential in order to qualify for membership. further technical knowledge to real situations.  Ethics and professionalism – recognising issues. These skills are broadly categorised as:  Assimilating and using information  Structuring problems and solutions  Applying judgement  Drawing conclusions and making recommendations 4. making confident decisions and recommendations. x Business Analysis .1 Introduction As a Chartered Accountant in the business world. using knowledge and experience to assess implications. targeted and relevant solutions.  Professional judgement – making recommendations and adding value with appropriate. In a similar way to the required knowledge. Work experience is also an essential component for examination preparation. 4 Skills assessment guide 4. the ACA syllabus has been designed to develop your professional skills in a progressive manner. and communicate the underlying issues to your clients.  Technical and functional expertise – applying syllabus learning outcomes and where appropriate. you will require the knowledge and skills to interpret financial and other numerical and business data.

there is a description of:  The specific skills that are assessed  How these skills are assessed Using these grids will enable you to determine how the examination paper will be structured and to consider whether your knowledge of Business Analysis is sufficiently strong to enable you to apply it in the required manner. The link between work experience and the examinations is demonstrated by the skills development grids produced by the examiners. 4.  Personal effectiveness – developing.3 Assessment grids The following pages set out the learning outcomes for Business Analysis that are addressed under each of the four skills areas. In addition. This will help students see that their practical knowledge and skills gained in the workplace feed back into the exam room and vice-versa. maintaining and exercising skills and personal attributes necessary for the role and responsibilities. for each skills area. embrace all of these skills. Introduction xi . The examinations. and in particular the Advanced Stage.

xii Business Analysis .

Level A A thorough knowledge with a solid understanding of the subject matter and experience in the application thereof sufficient to exercise reasonable professional judgement in the application of the subject matter in those circumstances generally encountered by Chartered Accountants.4. Level C A general knowledge with a basic understanding of the subject matter and training in its application sufficient to identify significant issues and evaluate their potential implications or impact. The knowledge levels are defined as follows: Level D An awareness of the scope of the standard. For each individual standard the level of knowledge required in the relevant Professional Stage module and at the Advanced Stage is shown. Level B A working knowledge with a broad understanding of the subject matter and a level of experience in the application thereof sufficient to apply the subject matter in straightforward circumstances.4 Technical knowledge The table contained in this section shows the technical knowledge covered in the ACA Syllabus by module. Key to other symbols:  the knowledge level reached is assumed to be continued Business Analysis Professional Stage Advanced Stage Management Management Information Business & Financial Strategy Business Finance Topic STRATEGIC ANALYSIS Environmental and market analysis tools PESTEL analysis C A  Porter's five forces B A  Product life cycle B A  Boston consulting group matrix B A  Competitor analysis B A  Positional and other analysis tools Resource audit C A  Resource-based strategy C A  Value chain analysis B A  SWOT analysis C A  Gap analysis C A  Marketing analysis A  Competitive advantage A  Benchmarking A  Directional policy matrix B Business process analysis B A Strategic risk analysis A  Balanced scorecard C A  Introduction xiii .

marginal. absorption B  Activity based costing (ABC) C B Break even analysis B  A Multi-product break even analysis B Budgeting and performance management B A Pricing Pricing decisions B A  Transfer pricing B A  BUSINESS AND SHAREHOLDER VALUE Valuation Techniques Income – dividend yield B A Income – P/E B A Income – discounted cash flow B A Asset based measures B A Options approach  Shareholder value Value based management (VBM)  Value drivers B A Shareholder value analysis (SVA) B A Short and long term growth rates and terminal values A Economic profit A Cash flow return on investment (CFROI) A Total shareholder return (TSR) A Market value added (MVA) A INVESTMENT APPRAISAL AND BASIC RISK ANALYSIS Project appraisal NPV B A  IRR B A  Payback B A  Relevant cash flows A  Tax and inflation A  Replacement Analysis A  Capital rationing A  Adjusted present value (APV) A  Assessing risk xiv Business Analysis . Professional Stage Advanced Stage Management Management Information Business & Financial Strategy Business Finance Topic STRATEGIC CHOICE Strategy formulation. evaluation and choice C A  Business risk management C A  Financial analysis and data analysis A  Stakeholder analysis B A  Objectives and stakeholders preferences C B Corporate responsibility and sustainability C B A STRATEGIC IMPLEMENTATION Business plans C B A Organisational structure C B A Information management C B A Change management A  Project management A COST ANALYSIS FOR DECISION MAKING Costing Cost classification A  Costing systems – direct.

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

Professional Stage Advanced Stage Management Management Information Business & Financial Strategy Business Finance Topic Currency swaps B A Operational techniques for managing currency risk B A Theoretical determinants of foreign exchange rates B A Option value Value of a call and put option C Black Scholes option pricing model B Binomial Option Pricing Model B Real options C B xvi Business Analysis .

Ethics Codes and Standards Ethics Codes and Standards Level Professional Stage modules IFAC Code of Ethics for Professional Accountants A Assurance (parts A. B and C and Definitions) Business and Finance Law Principles of Taxation ICAEW Code of Ethics A Audit and Assurance Business Strategy Financial Reporting Taxation APB Ethical Standards 1–5 (revised) A Assurance Provisions Available to Small Entities (revised) Audit and Assurance Introduction xvii .

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

better reporting to clients.  Companies Act 2006 – Auditor related requirements and regulations third edition – March 2012 ICAEW. or downloading specific modules on which they want to focus.com ICAEW no longer prints a Members Handbook. including some examples for sole practitioners. An international edition is also available. You are not required to study these publications for your exams. An international edition is also available.  Alternatives to Audit ICAEW. This report presents findings from the practical experience of providing the ICAEW Assurance Service over the subsequent two years and views of users of financial information that help in assessing the relevance of the service to their needs. This modular guide has been developed by ICAEW's ISA implementation sub-group to help medium-sized and smaller firms implement the clarified ISAs and take advantage of these opportunities.  The Audit of Related Parties in Practice. and enhanced audit quality overall. ICAEW 2010. ISBN 978-1-84125-565-6 This practical guide to the audit of related party relationships and transactions is set in the context of the significant change in approach that is required under the revised ISA and highlights the importance of planning. It covers the various types of reports issued by auditors in accordance with the Act.com/aaf Right First Time with the Clarified ISAs. For a full list of publications. It is designed to be a signposting tool for Introduction xix . visit the Technical Resources section of the ICAEW website at icaew. The guide also includes an appendix with answers to a number of frequently asked questions on the standard. to assign staff with the appropriate level of experience to audit this area and upfront discussions with the client to identify related parties. standards and guidance are available at icaew.6 ICAEW publications for further reading ICAEW produces publications and guidance for its students and members on a variety of technical and business topics. ICAEW 2010. investment business and insolvency as well as materials that was previously in the handbook. an alternative to audit based on the idea of limited assurance introduced by the International Auditing and Assurance Standards Board (IAASB). ISBN 978-0-85760-442-2 This third edition of the guide provides a brief summary of the key sections in the Companies Act 2006 (the Act) which relate directly to the rights and duties of auditors. the need to involve the entire audit team in this. or to access any of the publications listed below.  Quality Control in the Audit Environment. ISBN 978-1-84152-819-9 In August 2006. 2009. An international edition is also available. The TECH and AUDIT series of technical releases are another source of guidance available to members and students. ICAEW 2010. Illustrative policies and procedures are provided for selected aspects of each key area. Visit icaew. ICAEW regulations.com/technicalreleases for the most up-to-date releases.com/regulations This area includes regulations and guidance relevant to the regulated areas of audit. ISBN 978-0-85760-063-9 Clarified ISAs provide many opportunities for practitioners in terms of potential efficiencies. This list of publications has been prepared for students who wish to undertake further reading in a particular subject area and is by no means exhaustive. ISBN 0-497-80857-605-5 The publication identifies seven key areas for firms to consider. 2012. This modular guide is designed to give users the choice of either downloading the publication in its entirety. Audit and Assurance Faculty – icaew. better documentation. the ICAEW Audit and Assurance Faculty began a two-year consultation on a new assurance service (the ICAEW Assurance Service).

ISBN 978-1- 84152-628-7 The guide describes special considerations for auditors at each stage of the group audit's cycle. The first version of the UK Corporate Governance Code was produced in 1992 by the Cadbury Committee. analysis and research. ISSN 1367-4544 The award-winning Corporate Financier magazine is published ten times a year for members.com/corpfinfac  Private equity demystified –an explanatory guide Second Edition. following a review by the Financial Reporting Council. commercial and professional development issues. March 2010. The magazine includes features. Listed companies are required to report on how they have applied the main principles of the Code. written by experts. Hard copies of the abstract and full report are free and are also available by download from icaew. regulatory trends and technical issues. accountability and relations with shareholders. Financing Change Initiative. practitioners and identifies the other pieces of guidance issued by ICAEW. the Turnbull guidance was revised and updated in October 2005.com/corporategovernance  The UK Corporate Governance Code 2010 The UK Corporate Governance Code (formerly the Combined Code) sets out standards of good practice in relation to board leadership and effectiveness. John Gilligan and Mike Wright This guide summarises the findings of academic work on private equity transactions from around the world. experienced editors and professional journalists. Aimed at professionals. All companies with a Premium Listing of equity shares in the UK are required under the Listing Rules to report on how they have applied the UK Corporate Governance Code in their annual report and accounts. remuneration. 2008. Corporate governance – icaew. news. The revised publication contains suggestions for both group auditors and component auditors.  Auditing in a group context: practical considerations for auditors ICAEW. Corporate Finance Faculty – icaew. Authored by leading practitioners in corporate finance. they are succinct and clear overviews of emerging issues in UK corporate finance. In 2011. In May 2010 the Financial Reporting Council issued a new edition of the Code which applies to financial years beginning on or after 29 June 2010. stakeholders and key associates of ICAEW's Corporate Finance Faculty. POB and others to support implementation of the Act. FRC. APB. three major themes were introduced: Innovation & Corporate Finance. The UK Corporate Governance Code contains broad principles and more specific provisions. icaew.com/thoughtleadership  Best Practice Guidelines The Corporate Finance Faculty publishes a series of guidelines on best-practice.  Internal Control: Revised Guidance on Internal Control for Directors on the Combined Code (now the UK Corporate Governance Code) Originally published in 1999. The updated guidance applies to listed companies for financial years beginning on or after 1 January 2006. Financing Entrepreneurship. and Deal Leadership.com/corpfinfac  Corporate Financier magazine. investors and company directors involved in corporate finance. it covers a wide range of emerging regulatory. While no decisions have been taken on UK adoption of the IAASB's clarity ISAs. xx Business Analysis . ICAEW. and either to confirm that they have complied with the Code's provisions or – where they have not – to provide an explanation. the publication also covers matters in the IAASB's revised and redrafted 'ISA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors)'.

A report summarising the actions being taken by the Financial Reporting Council and explaining how the UK Stewardship Code is intended to operate was also published in July 2010. ISBN 978-1-84152-610-2 This report is a joint initiative with the Environment Agency. use or audit the financial statements in statutory annual reports and accounts. through case studies and finally towards developing an individually tailored sustainability strategy for their business. The FRC Guidance on Audit Committees (formerly known as The Smith Guidance) First published by the Financial Reporting Council in January 2003. It is intended to assist company boards when implementing the sections of the UK Corporate Governance Code dealing with audit committees and to assist directors serving on audit committees in carrying out their role. in all of their professional and business activities. won an Economic and Social Research Council grant to run a seminar series which aims to bring academics and the business community together to tackle some of the big challenges in corporate responsibility. icaew. whether remunerated or voluntary. For more information and to download a brochure visit icaew. A downloadable pdf is available at icaew. where applicable.com/sustainablebusiness  ESRC seminar series – When worlds collide: contested paradigms of corporate responsibility ICAEW. which is where the accounting profession plays an important role.com/corporateresponsibility  Sustainable Business January 2009 The new thought leadership prospectus acts as a framework for the work that ICAEW do in sustainability/corporate responsibility. in conjunction with the British Academy of Management. Corporate responsibility – icaew. It aims to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities by setting out good practice on engagement with investee companies to which the Financial Reporting Council believes institutional investors should aspire. member firms. affiliates. and most recently updated in 2010. May 2009.  The UK Stewardship Code The UK Stewardship Code was published in July 2010.com/sustainablebusiness  Environmental issues in annual financial statements ICAEW. This document may also be helpful to audit firms discussing this topic with clients and individuals seeking to address issues in this area with their employers. The first two modules are free to everyone.com/bsp Ethics – icaew.  Instilling integrity in organisations ICAEW June 2009 Practical guidance aimed at directors and management to assist them in instilling integrity in their organisations. The course is spread across five modules taking users from definitions of sustainability and corporate responsibility.com/corporateresponsibility  The Business Sustainability Programme (BSP) The Business Sustainability Programme is an e-learning package for accountants and business professionals who want to learn about the business case for sustainability.com/ethics  Code of Ethics The Code of Ethics helps ICAEW members meet these obligations by providing them with ethical guidance. Introduction xxi . The Code applies to all members. students. Companies are encouraged to use the 2010 edition of the guidance with effect from 30 April 2011. It is aimed at business accountants who prepare. or who advise or sit on the boards of the UK companies and public sector organisations. It offers practical advice on measuring and disclosing environmental performance. It argues that any system that is sustainable needs accurate and reliable information to help it learn and adapt. employees of member firms and. A downloadable pdf is available at icaew.

 Starting a business SR28: March 2010.  Reporting with Integrity ICAEW May 2007. ISBN 978-1-84152-546-4 This report suggests that more work is required on matching measurement practices in the financial services industry to the needs of different users of financial information. the benefits of having one. organisations and professions. despite the fact xxii Business Analysis . Financial Reporting Faculty – icaew. October 2007. ISBN 978-0-85760-285-5 This report is a source of reference for those analysing or researching the role of the finance function and provides a foundation for considering the key challenges involved.  Investment appraisal SR27: December 2009. both as a concept and in practice. The project has included the publication of stakeholder feedback and development of a final report. because this report sees reporting with integrity as a joint endeavour of individuals.  Finance transformation – the outsourcing perspective SR31: December 2010. at icaew. the concept of integrity is considered in all these contexts. Finance and Management Faculty – icaew. (Inspiring Confidence in Financial Services initiative) ICAEW. By All Accounts.com/fsf  Audit of banks: lessons from the crisis. ISBN 978-1-84152-854-4 This special report looks at the key issues and advises managers on how they can contribute effectively to decision making and control during the process of investment appraisal.  The Finance Function: A Framework for Analysis September 2011. leadership.com/frfac Financial Services Faculty – icaew. people management. as well as its journal. ISBN 978-1-84152-855-7 This considers the challenges of designing successful organisations. ISBN 978-1- 84152-519-8 The most comprehensive assessment to date of compliance with the requirements of IFRS and the overall quality of IFRS financial reporting. the role of the FD in the process. (Inspiring Confidence in Financial Services initiative) ICAEW.com/frfac  EU Implementation of IFRS and the Fair Value Directive ICAEW.  Measurement in financial services. ISBN 978-1-84152-455-9 This publication brings ideas from a variety of disciplines. written by Rick Payne.  Developing a vision for your business SR30: September 2010. The Financial Reporting Faculty makes available to students copies of its highly-regarded factsheets on UK GAAP and IFRS issues. including the accounting profession. written by Rick Payne. March 2008. and innovation and technology. Moreover. ISBN 978-0- 85760-079-0 The authors of this outsourcing special report share their expertise on topics including service level agreements.com/fmfac  Finance's role in the organisation November 2009. who leads the faculty's finance direction programme. ISBN 978-1-84152-984-2 This report provides accountants with a realistic and motivational overview of what to consider when starting a business. who leads the faculty's finance direction programme. in order to obtain a more comprehensive understanding of what is meant by integrity. June 2010 ISBN 978-0-85760-051-6 This research has looked into the role played by bank auditors and examined improvements that can be made in light of lessons learned from the financial crisis. ISBN 978-0-85760-054-7 This special report looks at what makes a good vision. storytelling and the use of visions in medium-sized businesses.

with the consumer market now leading in terms of ease of use and portability. ISBN 978-0-85760-617-4 Cloud computing in its purest form is pay-as-you-go IT. produced jointly by Thompson Reuters. Introduction xxiii . ISBN 978- 0-85760-286-2 This guide will enable the business manager to develop a philosophy that allies social media's potential with the business's objectives and capabilities.com/taxfac The Tax Faculty runs a Younger Members Tax Club which provides informal presentations.  Bringing employee personal devices into the business . A downloadable pdf is available at icaew. The IT capabilities provided as a service to businesses include: single software applications or software suites.com/technicalreleases Information Technology Faculty – icaew. produced jointly by KPMG. All young professionals interested in tax are welcome to attend. the Tax Faculty and the Information Technology Faculty. ranging from data storage to computer grids.  Making the most of social media . And you can subscribe to the free newswire which gives you a weekly round up. The following publications should also be of interest to students:  Make the move to cloud computing ICAEW. is a practical guide for accountants in business and practice. The online community (ion. For more details visit icaew. 2011.com/itcountshome) provides regular free updates as well as a link to the faculty's Twitter feed which provides helpful updates and links to relevant articles.com/thoughtleadership  Skilled Persons' Guidance – Reporting Under s166 Financial Services and Markets Act 2000 (Interim Technical Release FSF 01/08) This interim guidance was issued by ICAEW in April 2008 as a revision to TECH 20/30 to assist chartered accountants and other professionals who are requested to report under s166 Financial Services and Markets Act 2000. the Tax Faculty and the Information Technology Faculty. online software development platforms. and follows on from Demystifying XBRL. Tax Faculty – icaew.  Implementing XBRL This booklet. explains exactly what iXBRL is all about and what must be done in order to e-file corporation tax returns using the new standard. discussions and socialising.a guide to IT consumerisation ICAEW. and then to take the first practical steps in a mass communications medium very different from any that British business has encountered before. See the website for more details icaew. 2012. and virtual computing infrastructure.a practical guide for your business ICAEW. to set objectives and protect against pitfalls. 2012. online and on demand. that the financial services industry has the greatest concentration of measurement and modelling skills of any industry. A downloadable pdf is available at icaew.com/itfac The IT Faculty provides ongoing advice and guidance that will help students in their studies and their work.com/taxfac  Tax news service You can keep up with the tax news as it develops on the Tax Faculty's news site icaew.com/taxfac  Demystifying XBRL This booklet.com/taxnews.icaew. ISBN 978-0-85760-443-9 The gap between business and consumer technology has been growing over the last few years.

 TAXline Tax Practice series of detailed briefings on current topics: TAXline Tax Practice 27 Let property – a brief guide by Rebecca Cave (published November 2011) TAXline Tax Practice 26 The new pension rules by Anne Redston (published July 2011) TAXline Tax Practice 25 Tax Credits by Robin Williamson (published April 2011) TAXline Tax Practice No 23 HMRC Powers – an overview of the new powers and penalties regime by Paula Clemett (published October 2010) xxiv Business Analysis .

CHAPTER 1 Strategic analysis Introduction Topic List 1 Overview of analysis tools 2 Overview of data analysis 3 Overview of strategic implementation 4 Ethics and corporate responsibility issues 5 Integrating the use of analysis tools in a complex scenario Summary and Self-test Answers to Self-test Answers to Interactive questions 1 .

Introduction Learning objectives Tick off  Demonstrate a detailed understanding and application of the analysis tools studied at the Professional stage  Demonstrate the ability to integrate business strategy with financial strategy in a complex scenario  Demonstrate detailed understanding of how business strategy decisions can impact on financial strategy decisions in a complex scenario  Demonstrate a detailed understanding and application of the management of strategic implementation studied at the Professional stage 2 Business Analysis .

which collectively determine the profit potential of the industry as a whole. Any analysis must pursue as high a degree of objectivity as possible. Project management techniques were not covered in earlier material. In particular. You are likely to be required to demonstrate your knowledge and application of the techniques reviewed in this section in a more integrated scenario. political. If there is too much subjectivity unfounded complacency will result. The political situation in Greece is in turn influenced by the level of social discontent and the social impacts of the reduction of economic activity within the country. 1. For now. Strategic analysis 3 . Case example: Greece We shall cover the Euro crisis in more detail later in the text.1. Unfortunately. Detailed knowledge of these techniques is critical at the Advanced stage and you should R refer to earlier materials for an in-depth analysis of each of them. social and economic affairs tend to be closely intertwined.1. Given that case studies at this level are likely to be quite involved. you should not waste time trying to impose unnecessary divisions on any environmental analysis – the important thing is substance. this is never the case. A word of caution about using the five forces model though – its very comprehensiveness can encourage users to feel that all factors have been duly considered and dealt with.1 PESTEL analysis The PESTEL framework is used to analyse the macro-environment into the following segments:  Political  Economic  Socio-cultural  Technological  Environmental protection  Legal This analysis is a useful checklist for general environmental factors. 1. Greece's future within the Euro (and the economic impacts of its departure and the wider uncertainties about the Euro's future that will result) will depend on the ability of its government to deliver an economic package that satisfies financial market opinion. 1 Overview of analysis tools C H A Section overview P T  This section reviews the analysis tools that were covered in the Professional stage Business Strategy E paper. Greece is an obvious example of how PESTEL factors are interlinked. 1  Most of the critical tools for strategic analysis were covered in detail at the Professional stage.2 Porter's five forces The competitive environment is structured by five forces:  Threat of new entrants  Threat of substitute products or services  Bargaining power of customers  Bargaining power of suppliers  Rivalry amongst current competitors in the industry These forces influence the state of competition in an industry.1 Environmental and market analysis tools 1. although in the real world they are obviously all interlinked. Any single environmental development can have implications for all six PESTEL segments.

They were redesigned together and reached obsolescence at the same time. Tea is produced in Africa and India.. the desire to make rapid progress led to two important products – the Golf and the Passat. Because of the huge capital investment involved. 4 Business Analysis .000 tonnes a year. Interactive question 1: The tea industry [Difficulty level: Intermediate] The tea industry is characterised by oversupply.3 Product life cycle The product life cycle concept holds that products have a life cycle and that a product demonstrates different characteristics of profit and investment at each stage in its life cycle. 1. with a surplus of about 80. products should be assessed in three ways:  The stage of the life cycle the product has reached  The product's remaining life (how much longer will it contribute to profits)  How urgent is the need to innovate (to develop new and improved products) Case example: Volkswagen Under Ferdinand Piech. Tea is auctioned in London and prices are the same in absolute terms as they were 15 years ago. Poland. This led to overload in showrooms when the new products were launched. Tea estates 'swallow capital. as being 'exceptionally firm . not a prediction (not all products pass through each stage of the life cycle). Tea-bag manufacturers own their own estates.. There is no simple demarcation between buyers and sellers. The shortage and high prices of coffee have also raised demand for tea which remains the cheapest of all beverages in spite of the recent rise in prices. It enables a firm to examine its portfolio of goods and services as a whole. (b) Thinking ahead. The stages in a product's life cycle are:  Introduction  Development and growth  Maturity  Decline During strategic planning. as well as buying in tea from outside sources. Sri Lanka and China. suggest a possible strategy for a tea-grower owning a number of estates which has traditionally sold its tea at auction. the most recent investments have been quasi-governmental. which moved through their model life cycles in parallel.' Requirements (a) Carry out a five forces analysis. such as those by the Commonwealth Development Corporation in ailing estates in East Africa.1. Iran and Iraq are expected to rise. In 1997 tea prices were described in India at least. Demand from Russia. See Answer at the end of this chapter. and the return is not as attractive as in industries such as technology or services'. The life cycle concept is a model.

Such a development is clearly very stylised. 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. New competitors have been attracted by the premium prices charged by existing players to the extent that over capacity is an increasing threat. The main challenge with competitor analysis is determining how to obtain critical information that is reliable. LBG feels it should know more about its competitors. Strategic analysis 5 .1. LBG is concerned about the rapid growth of this specialist industry. R Market share High Low 1 Market High Stars Question marks growth Low Cash cows Dogs A company's portfolio should be balanced.1.5 Competitor analysis As the name suggests. up-to-date and available legally! Interactive question 2: Competitor analysis [Difficulty level: Intermediate] LBG is a manufacturer of specialist stage cosmetics that are specifically targeted at the theatre and film industries. both new and existing in order to maintain its industry status. Strategic business units are categorised in terms of P market growth rate and relative market share. 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? See Answer at the end of this chapter. LBG is keen to protect its market leader status. particularly in such industries as electronics and cars.1. One of the main problems with the matrix is that it is built around cash flows but innovative capacity may be the critical resource. with cash cows providing finance for stars and question marks. and its current market share of approximately 40%. 1. competitor analysis is an assessment of the strengths and weaknesses of current and potential competitors. through stars and then cash cows as they enter maturity and finally dogs as the product declines. This is an important strategic tool – it helps management to understand their competitive advantages or disadvantages relative to competitors and provides an informed basis to develop strategies to create or strengthen future competitive advantage. and a minimum of dogs. despite evidence that the market is maturing. However. The BCG matrix can be paralleled with the product life cycle as products develop from question marks. T E The matrix is as follows.4 Boston matrix C The Boston Consulting Group developed a matrix that assesses businesses in terms of potential cash H A generation and cash expenditure requirements.

The threads must be drawn together so that potential strategies may be developed and assessed. including the identification of critical success factors and opportunities to use information strategically. managing the linkages in its own value chain.2. weaknesses. 1. Primary activities are involved in the production of goods and services. It provides a starting point for measuring the amount of time.2. the processes of the business and information technology. For example.3 Value chain analysis The value chain describes those activities of the organisation that add value to purchased inputs. or by managing the linkages in the value system. threats – combines environmental analysis with internal appraisal to assess the firm's current and future strategic fit (or lack of it) with the environment. Gap analysis can be conducted from the perspective of the organisation.4 Gap analysis This tool enables organisations to study what they are doing currently and where they want to go in the future.2 Positional and other analysis tools 1. 1. combining activities in new or better ways. A complete awareness of the organisation's environment and its internal capacities is necessary for a rational consideration of future strategy. companies can identify what additional resources are required to pursue its chosen strategy. and linkages are the relationships between activities. 1. the direction of the business. Threats can sometimes be converted into opportunities which can then be matched with strengths. Strengths that cannot be matched with an available opportunity are of limited value and likewise with opportunities that cannot be matched with strengths.2. These resources can be categorised as financial. but it is not sufficient. 1. By determining what resources they have.2. 1. intangible or physical. an organisation can also use the model in other strategically valuable ways. It involves 6 Business Analysis . opportunities.2 Resource audit As the name suggests. human.5 Benchmarking Benchmarking enables organisations to meet industry standards by copying others. to identify gaps in the market. an organisation can use the value chain to secure competitive advantage by inventing new or better ways to perform tasks. support activities provide necessary assistance. Strengths Weaknesses Internal to the M company a Conversion t c h i Exist n independently g Conversion of the company Opportunities Threats Remember that strengths and weaknesses identified by internal personnel are only relevant if they are perceived as such by the organisation's consumers. It is less valuable as a source of innovation but is a good way to challenge existing ways of doing things. As well as using the value chain to establish where it creates value for the customer.1 SWOT analysis SWOT analysis – strengths. money and human resources required to achieve a particular outcome.2. resource audits identify the resources available to an organisation. It can also be used for new products. Weaknesses may also be converted into strengths which can be matched with opportunities.

inspection.2. The idea is to concentrate on and re-think activities that create value for customers whilst removing any activities that do not add value. Strategies include transferring risk to other parties. for our shareholders? profitability and shareholder value but set through talking to the shareholder or shareholders directly. Internal What processes must we Aims to improve internal processes and decision business excel at to achieve our making.2.9 Balanced scorecard The balanced scorecard emphasises the need for a broad range of key performance indicators (KPIs) and builds a rational structure that reflects longer-term prospects as well as immediate performance. such as industry averages. 1. Recommendations based on the position of these two elements are shown below. The balanced scorecard focuses on four different perspectives.8 Strategic risk analysis This involves recognising and assessing risks faced by the organisation. Business strengths High Low Market High Invest Grow attractiveness Low Harvest Divest 1. financial and customer objectives? Innovation Can we continue to Considers the business's capacity to maintain its and learning improve and create future competitive position through the acquisition of value? new skills and the development of new products.7 Business process analysis This tool helps organisations improve how they conduct their functions and activities with a view to reducing costs. and allows you to identify areas where you are performing relatively well and areas where your relative performance is C below expectations. quality. delivery.6 Directional policy matrix This matrix resembles the Boston matrix but measures the attractiveness of the market and your company's strength to pursue it. 1. H A When carrying out benchmarking exercises. comparing your own performance with recognised targets. Perspective Question Explanation Customer What do existing and Gives rise to targets that matter to customers: new customers value cost.2.2. improving the efficient use of resources and giving better support to customers. Financial How do we create value Covers traditional measures such as growth. developing strategies to manage them and mitigating risks using managerial resources. Strategic analysis 7 . you should be asking such questions as: P T  Why are these products or services provided at all? E  Why are they provided in that particular way? R  What are the examples of best practice elsewhere?  How should activities be reshaped in the light of these comparisons? 1 1. avoiding the risk altogether. reducing negative effects of the risk and accepting some or all of the consequences of a particular risk. handling and from us? so on.

the direction of investments. because it aims to increase long-term shareholder value by gearing strategies and management to harness the potential for sustainability products and services whilst also reducing and avoiding sustainability costs and risks. the orientation of technological development and institutional change are made consistent with future as well as present needs. or which society expects it to achieve. They include charitable donations. Sustainability Much of the discussion about corporate responsibility has focused on businesses' commitment to sustainability. to employees wanting fair employment conditions and customers seeking good-quality products at a fair price. A corporate sustainability assessment is carried out. 1. 2007) argued that there are four main 'layers' of corporate responsibility. ensuring that development meets the needs of the present without compromising the ability of future generations to meet their own needs. The index is designed to provide quantification of sustainability strategies and management of sustainability opportunities. obeying these laws must be the foundation of compliance with social responsibilities. The influential Brundtland report of 1987 emphasised that sustainability should involve developing strategies so that the organisation only uses resources at a rate that allows them to be replenished (in order to ensure that they will continue to be available).10 Corporate responsibility An important element of assessing a business may be the extent to which it fulfils corporate responsibility targets that it sets itself. Philanthropic responsibilities According to Carroll & Buchholtz (2000). At the same time emissions of waste should be confined to levels that do not exceed the capacity of the environment to absorb them. Companies included in the index as sustainability leaders are expected to show superior performance and favourable risk and return profiles. The Brundtland report defined sustainable development as 'not a fixed state of harmony. there is perhaps more emphasis on them in continental Europe than in the Anglo-American economies. and 8 Business Analysis . The creators of the index argue that corporate sustainability is attractive to investors. Economic responsibilities Companies have economic responsibilities to shareholders demanding a good return. Carroll & Buchholtz (2000. The scorecard is balanced in the sense that managers are required to think in terms of all four perspectives to prevent improvements being made in one area at the expense of another. but rather a process of change in which the exploitation of resources.' We shall consider corporate responsibility and sustainability in more detail in Section 4 of this chapter. contributions to local communities and providing employees with the chances to improve their own lives. Businesses are formed to be properly functioning economic units and so economic responsibilities form the basis of all others.2. Worked example: Measurement of sustainability Dow Jones Sustainability Index The Dow Jones Sustainability Index is one of a number of global indexes that have been developed to assess corporate sustainability. these are desired rather than being required of businesses. Although in all societies corporations will have some legal responsibilities. Ethical responsibilities These are responsibilities that require corporations to act in a fair and just way even if the law does not compel them to do so. In Anglo-American economies the focus of discussion has often been whether many legal responsibilities are unnecessary burdens on business. cited in Jobber. Legal responsibilities Since laws codify society's moral views. risks and costs.

companies' performance is monitored. Strategic analysis 9 . Business travel Ways in which Pearson is trying to reduce air travel include upgrading video-conferencing facilities. such as using the whole tree rather than part of the tree. Employee Green messages are a regular part of Pearson's internal communications. An intranet site offers ideas for carbon reductions. use of renewable energy sources and establishing partnerships that deliver carbon offsets. Climate neutrality Initiatives include a carbon management programme focusing on energy efficiency in buildings. links to local green groups and performance reports. magazines and newspapers cover climate change. Recent supersector leaders in the Dow Jones index have included Pearson.companies are ranked and selected for the index if they are among the sustainability leaders in their field. Environmental responsibility is included in contracts between Pearson and its suppliers. Supply chain Pearson has introduced various initiatives to improve resource efficiency. Pearson has also sought accreditation from the Forest Stewardship Council. Pearson's books. engagement It uses green teams – volunteers working to improve environmental practice. They are removed from the index if their performance is judged unsatisfactory. Pearson collects environmental data on the papers it purchases. The assessment uses the following criteria: C H Dimension Criteria A P Economic Corporate governance T E Codes of conduct/Compliance R Risk and crisis management Customer relationship management 1 Innovation management Industry specific criteria Environment Environmental management system Climate strategy Product stewardship Biodiversity Industry specific criteria Social Human capital development Talent attraction and retention Occupational health and safety Stakeholder engagement Social reporting Industry specific criteria Once the initial assessment has taken place. It holds training sessions for production teams around the world and discusses its approach to paper purchasing with various stakeholders. A key aspect of this monitoring is seeing how the company copes with crisis situations that carry a serious reputation risk. Principal areas in which Pearson reports its environmental and sustainability performance include: Property management Pearson has targets to reduce energy use and is investing in renewable energy at some of its sites. the leader in the Media sector. reducing the base weight of papers used and custom publishing.

eg stating that sales have grown by 15% in the period but not indicating why they have done so. eg 'falling R&D expenditure may be a problem for XYZ Ltd because it has built market share on the basis of its innovative products.' 10 Business Analysis . for example a fall in production costs perhaps harming product quality  Exercising judgement to draw conclusions and/or produce sensible recommendations  Looking beyond the information provided at what additional information may be useful to generate a better analysis/understanding and at any reservations regarding the data/techniques/assumptions applied  Linking different pieces of data to explain trends or outcomes  Highlighting weaknesses or omissions in the data provided  Discussing cause and effect relationships – eg identifying underlying causes of changes in the data 2. 2 Overview of data analysis Section overview  This section reviews the data analysis skills that you covered in Business Strategy at the Professional Stage. In most cases a good answer passes the 'because' test. break-even calculations  Carrying out the relevant calculations  Interpreting the resulting information to demonstrate an understanding of the story behind the numbers and communicating that analysis succinctly  Analysing the wider consequences and implications of the numerical data.1 Data analysis skills required The examiners are looking for you to demonstrate the following skills:  Choosing analytical tools that are appropriate in the context of the question eg financial ratios. A lack of meaningful analysis remains a common weakness at the Advanced Stage. resulting in generic answers that could apply to any company rather than the one in the scenario Solution: Make specific points. 2 Failing to use the additional information from the scenario in answers. Solution: Including the word 'because' in your answer changes the 'what' into a 'why'.2 Key weaknesses in answers The following list highlights weaknesses commonly identified in exam answers and suggests ways to address these: 1 Restating facts or numbers without applying them to the context of the question A common failing is to explain what has happened rather than why. demonstrating that you have understood the relationship between the financial/quantitative information and the business issues. focusing on the particular organisation and relating to the circumstances in the scenario.' The 'because' should be related to specific information in the scenario. These techniques are even more important at the Advanced Stage with its requirements to analyse more complex scenarios. KPIs. eg 'Market share has fallen from 35% to 29% because of the entry of a new lower-cost competitor. 2.

where possible. 7 Failing to achieve a reasonable balance between numerical and descriptive analysis Some weak answers are almost entirely descriptive. on average. Other weak answers include enough calculations. Any new strategy that is expected to address this decline or increase returns should be acceptable to the shareholders. P T 4 Focusing on a narrow range of measures E R Financial measures alone will not provide the full picture and are often the result of other factors. Then produce the descriptive interpretation of these numbers. Eg where sales revenues are growing by (say) 10% per year but the number of branches/outlets is growing by 15% per year then calculating the sales per branch/outlet will show that sales per branch is. Solution: Examine the information from different perspectives. Analysis of this data may reveal the relative causes (quantitatively) of sales revenue growth from each of these underlying factors. for example. Conclusions that you draw from this will help in answering later parts of the question. Solution: Both numerical and descriptive analysis are important and need due emphasis. with clearer workings. Strategic analysis 11 . In general approach (1) tends to produce better answers with a more systematic evaluation of the issues. 6 Failing to explain trends in the data by identifying cause and effect relationships. Two possible approaches are: (1) Set out a comprehensive numerical analysis at the beginning of the answer or in an appendix with workings (eg in a table). Thus. Solution: Your answer should. Alternatively sales revenue growth might be analysed in relation to volume growth. 3 Interpreting figures/results in isolation C Solution: Link the figures/analysis eg if market share has increased but gross margins have H decreased. This may. However if you use approach (1) make sure that you are careful with your time allocation. the company may have made a decision to reduce the selling price as part of a market A penetration strategy. rather than generic growth in sales per branch because of improved efficiency or stronger market conditions. 5 Failing to use numerical analysis to support the rest of your answer The data analysis element may be one of the first requirements. The numerical analysis tends to be more comprehensive and better thought out. then the business cannot afford to do nothing. address a variety of performance indicators. but their descriptive analysis is little more than stating which numbers have gone up and which have gone down. growth in overall sales revenue may be due to investment in more outlets. Use the 1 balanced scorecard headings to help you consider a wider range of measures. you may not have enough time to produce sufficient descriptive analysis. (2) Mix the numerical analysis with the descriptive analysis by producing calculations as each issue arises. falling. Remember that these measures will often help you understand what is causing the strategy to succeed or fail. Eg if the data analysis shows that the business is currently loss making and that sales and profitability are forecast to decline further. not the cause. changes in selling prices and changes in sales mix. include analysing information into ratios or percentages based on the data provided. If you spend too much time on calculations. Solution: Consider where else in your answer the analysis may be relevant / how you can 'make the numbers talk'.

in particular:  Distortions and creative accounting policies. If you are analysing the income statement you may need to strip out non-operating or non-recurring items from results to be able to make a fairer comparison over time. The next stage is to ask the question 'so what are the consequences of our analysis for deciding on the future business strategy?' (eg what are the consequences for profit of the 10% increases in sales price and sales volume after considering the variable cost increases arising from the product improvements and volume increases? How have competitors responded with price changes and improvements in their own products which may make the consequences next year different from those which occurred this year?). Consider for instance that good strategic decisions may take some time to be reflected in reported profit. which may even fall in the short-term. then the increase in sales revenues for the current year may be limited to say 10. These may include re-measurement to market value and recognising assets or liabilities that are not included in the accounts. WHEN If you're assessing the impact of changes in strategy over time or in making comparisons it is important to know WHEN changes occurred. in particular operating profit.3 Recommended approach The following is a suggestion for the approach to adopt when tackling data analysis:  Step 1: Review scenario and requirements  Step 2: Decide what analysis is appropriate  Step 3: Produce the necessary calculations  Step 4: Interpret your analysis  Step 5: State the additional information required The steps that cause most problems are Steps 3 and 4. 2. 8 Failing to understand how IFRS reported profit may fail to reflect the underlying performance of the business Solution: Question whether changes in profit. 2. HOW Analyse the available data in more detail to obtain a better understanding of HOW the WHAT element occurred (eg sales prices have risen by 10% and monthly sales volumes have risen by 10% following the price change). 12 Business Analysis . such as income smoothing or understated provisions  The factors determining important figures in the accounts.4 WHAT-HOW-WHY-WHEN-SO WHAT analysis It is difficult to produce a universal approach but one tool which includes both numerical and descriptive elements is: WHAT-HOW-WHY-WHEN-SO WHAT Analysis. but the changes will be more significant in next year's figures). 2. you will need to use what you've learnt specifically about analysing financial statements. reflect changes in underlying performance.5 Issues with accounts When carrying out data analysis. which may be part of the data provided in the question (eg there have been significant product improvements introduced during the year with additional features compared to competitors. SO WHAT The above steps analyse and interpret the nature of the data provided and attempt to identify and explain the underlying causes of any changes in the data. as measured by IFRS. Adjustments may be needed to the figures reported in the financial accounts before data analysis can be carried out. (eg If the price and volume changes above occurred half way through the year. WHAT Look at WHAT has happened overall (eg revenue has increased by 21%). WHY Look for the underlying causes of the HOW element.5%. This has meant that a higher price can be charged but has also resulted in an increase in demand despite this increased price).

In large organisations. typically over one year. These short-term plans:  Co-ordinate the roles of different functions so that they are consistent with strategic objectives  Give confidence to stakeholders such as finance providers or important customers  Help to ensure the accountability of operational managers The planning of implementation should include resource planning. Forces decision-making Businesses cannot remain static – they have to cope with changes in the environment. Enforces consistency at Long-term. R  Most of the techniques described were covered in detail in Business Strategy. However if business strategies are to be implemented successfully. operations planning and organisation structure and control systems. not just to 'stand still' and survive. 3.1 Business planning 3. as decisions cannot be taken only by one person. plans and all levels controls can be made consistent with one another. A business plan draws attention to the need to change and adapt. However project management is not currently covered 1 in Business Strategy.2 Advantages and disadvantages of formal business planning The advantages of a formal system of business planning are as follows Advantages Comment Identifies risks Planning helps in managing these risks. the corporate plan needs to be supported by shorter-term business plans. Time horizon Some plans are needed for the long term. Forces managers to Planning can encourage creativity and initiative by tapping the ideas think of the management team. strategies can be rendered ineffective by budgeting systems and performance measures which have no strategic content. Public knowledge Drucker has argued that an entrepreneur who builds a long-lasting business has 'a theory of the business' which informs his or her business decisions. and these are worth revisiting.1. medium-term and short-term objectives. Co-ordinates Activities of different business functions need to be directed towards a common goal. that theory of the business has to become public knowledge. However there are disadvantages of planning for strategy implementation in a structured way. Strategic analysis 13 . Better control Management control can be better exercised if targets are explicit. 3. and therefore we discuss it here in greater depth. You may remember that Mintzberg in his book The Rise and Fall of Strategic Planning made a number of criticisms of a structured approach to planning the implementation of strategy. Clarifies objectives Managers are forced to define what they want to achieve. Allocates responsibility A plan shows people where they fit in. Otherwise.1 Strategic planning and business planning A business's strategic plan or corporate plan provides the long-term framework for its activities. so you may need to go back to your materials from that paper. 3 Overview of strategic implementation C H A Section overview P T  This section continues the revision of strategic issues from the Professional Stage Business Strategy E paper.1.

2. while controlling behaviour and resources in the interests of the organisation as a whole.2 Organisational structure 3. so that overall aims are achieved without gaps or overlaps in the flow of work required. Internal politics The assumption of 'objectivity' in evaluation ignores political battles between different managers and departments. Problem Comments Practical failure Empirical studies have not proved that formal planning processes contribute to success. The advantages of this approach are claimed to be that good opportunities are not lost. This also includes the processes used to monitor financial results. 3. people are unwilling to question it.1. It can also mean that the firm ends up reacting all the time rather than developing proactively. and allocate them to suitable individuals or groups. so that some opportunities get missed anyway. But a firm 'cannot allow regular itself to wait every year for the month of February to address its problems. 14 Business Analysis . However the lack of formal planning means there is no co-ordinating framework for the organisation. it is easier to adapt to change and it encourages a more flexible. 3.2 Characteristics of organisational structure Hierarchy Within the organisation's hierarchy there will be lines of authority or chains of command.  Give each individual or group the authority required to perform the allocated functions.  Co-ordinate the objectives and activities of separate units. running from senior management vertically downwards through the organisation.2. using the concept of hierarchy.1 Purposes of organisational structure Organisational design or structure implies a framework or mechanism intended to do the following:  Link individuals in an established network of relationships so that authority.  Facilitate the flow of work. 3. to arrive at strategic decisions and to manage risk.  Management systems – the make-up of the senior management team. Exaggerates Managers are not all-knowing. creative attitude.3 Freewheeling opportunism The opposite approach to formal business planning is freewheeling opportunism. control and other systems. connecting the various levels of managers. Once a plan is locked in place. eg the corporate board. responsibility and communications can be controlled. and the methods they use to govern the organisation.  Centralisation/Decentralisation – where the responsibility for decision making lies. Developing an appropriate structure requires consideration of three areas:  Organisational configuration – the primary groupings of staff into departments or divisions. This approach suggests firms should not bother with formal plans and should exploit opportunities as they arise.' Reduces initiative Formal planning discourages strategic thinking. through planning. and there are limits to the extent to which power they can control the behaviour of the organisation.  Group together (in any appropriate way) the tasks required to fulfil the objectives of the organisation. information and other resources required. Routine and Strategic planning occurs often in an annual cycle.

Empowerment goes hand in hand with the following developments. has a large number of management levels.  Long chains of command distance junior managers from thinking and decision making at the top. and even setting. since giving responsibility to the people closest to the products and customer encourages responsiveness. and may leave the organisation in search of flatter organisations and greater opportunities for responsibility. in relation to its size. T E  Long chains of command will increase the amount of time taken for information to reach the R relevant decision makers. in relation to its size. Strategic analysis 15 . Flat organisations have become more common as a result of the current fashion for delayering and empowerment. being better able to identify and control the means to clearly understood ends. despite the advantages of a narrow span of control and the possibility of graduated promotions. since there are more 'knowledge workers'. with the freedom to make decisions about how they are to be achieved. it also provides a defined channel for formal communication up and down the organisation. Chief executive MD Divisional directors Senior management Department heads Section heads Middle management Assistants MD Foremen Department Supervisory heads management Charge hands Supervisors Workers Workers Tall and flat organisations A tall organisation structure might be inefficient. Empowerment Empowerment means making workers (and particularly work teams) responsible for achieving.  Delayering or a cut in the number of levels (and managers) in the chain of command.  Flexibility. Tall structures can impose rigid supervision and control and therefore block initiative and ruin the motivation of subordinates. C H Decisions on chains of command must also take into account the following issues. Tall and flat organisations A tall organisation is one which. A flat organisation is one which.The chain of command not only represents the decision making hierarchy. A P  Communications can become distorted as more layers are added to the chain of command. work targets. has a smaller number of hierarchical levels.  New technology. Such people need less supervision. and limit development into a general management role. Managers may therefore become 1 frustrated and de-motivated.

There are several issues. 'life or death' decisions are taken at 'operations level'. Philosophy Example Style of management Core businesses 'The company commits itself to a few Strategic planning style industries and sets out to win big in those industries.2.' The businesses have few linkages with each other. but standards might be set centrally and distributed throughout the organisation. Goold and Campbell conducted a study of a large number of high profile diversified companies to examine how different companies cope with the problem of managing diversity. strategy or structure?  The top-down approach says that management decide the strategy then build or revise organisational structure to implement it. decisions of any significance have to be referred back to head office.  Cultural control. In practice structure and strategy will feed off each other.' 16 Business Analysis .  Operations might be decentralised.4 Centralisation of organisations Centralisation and decentralisation refer to the degree to which authority is delegated in an organisation. In other businesses. Restructuring may also involve new possibilities and business initiatives.  The bottom-up view is that the strategy a firm follows emerges from. profitability and cash flow. Restructuring will be required to implement new strategies and structures may develop more informally in response to environmental challenges. should be in relatively stable competitive environments and should not involve large or long-term investment decisions.  Some businesses have regional offices with decision autonomy.' Manageable businesses 'The emphasis is on selecting businesses for Financial control style the portfolio which can be effectively managed using short-term financial controls. authority is centralised and decisions are taken at the top.3 Structure and strategy Which comes first.. Establishing control in an empowered culture can be achieved perhaps through:  Standardisation of processes. However. In a small business. or depends on. They discovered three main philosophies and three corresponding styles of strategic management. Diverse businesses 'The centre seeks to build a portfolio that Strategic control style spreads risk across industries and geographic areas as well as ensuring that the portfolio is balanced in terms of growth. 3. its structure or that the structure limits the choice of strategy. and therefore the level at which decisions are taken in the management hierarchy.2. in a hospital environment. the owner-manager may take all the decisions. 3..  Team working.  In some businesses. with clear guidelines (eg bank lending). so that everyone accepts the responsibilities that come with empowerment.

5 Evolution of organisational structures Organisations are responding to the following developments in the business environment: Development Features Growth of knowledge work 'Today's economy runs on knowledge and most companies work assiduously to capitalise on that fact. Goold and Campbell describe the features of the different styles of central management in terms of their management structures. The centre does not advocate strategies or interfere with major decisions but maintains control through financial targets and strategic objectives.'  The need to change functional hierarchies. Financial control As the name suggests.  The need to address the problem of fragmented staff roles: 'roles have become specialised with the result that staff are only responsible for a small part of an overall task. The centre establishes a planning process and contributes to strategic thinking.or product-focused business units. Strategic control Concerned with the plans of its business units but believes in autonomy for business unit managers. Plans are therefore made locally but reviewed in a formal planning process to upgrade the quality of the thinking. the strategies of the core R businesses. Changing conditions 'impact all functions of the company and lead to a radically different way of doing business. and influencing. de-skilling of work and the need for highly complex scheduling systems.' (Wenger and Snyder. eg a core of full-time permanent staff and periphery part-timers and temporary or contract workers. Core/periphery Some firms have been changing the structure of their workforces for the sake of greater flexibility. The role of the centre is limited to approving budgets and monitoring performance. and the development of improved understanding of how they operate and of the scope for radical redesign with a view to creating and delivering better customer value. Rather less emphasis is placed on financial controls. C H Style of central Features A P management T E Strategic planning Entails the centre participating in.2. customer.  The need to make radical changes to the entire organisation. Business Process Re-engineering (BPR) Business Process Re-engineering means selection of areas of business activity in which repeatable and repeated sets of activities are undertaken. 3. 1 term progress. 2000). Delayering A reduction in the number of levels in the management hierarchy. There are no long- term planning documents and no strategy documents. (CIMA Official Terminology) There are three common themes. focuses on annual profit targets.' Strategic analysis 17 . and performance targets are set flexibly and reviewed within the context of long. and workgroups. They use cross-functional teams. This can result in loss of accountability for a finished task. Communications Organisational life has been revolutionised by email and network technology technology.

cash flow forecasts. Senior managers need the operational systems to summarise data to aid their decision-making. budgetary control or variance analysis reports. improve customer services.1 Information at different levels To function effectively. The horizontal organisation Based on business process re-engineering. However. Properly implemented BPR may help an organisation reduce costs. The activities of strategic planning. cut down on the complexity of the business and improve internal communication.3. 18 Business Analysis . BPR is simply a synonym for squeezing costs (usually through redundancies). total cash needs. organisations need different levels of information and therefore must operate different types of information systems. are the basis of this approach. Such information includes overall profitability.2 Types of information Strategic information is used to plan the objectives of the organisation. the customer may be at the receiving end of several 'core' processes. Instead management is based on processes. (a) At best it may bring about new insights into the objectives of the organisation and how best to achieve them. Team Teams. 3.3 Information management 3. 3. and claims to eliminate the hierarchies of command and control. not individuals. future market prospects. however. total manning levels and capital equipment needs. 3. Many organisations have taken it too far and become so 'lean' that they cannot respond when demand begins to rise. ACCURATE can also be used as a framework when describing how poor information can be improved. Tactical information is used to decide how the resources of the business should be employed. Characteristic Comment Structure Organisation structure is based on cross-functional processes rather than tasks or geography. Ownership A process owner is responsible for the whole process.3. management control and operational control each have their own information requirements. Also the process owner should be the person or group that controls the process. Customers Customers drive the process: the process owner puts customer-performance first. the availability and cost of raising new funds. (b) At worst. and to monitor how they are being employed. Where. a horizontal structure is in place. staffing levels and profit results within a particular department of the organisation and short-term purchasing requirements. The process focuses the organisation on the customer. Such information includes productivity measurements. the profitability of different segments of the business.3.3 Qualities of good information You may remember the mnemonic ACCURATE as an easy way to remember the qualities of good information. the responsibility for taking control action is not always clear. and to assess whether the objectives are being met in practice. the horizontal organisation is a technique which breaks down 'vertical' departmental boundaries. Operational information is used to ensure that specific operational tasks are planned and carried out as intended.

Include external data. It needs to ensure that information is obtained. 1 Complete Include past data as a reference point for future projections. The IS strategy is supported by:  The information technology (IT) strategy which involves deciding how information needs will be met by balancing supply and demand of funds and facilities. IT costs include hardware and software costs. distributed and made available for implementing strategy in all areas of an organisation's activities. Perhaps several shorter reports would be more effective. such as new products. A coherent strategy is required because information technology is a high cost activity.4 Information strategies The information systems (IS) strategy refers to the long-term plan concerned with exploiting IS and IT either to support business strategies or create new strategic options.  The information management (IM) strategy which aims to ensure that information is provided to users and that redundant information is not being produced. Strategic analysis 19 . Authoritative Use reliable sources and experienced personnel. User-targeted Summarise information and present it together with relevant ratios or percentages. Many organisations invest large amounts of money in IS. allowing trends to be quickly assimilated and relevant action decided upon. where only those items that are worthy of note – and the control actions taken by more junior managers to deal with them – are reported. Easy-to-use Use graphical presentation. Devise a 'house style' for reports. R Incorporate elements of probability within projections so that the required response to different future scenarios can be assessed. Feature Examples of possible improvements C Accurate Use computerised systems with automatic input checks rather than manual H A systems. P Allow sufficient time for collation and analysis of data if pinpoint accuracy is T E crucial. Timely Speed up Information collection and analysis by production managers. retained. 3. Explain the method of derivation if some figures are derived from other figures. Relevant Define the purpose of the report clearly. Cost-beneficial Consider whether the benefit of having the information is greater than the cost of obtaining it. implementation costs associated with a new systems development and day-to-day costs such as salaries and accommodation. and the development of programmes to supply IT. probably by the introduction of better information systems. Include any planned developments. but not always wisely. Information about future demand would be more useful than information about past demand. Include exception reporting. It may be trying to fulfil too many purposes at once.3. The unmanaged proliferation of IT is likely to lead to expensive mistakes.

20 Business Analysis . (d) The way in which markets are identified Database systems make it much easier to analyse the market place. customer buying patterns or technology. (b) The way in which products are made There is a continuing trend towards the use of automation and computer aided design and manufacture. (f) The way in which firms are managed An empowered workforce often leads to the 'delayering' of organisational hierarchies (in other words. such as the introduction of tennis and squash rackets with graphite frames. or telephone or internet banking. Some common ways in which IS/IT/IM have had a major impact on organisations are explained below. The manufacturing environment is undergoing rapid changes with the growth of advanced manufacturing technology. There may also be powerful internal drivers of change including changes in leadership style. At the other extreme it could be transformational change. More fundamentally an organisation's information systems may not only support corporate and business strategy. For example:  IS/IT/IM may provide a possible source of competitive advantage. Many organisations use e-commerce: selling products and services over the internet. Technological changes can be relatively minor. including changes in competitor behaviour.  The information system may help in formulating business strategy by providing information from internal and external sources. for example greater centralisation to allow more efficient decision-making.4. (a) The type of products or services that are made and sold For example.  Developments in IT may provide new channels for distributing and collecting information.2 Types of change Change can take the form of a series of small steps (incremental change). the reduction of management layers). (e) The way in which employees are mobilised Technology encourages workforce empowerment. These will feed through into changes the organisation makes or the services it provides. Change may follow a series of carefully planned steps or it may consist of continuous adjustment to the environment.4. Most shops now use computerised Point of Sale terminals at cash desks. They may also help determine corporate/business strategy. significant change being introduced relatively quickly.1 Factors promoting change Strategic analysis may identify material changes in the business environment to which an organisation has to respond. industrial markets have seen the emergence of robots and local area networks for office information systems. Using technology frequently requires changes in working methods. This could involve new technology not yet available to others or simply using existing technology in a different way. (c) The way in which services are provided High-street banks encourage customers to use 'hole-in-the-wall' cash dispensers.4 Change management 3. characterised by major. fluoride toothpaste and turbo-powered car engines. 3. and /or for conducting transactions eg the internet. Internal change may also be required to respond to external challenges. 3.

beginning at Step 1 and going through to Step 7. Step 6 Communicate the plan for change. behaviour.  Identify those in favour of the change. The decision may be taken either by group problem-solving (participative) or by a manager on his own (coercive). Step 1 Determine need or desire for change in a particular area. values.3. move and refreeze. and perhaps set up a pilot programme involving them. communicating it and encouraging individuals and groups to 'own' the new attitude or behaviour. desirable behaviour or norm should be.4 Change processes The following steps will normally apply in any process of major change. Step 4 Make a final decision from the choice of alternative options. Step 5 Establish a timetable for change. Alternatively the Lewin/Schein three-stage model of change identifies key steps as unfreeze. R  Individual – emphasis on improving individual skill levels. systems or structures. This requires continuous evaluation. Strategic analysis 21 . H A  Organisational culture – the focus is on the social and informal processes that promote the ethos P of the organisation.  Speed of implementation that is achievable will depend on the likely reactions of the people affected. Step 2 Prepare a tentative plan.  'Coerced' changes can probably be implemented faster. Step 8 Review the change. UNFREEZE MOVE REFREEZE Existing behaviour  Attitudinal/behavioural  New behaviour change Step 1 Unfreeze is concerned mainly with selling the change. Step 2 Move is the second stage. attitudes and motivation.4. Step 7 Implement the change. since alternatives for change should be considered. without time for discussions. giving individuals or groups a motive for changing their attitudes.3 Focus of change C Change may focus at one of three main levels. This might involve the adoption of a new culture. Talk with any others likely to resist the change. mainly concerned with identifying what the new. T E  Restructuring – covering reporting lines and how people work together. Brainstorming sessions are a good idea.4. 1 3. Step 3 Analyse probable reactions to the change. This is really a continuous process.

the work which organisations undertake involves either operations or projects. Reframing involves fundamental questions about what the organisation is and what it is for:  Achieve mobilisation: Create the will and desire to change.5. but is also likely to involve cultural changes:  Construct an economic model to show in detail how value is created and where resources should be deployed.  Develop the organisation and its adaptive capability.4.  Change the rules of competition by exploiting technology.  Build a measurement system that will set targets and measure progress. supplies.  Build individual learning. Restructuring is about the organisation's structure.5 Strategic change Gouillart and Kelly's Gemini 4Rs framework demonstrates how strategic change can be worked through all aspects of an organisation's identity. Operations and projects are planned. services and people allocated to the project.  Create the vision of where the organisation is going. Resources used 'full-time' although often on a shared basis Are intended to be done only once (eg organising A mixture of many recurring tasks the 2010 London Marathon – the 2011 event is a separate project) Follow a plan towards a clear intended end-result Goals and deadlines are more general Often cut across organisational and functional lines Usually follows the organisation or functional structure 22 Business Analysis . controlled and executed. In general. Step 3 Refreeze is the final stage. So how are projects distinguished from 'ordinary work'? Projects Operations Have a defined beginning and end On-going Have resources allocated specifically to them. (Haynes. facilities. 3.  Invent new businesses. Revitalising is the process of securing a good fit with the environment:  Achieve market focus. 3.  Align the physical infrastructure with the overall plan. Renewal ensures that the people in the organisation support the change process and acquire the necessary skills to contribute to it:  Create a reward system in order to motivate. implying consolidation or reinforcement of the new behaviour. Project Management) Resources are the money. schedule and quality objectives'.  Redesign the work architecture so that processes interact to create value. Positive reinforcement (praise and reward) or negative reinforcement (sanctions applied to those who deviate from the new behaviour) may be used.1 What is a project? Definitions A project is 'an undertaking that has a beginning and an end and is carried out to meet established goals within cost.5 Project management 3.

Timescale The progress of the project must follow the planned process. Objective Comment Quality The end result should conform to the project specification. The project management process also provides a structure for communicating within and across organisational boundaries.2 What is project management? 1 Definition Project management is the combination of systems. Unexpected There should be mechanisms within the project to enable these problems problems to be resolved quickly and efficiently. As time is money.5. Specialists Contributions made by specialists are of differing importance at each stage. Budget The project should be completed without exceeding authorised expenditure. the result should achieve what the project was supposed to do. All projects require a person who is ultimately responsible for delivering the required outcome. Common examples of projects include: C  Producing a new product. Project management ensures responsibilities are clearly defined and that resources are focussed on specific objectives. This may lead conflict to conflict. Challenge Comment Teambuilding The work is carried out by a team of people often from varied work and social backgrounds. proper time management can help contain costs. Expected Expected problems should be avoided by careful design and planning problems prior to commencement of work. The 'lead in' time to this can cause a strain on the eventual recipient who is also faced with increasing expenditure for no immediate benefit. Projects present some management challenges. The team must 'gel' quickly and be able to communicate effectively with each other. Strategic analysis 23 . and people used to control and monitor activities undertaken within the project. Delayed benefit There is normally no benefit until the work is finished. Project management co-ordinates the resources necessary to complete the project successfully. In other words. service or object H  Changing the structure of an organisation A  Developing or modifying a new information system P T  Implementing a new business procedure or process E R 3. Potential for Projects often involve several parties with different interests. so that the 'result' is ready for use at the agreed date. techniques. This person (whether officially given the title or not) is the project manager.

Maylor (Project Management) describes four phases or stages: this is the 4D model. Month January February Activity w/c 7 14 21 28 4 Week 1 2 3 4 5 1 2 3 4 Plan Actual Gantt chart 24 Business Analysis . if it is decided to continue with the project. This will include a statement of requirements. since their type and quantity vary from phase to phase. since it breaks the whole down into more easily manageable parts. A project initiation document may be prepared.3.5. quality and risk using techniques such as risk assessment. a statement of the vision for the project and a business case. resource budgeting. such as network analysis and Gantt charts (diagram below). This is particularly applicable to the allocation and management of resources. This stage also deals with the need to plan for cost. and cost budgeting. (2) Design the project There are several techniques used for scheduling and time planning.3 The project life cycle The life cycle concept can be useful in the management of projects. Stage in project life cycle Component Activities Define the project Conceptualisation Produce a clear and definitive statement of needs Analysis Identify what has to be done and check its feasibility Design the project Planning Show how the needs will be met Justification Compute costs and benefits Agreement Obtain sponsor agreement Deliver the project Start up Assemble resources and people (Do it!) Execution Carry out planned project activities Completion Success or abandonment Handover Output passed to sponsor/user Develop the process Review Identify outcomes for all stakeholders Feedback Document lessons and improvements for future use (1) Define the project Larger projects are likely to involve the creation of a project brief or terms of reference for discussion.

especially with projects involving significant physical output. but in a proper fashion: In particular. Planning will continue as required in order to control H agreed changes and to deal with unforeseen circumstances. scheduling.  Supply chain: All the aspects of logistics management must be implemented.4 The role of the project manager Definition Project manager: The person who takes ultimate responsibility for ensuring the desired result of the project is achieved on time and within budget.  Problems and decisions: Problems are bound to arise and must be solved sensibly and expeditiously. Duty Comment Outline planning Project planning (eg targets. but the main emphasis is on getting A the work done. such as the operation and maintenance of a system. care must be taken that contractors do not either leave small things undone or.5. (4) Develop the process Improve the way the organisation and project teams cope with projects:  Completion: All activities must be properly and promptly finished.  Documentation must be completed: This is important on any project but it is vital if there are quality certification issues or it is necessary to provide the user with operating documentation.  Immediate review is required to provide staff with immediate feedback on performance and to identify short-term needs such as staff training or remedial action for procedure failures.  Dividing the project into activities and placing these activities into the right sequence. Strategic analysis 25 .  Handover must take place where the project has been managed for a client under contract: At some point the client must formally accept that the contract is complete and take responsibility for any future action that may be required. cost and quality must be kept under control. (3) Deliver the project C This is the operational phase of the project. if paid by time. spin things out for as long as possible. 3. as must the tendency for 1 changes to proliferate.  Project systems must be closed down. Detailed planning Break work into pieces.  Control: Time. sequencing):  Developing project targets such as overall costs or timescale needed (eg project should take 20 weeks). The duties of a project manager are summarised below. P T There are several important themes. Complex problems will require careful analysis using the scientific tools of decision theory. the project accounts and any special accounting systems must remain in operation and under control until all costs have been posted but must then be closed down to avoid improper posting.  Developing a framework for procedures and structures needed to manage the project. assessing resource requirements. E R  Management and leadership: People management assumes a greater importance as the size of the project work force increases.

unforeseen problems may arise. and other external parties (eg activities suppliers of hardware and software). Obviously in the case of a complex project there would be far more activities and a far more complex network. Communication The project manager must let superiors know what is going on. Subsequently the network can be analysed in terms of cost. 3. CPA allows the network to be analysed – in the first instance in terms of time.5.5 Network or critical path analysis Network or critical path analysis (CPA) may be defined as a diagrammatic representation of the interrelation over time of the activities involved in a project and the subsequent analysis of those activities in terms of time. Quality control There is often a short-sighted trade-off between getting the project out on time and the project's quality. and ensure that members of the project team are properly briefed. Any delays to activities on the critical path delay the whole project. This is particularly useful when trying to assess the impact of potential delays in terms of time and cost. Resource requirements unforeseen at the planning stage will probably have to be authorised separately by the project board or project sponsor. Monitoring and The project manager should estimate the causes for each departure from control the standard. and take corrective measures. ie the longest path through the network. eg the effect on cost of accelerating activities. but the principle is the same. Variability in activity times (ie risk) can be analysed using PERT (project evaluation and review technique) which can forecast likely outcomes and the probability of a particular outcome occurring. Problem-resolution Even with the best planning. which enables the minimum project time to be determined and the critical path. It shows that some activities logically follow others (boil water after filling kettle) and some can take place at the same time (getting cup and adding coffee while water is boiling). fill boil add 1 2 4 water 5 kettle water get cup add coffee 3 Network for black coffee. no sugar The figure above shows an extremely simple network diagram for making a cup of coffee. Team building Build cohesion and team spirit. Duty Comment Obtain necessary Resources may already exist within the organisation or may have to be resources bought in. The basic analysis assumes the times for each activity are known with certainty. cost and risk. Co-ordinating project Between the project team and users. 26 Business Analysis .

objectives and strategy. selling arms to tyrannical regimes. Corporate social responsibility and sustainability issues are covered in the Business Strategy learning materials. 2 Objectivity: Not allow bias.2 Regulating ethical behaviour Ethical business regulation operates in two ways: 1 Forbidding or constraining certain types of conduct or decisions: eg most organisations have regulations forbidding ethically inappropriate use of their IT systems. charities. 4. 1  Advanced Stage will include more complex ethical dilemmas than Professional Stage. sustainability of resources. 3 Professional competence and due care: Be aware of all prevailing knowledge necessary to give professional service and apply the same diligently to affairs of clients in accordance with technical and professional standards.  Go beyond minimum legal and corporate governance obligations to include explicitly the interests of other stakeholders in setting mission.  Ethical standards for Reporting Accountants – concerned with the integrity and independence of accountants involved in writing investment circulars. 2 Disclosure of certain facts or decisions: eg because the board sets its own pay they disclose it. An organisation can adopt a range of ethical stances:  Meet minimum legal obligations and concentrate on short-term shareholder interests. The following codes are potentially binding on you as a trainee Chartered Accountant. Further ethical issues R are covered in an Auditing context in the Audit and Assurance learning materials. This section therefore deals with the Accountant in Business. Similarly many will forbid the offering or taking of inducements in order to secure contracts. 4.1 Ethical stances of organisations Ethics can be defined as the moral principles that determine individual or business conduct. Nevertheless much of the basic guidance still applies. or behaviour that is deemed acceptable in the society or context. Strategic analysis 27 .  Public sector organisations. The ICAEW Code of Ethics for members Five fundamental principles: 1 Integrity: Straightforward and honest in business and professional relationships. conflict of interest or influence of others to override professional or business judgement. using child labour etc would be considered. The Auditing Practices Board (APB)  Ethical standards for Auditors – concerned with assuring their integrity and independence in the audit of financial statements and in how fees are levied. and sometimes the reasons behind the awards. paying bribes to secure contracts. to shareholders in the final accounts. In this context issues such as environmental protection.  Recognise that long-term shareholder wealth may be increased by well-managed relationships with other stakeholders. for example where the ethical issue and the appropriate course of action involve multiple considerations. etc where the interests of shareholders are not relevant. 4 Ethics and corporate responsibility issues C H A Section overview P T  In this section we recap the factors you need to consider if any questions in your exam include E ethical issues.

or be developed in the working environment by the individual or their organisation. unless the value is clearly insignificant. concern over employment security. loans or guarantees. A professional accountant in business is expected to encourage an ethics-based culture in an employing organisation. acceptance of a gift or preferential treatment. professional accountants are required to refrain from the action or relationship in question. 28 Business Analysis . they must implement safeguards. provided any statements made are neither false nor misleading. 4 Confidentiality: Respect the confidentiality of information acquired as a consequence of professional or business engagements and not use the information for personal advantage or that of third parties. professional accountants are required to consider whether their actions or relationships might constitute threats to their adherence to the fundamental principles. long association with business contacts influencing business decisions.2 Safeguards To comply with the Code.3. (e) Intimidation – Threat of dismissal or replacement of the professional accountant or a close or immediate family member. The Code sets out the types of safeguards in the work environment which might be applied to overcome these threats:  The employing organisation's systems of corporate oversight or other oversight structures. created by the profession or regulation. These safeguards might be generic. over a disagreement about the application of an accounting principle or the way in which financial information is to be reported. (c) Advocacy – When furthering the legitimate goals and objectives of their employing organisations. 5 Professional behaviour: Comply with laws and regulations and not discredit the profession. Such actions generally would not create an advocacy threat. (d) Familiarity – A professional accountant in business in a position to influence financial or non- financial reporting or business decisions having an immediate or close family member who is in a position to benefit from that influence. (b) Self-review – Business decisions or data being subject to review and justification by the same professional accountant in business responsible for making those decisions or preparing that data. the business community. practices and attitudes. the greater the ability and opportunity to influence events. creditors. incentive compensation arrangements.1 Threats The Code outlines areas where there may be conflict for professional accountants in business between furthering the legitimate aims of their organisation and their absolute duty to comply with the fundamental principles: (a) Self-interest – Financial interests. inappropriate personal use of corporate assets. for example with regard to the awarding of contracts or the application of an accounting principle. 4. 4. commercial pressure from outside the employing organisation. 4. If effective safeguards are not possible. Where these are significant. a dominant personality attempting to influence the decision making process. professional accountants in business may promote the organisation's position.3. which emphasises the importance that senior management places on ethical behaviour.3 ICAEW Code of Ethics for Professional accountants working in business Investors. employers. government and the public may rely on the work of professional accountants in business in the context of:  Preparation and reporting of financial and other information  Providing effective financial management  Competent advice on a variety of business-related matters The more senior the position held.

 Privacy of customers and employees: Modern databases enable tracking of spending for marketing purposes or discriminating between customers on basis of their value. ie consistent with present and future ethical expectations. This will raise expectations of its behaviour. a professional accountant in business may conclude that it is appropriate to disassociate from the task and/or resign from the employing organisation.  Fairness of labour contracts: Firms can use their power to exploit workers.  Policies and procedures to empower and encourage employees to communicate to senior levels within the employing organisation any ethical issues that concern them without fear of retribution.  Consultation with another appropriate professional accountant.  Strategy selection: Management should consider the ethical implications of proposed strategies before selecting and implementing them. 4. In extreme situations where all available safeguards have been exhausted and it is not possible to reduce the threat to an acceptable level. and subject them to unethical treatment in areas where jobs are scarce.  Terms of trade with suppliers: Large firms may pay poor prices or demand long credit periods and other payments from weak suppliers. 4. A P  Strong internal controls.4 Impact of ethics on strategy Ethics may impact upon strategy in various ways:  In the formulation of strategic objectives.  The employing organisation's ethics and conduct programmes.  Timely communication of the employing organisation's policies and procedures. C  Recruitment procedures in the employing organisation emphasising the importance of employing H high calibre competent staff.1 Conflict between ethics and business Potential areas for conflict between ethics and business strategy include:  Cultivating and benefiting from relationships with legislators and governments: Such relationships may lead politicians to ignore the national interest (eg of the people who elected them) to further their own personal interests.  External appraisal will need to consider the ethical climate in which the firm operates.4. they should consider seeking legal advice. Staff can be subject to background checks and monitored through their use of email and the location of their mobile phones. some firms will not consider lines of business for ethical reasons. to all employees. including child labour. 4.3.3 Action required in unethical circumstances In circumstances where a professional accountant in business believes that unethical behaviour or actions by others will continue to occur within the employing organisation. and appropriate training and education on such policies and procedures. 1  Policies and procedures to implement and monitor the quality of employee performance.  Internal appraisal: Management should consider whether present operations are 'sustainable'. R  Leadership that stresses the importance of ethical behaviour and the expectation that employees will act in an ethical manner. T E  Appropriate disciplinary processes. This has been a particular criticism of large retail food Strategic analysis 29 . including any changes to them.

However this stance assumes superiority of judgement over the consumers who buy the products. what are the issues? (6) What are the alternative actions that could be taken and what are the consequences of each course of action ? (7) Are there any sustainability issues? 30 Business Analysis . how staff are treated. Examples here include anti-aids drugs to Africa or purified water to developing countries. life saving drugs or petrol. as discussed above  Conflicts of interest amongst stakeholders  Attempts to mislead key stakeholders (by disclosure or non-disclosure of information)  Doubtful accounting or commercial business practices  Facilitation of unethical strategies  Inappropriate pressure to achieve results  Conflict between the accountant's professional obligations and the responsibilities to the organisation  Lack of professional independence eg personal financial interest in business proposals  Actions contrary to law.  Prices to customers: Powerful suppliers of scarce products such as energy. are able to charge high prices that exclude poorer individuals or nations. There is the basic argument that marketing persuades people to buy what they don't need.  Product and production problems: These include the environmental impacts of the production itself. 4.  Managing cross cultural businesses: Different countries of operation or different ethnic groups within the domestic environment can present ethical issues affecting what products are made. stores in North America and Europe. encouraging anti-social behaviour and upsetting observers. the manufacture of products with adverse impacts on health and the impact on the environment when products are thrown away. dress conventions. observance of religion and promotional methods.6 Recommended approach The following is a suggested list of factors to consider when tackling questions involving ethical issues: (1) Is there a legal issue (criminal or civil law)? (2) Do any other codes or professional principles apply? (eg is the individual with the ethical dilemma a professional accountant?) (3) Upon which stakeholders does the decision/action impact? (4) What are the implications in terms of:  Transparency  Effect  Fairness (5) If the proposed action/decision is not taken. Some promotion techniques have also been criticised for attempting to brainwash consumers. 4. product testing on animals or humans. alcohol and fatty foods. You need to develop a balanced argument.  Marketing. but it can also be used to promote unhealthy products such as cigarettes. Marketing can be used to promote ecologically responsible ways of life. using appropriate ethical language and discussing relevant professional principles.5 What will the ethics requirement involve? Possible ethical problems that you may find in questions include:  The impact of ethics on strategies and strategic choice. regulation and/or technical and professional standards Some of these issues are not clear-cut. A key issue is the ends to which marketing is put. who are blamed for the impoverishment of farmers at home and in developing countries.

(c) Staff motivation A commitment to CR helps establish values and mission within the organisation. suppliers and supply chain participants and competitors. sourcing.  Staff welfare: Issues such as stress at work. Stakeholders include communities (particularly where operations are based). than having it imposed by statute. and not having to incur costs of remediation if they have negatively affected the environment. suppliers. emissions (notably carbon dioxide).  Environmental protection: Energy use.1 Reasons for pursuing corporate responsibility We mentioned corporate responsibility (CR) or corporate social responsibility earlier in this chapter. personal development. water use and pollution.7. (b) Corporate reputation Increasingly a business must have the reputation of being a responsible business that enhances long-term shareholder value by addressing the needs of its stakeholders – employees. Factors frequently included are:  Health and safety: This includes workplace injury. equal opportunities for disadvantaged or minority groups. (a) Stakeholder pressures Businesses face pressures from various different stakeholder groups to consider their wider responsibilities. Stakeholders also include governments facing political pressures. pollution. Strategic analysis 31 . Sponsorship and community involvement can reflect well on the business and attract ethical customers. customers (product safety issues).2 Scope of corporate responsibility The scope of CR varies from business to business. etc can have powerful social effects for good or ill on these stakeholders. customers. achieving work/life balances through flexibility. the community and the environment. (d) Business issues CR initiatives may provide opportunities to enter new markets or build new core competencies. Businesses face a number of pressures to widen the scope of their accountability. Key weaknesses in answering ethical questions include: C (1) Failing to identify the ethical issue (eg transparency) H (2) Failing to use ethical language A P (3) Quoting chunks of the ICAEW's ethical code without applying it to the scenario T E (4) Failing to identify appropriate safeguards R (5) Applying professional accountants' ethical codes to individuals in the scenario who are not accountants (6) Failing to distinguish between the ethical responsibilities of the individual and those of the 1 organisation (7) Concluding by asserting an opinion that is not supported by clear justification on ethical grounds – stating 'X should be done because it is right' is insufficient 4. customer and supplier injury and harm to third parties.7 Corporate responsibility 4. recycling of materials and heat. Adopting CR voluntarily may be more flexible. Businesses can achieve lower costs through using resources more efficiently. Issues such as plant closures. non-exclusion of customer groups. which may help attract and retain staff. fair dealing and treatment. 4.  Customer welfare: Through content and description of products. impact of product on environment.7. Without the support of stakeholders a business will find its ability to operate is impaired and this will damage performance. and in the end less costly. job creation.

 Supply-chain management: Insisting that providers of bought-in supplies also have appropriate CR policies. for example a publishing company sending its employees to libraries and schools. ethical trading. Use hard data rather than impressions. Reactive strategy This involves allowing a situation to continue unresolved until the public. eliminating exploitative labour practices amongst contractors. provision of free products to the needy. management forbidden from offering bribes to win contracts. and the organisation and its competitors. before any injury or damage is caused. prohibitions on uses of data and IT. This should in turn mean that the organisation's approach to these issues is aligned and integrated with strategic initiatives in other parts of the business. or donating books 3 Planning the journey CR issues should be prioritised using a gap analysis between current and future states.  Ethical conduct: Staff codes for interpersonal behaviour. Assess availability of grants and tax concessions for green behaviour. Assess opportunities for action.  Engagement with social causes: This includes secondment of management and staff. understanding all the CR activity currently happening in the organisation 2 Envisioning the future Assessing the legacy the organisation wishes to leave. This will mean integrating CR activities with business strategies. involvement in the local community. Defence strategy This involves minimising or attempting to avoid additional obligations arising from a particular problem. For example a company which discovers a fault in a product and recalls the product without being forced to. though stakeholder feedback is important 32 Business Analysis . benchmarking against present competitor activity. charitable donations. Deloitte recommends a nine stage approach: 1 Understanding the This includes assessing regulatory trends.7. finding out what is important to stakeholders. Accommodation This approach involves taking responsibility for actions. enhancing governance procedures related to implementation 6 Review and revision Develop metrics to measure activities. seeing corporate responsibility issues as providing opportunities as well as dangers. Also consider broadening stakeholder base and organisation's ethical culture 5 Execution Develop in controlled fashion. government or consumer groups find out about it. elimination of pollution and un-recycled packaging. perhaps when one of the strategy following occurs:  Encouragement from special interest groups  Perception that a failure to act will result in government intervention Case example: Approaching corporate responsibility The Deloitte (2008) guide 'The risk intelligent approach to corporate responsibility and sustainability' suggests that corporate responsibility can be approached from a perspective of risk management. support for outreach projects such as cultural improvement or education. including example set and oversight by senior management. acts in a proactive way.3 Strategic approaches to corporate responsibility An organisation can adopt different strategic approaches to corporate responsibility: Proactive strategy A business is prepared to take full responsibility for its actions. CR achievements should be built into performance reviews and remuneration. risks of inaction and not achieving objectives 4 Planning and building The human resource element is vital. 4. ensuring non-exploitation of staff.

Its Children's safety education programme won two major awards. legal. A cable pipeline was drilled below the Dovey Estuary to avoid disturbance to a site of Special Scientific Interest. Strategic analysis 33 . The stakeholders emphasised the need for the company to prioritise its most significant social and environmental impacts. (b) Health and safety The Lost-Time Accident rate fell for the fifth successive year. It spent £456 million in refurbishing its electrical network and committed £20 million investment to its hydroelectric plant. Staff participated in community development programmes that provided training for young people. This consultation identified 12 impacts. seek verification from outside the organisation of assertions in CR report 1 Case example: Corporate responsibility programme Scottish Power's corporate responsibility programme has been developed from multi-stakeholder consultation. siting and infrastructure Scottish Power completed connections to more renewable energy sources and implemented a programme to keep parts of its network underground in Snowdonia. Use internal resources such as internal E audit.7 Reporting and A CSR development programme may mean reporting on CR needs to communicating be revamped. (c) Customer experience Scottish Power achieved the highest satisfaction rating for on-line energy service in the market and was ranked the second UK gas supplier. (h) Employee experience The company launched two new employee share plans. Its customer base increased by 4%. health and safety and human resources to assist in R development 9 Assure externally When CR reaches a certain level. It entered a contract to supply all Debenhams' properties with electricity generated from green sources and met 57% of its carbon emission reduction programme through customer energy efficiency programme.809 to 20 small renewable energy projects. (g) Sites. (f) Biodiversity The company took steps to allow the public to watch wildfowl. and Scottish Power's corporate responsibility report detailed what had been done to address these: (a) Provision of energy Scottish Power was involved in a competition to develop carbon capture and storage. (e) Waste and resource usage Scottish Power increased its investment in oil containment and received a Queen's Award in the Sustainable Development category. The organisation could report in accordance with C H various external reporting standards or produce customised reports A 8 Assuring internally Adapt measures used internally to assess CR development to monitor P T how the organisation is doing. (d) Climate change and emission to air Scottish Power's Green Energy Trust awarded £232.

which is based on four core values – in the marketplace. Coca-Cola Responsible corporate citizenship is at the heart of The Coca-Cola Promise. and being accountable and responsive to stakeholders. implements its policies. superb customer service. and respect for the unique customs and cultures in the communities where we do business. Scottish Power's classroom safety education programme. keeping the environment healthy. maximizing benefit. At Abbott. AT&T For AT&T. It launched a new social tariff that combined low prices with energy efficiency advice and measures to take vulnerable customers out of fuel poverty. Discussion of corporate citizenship also often has political undertones. 34 Business Analysis . (l) Economic Scottish Power provided employability training to 68 Skillseekers during the year. and exercises its influence to make productive contributions to society. Abbott Laboratories Global citizenship reflects how a company advances its business objectives. (j) Community Over 58. engages its stakeholders. Three core principles define the essence of corporate citizenship.8 Corporate citizenship Corporate citizenship is the business strategy that shapes the values underpinning a company's mission and the choices made each day by its executives. Case examples: Corporate citizenship Companies have devised a number of different definitions of corporate citizenship. and access to health care. the environment and the community:  Marketplace. environment. managers and employees as they engage with society. environmental and social responsibilities with providing quality health care worldwide. 4. Our programmes include public education. We will serve the people who enjoy our brands through innovation. (Boston Center for Corporate Citizenship) Much of the debate in recent years about corporate responsibility has been framed in terms of corporate citizenship. We will adhere to the highest ethical standards. the integrity of our brands and the dedication of our people build trust and strengthen relationships. partly because of unease about using words like ethics and responsibility in the context of business decisions. knowing that the quality of our products. health and safety. These efforts reflect an engagement and partnership with stakeholders in the pursuit of sustainable solutions to challenges facing the global community.000 primary schoolchildren benefited from Powerwise. and every company should apply them in a manner appropriate to its distinct needs: minimizing harm. the workplace. (k) Procurement Scottish Power developed a group-wide responsible procurement policy and spent £74 million on customer energy efficiency measures. (i) Customers with special circumstances Scottish Power contributed £1 million to the Scottish Power Energy People Trust. global citizenship also means thoughtfully balancing financial. with corporations acting instead of governments that cannot – or will not – act to deal effectively with problems. making AT&T a safe and rewarding place to work and behaving ethically in all its business dealings. corporate citizenship means caring about the communities it is involved with. applies its social investment and philanthropy.

healthy competition. or 'People. and where responsibility and P accountability are encouraged and rewarded. compliance with governance structures. C consistent with a commitment to human rights in our workplace. using the widely accepted Brundtland report definition of ensuring that the needs of the present are met without compromising the ability of future generations to meet their own needs.9 Sustainability We defined sustainability earlier in this chapter. 1  Community.  Planet means ensuring that the business's activities are environmentally sustainable. compliance with environmental legislation. transparency. We will seek to improve the quality of life through locally-relevant initiatives wherever we do business. Profit') approach. and bribery/corruption Environmental Climate change. We will conduct our business in ways that protect and preserve the environment. DHL DHL takes its definition of Corporate Citizenship from the World Economic Forum: Corporate citizenship is about the contribution a company makes to society through its core business activities. in turn making them better places to do business. emissions levels. the worth of a corporation is reflected in its impact in the community. One approach to sustainability is known as the triple bottom line (or 'TBL'. TI takes its commitment seriously and actively participates in community involvement through three ways – philanthropy.  Profit is the accounting measure of the returns of the business. A similar approach to thinking about sustainability issues is to differentiate three different types of sustainability: Issues Examples Social Health and safety. data protection and privacy. Giving back to the communities where we operate makes them better places to live and work. impacts of product use. '3BL'. community investment. workers' rights (in the business itself and its supply chain). We will foster an inclusive environment that encourages all employees to develop and perform to their fullest potential. Planet. pollution. 4. R We will integrate principles of environmental stewardship and sustainable development into our business decisions and processes.  People means balancing up the interests of different stakeholders and not automatically prioritising shareholder needs. our philosophy is simple and dates back to our founding fathers. local economic development. expertise and resources to help develop sustainable communities in partnership with local leaders. long-term viability of businesses. diversity and equal opportunities. pay and benefits. fairness and respect. T E  Environment. air quality Economic Economic stability and growth. its social investment and philanthropy programs. Texas Instruments Beyond the bottom line. At TI. waste. investment in innovation/NPD Strategic analysis 35 . job provision. civic leadership and public policy and grass roots efforts. and its engagement in public policy. responsible marketing. The Coca-Cola workplace will be H A a place where everyone's ideas and contributions are valued.  Workplace. use of natural resources. We will contribute our time. impacts of product use. We will treat each other with dignity.

Description of the reporting organisation's strategy with regard to sustainability.000 working hours (e) Health and safety sickness and absence rate – down from 2. a reporting framework that arose from the need to address the failure of current governance structures to respond to changes in the global economy.41% calendar days lost (f) Supplier relationship success – 86% satisfaction (g) Ethical trading (a measure of the application of BT's supply chain human rights standard) – 70 risk assessments with 100% follow-up (h) Community effectiveness (such as charity partnerships and support for learning and skills and helping people get on-line) rated at 98% (i) BT's investment in community improvements is 1.9% of pre-tax profits (j) Global warming CO2 emissions fell from 653.225 cases per 100. reporting and sustainable development.209 cases per 100. Useful numerical measures can include pollution amounts. The GRI published revised guidelines in 2006. and how the organisation has addressed the 36 Business Analysis . This section should focus firstly on key impacts on sustainability and associated challenges and opportunities. risks and opportunities.000 working hours to 0.10 Environmental and social reporting A business may provide social and environmental data as part of its external reporting.16 out of 5 in a measure designed to assess employee awareness and training.61 out of 5 (c) Diversity – BT maintains a top 10 placement in 4 out of 5 major diversity benchmarks (d) Health and safety lost time injury rate – up from 0. 4. accountability. The main section of the Guidelines sets out the framework of a sustainability report. (a) Customer service – 3% increase in service quality (b) Employee engagement index (measure of success of BT's relationship with employees) – a small rise to 3. environmental and social importance should become as routine and comparable as financial reporting.000 tonnes (k) Waste to landfill and recycling (a measure of use of resources) – reduction of 69% (l) Ethical performance – a small increase to 4. resources consumed or land use. explanations and reasons why targets have or have not been achieved. Reports can also address concerns of specific internal or external stakeholders.000 to 628. there should be a description of key impacts. The GRI aims to develop transparency. Its vision is that reporting on economic. To give an overview of the company's social and environmental performance. Case example: Environmental and social reporting BT's Social and Environmental Report for the year ended 31 March 2011 complies with the Global Reporting Initiative Guidelines (discussed below). compliance with the company's ethical code and behaviour with integrity 4. (a) Strategy and analysis.1 Global Reporting Initiative Earlier papers covered The Global Reporting Initiative (GRI). including a statement from the CEO. the report selects 12 non-financial key performance indicators. It consists of five sections. Narrative information includes objectives.10.46% calendar days lost due to sickness/absence to 2. Reports generally include narrative and numerical information about impact. In addition.

and waste Products and services Compliance Transport Overall Human rights Investment and procurement practices Non-discrimination Freedom of association and collective bargaining Child labour Forced and compulsory labour Security practices Indigenous rights Scale of assessment Remediation of grievances Labour practices and decent work Employment Labour/management relations Occupational health and safety Training and education Diversity and equal opportunity Equal remuneration for women and men Society Local community Corruption Role in public policy Anti-competitive behaviour Compliance Product responsibility Customer health and safety Products and service labelling Marketing communications Customer privacy Compliance Strategic analysis 37 . The report should give a description of charters. commitments and engagement structure and management systems. challenges and opportunities. trends and opportunities on the long-term prospects and financial performance of the organisation. C H (b) Organisational profile. Category Aspect Environmental Materials Water Biodiversity Emissions. environmental and social performance. principles or initiatives to which the organisation subscribes or which the organisation endorses. Details of the time and content of the report. Description of governance structure and practice. operations. It should secondly focus on the impact of sustainability risks. Overview of the reporting organisation's structure. The report should also list the stakeholder groups with which it engages and detail its approaches to stakeholder engagement. including the process for E R defining the report content and identifying the stakeholders that the organisation expects to use the report. (e) Performance indicators. P T (c) Report parameters. 1 (d) Governance. and A markets served and scale. Measures of the impact or effect of the reporting organisation divided into integrated indicators. and statements of mission and codes of conduct relevant to economic. The GRI structures performance indicators according to a hierarchy of category and aspect. Details should also be given of the policy and current practice for seeking external assurance for the report. effluents.

2 Integrated reporting In September 2011 the International Integrated Reporting Council launched a discussion document st Towards Integrated Reporting – Communicating Value in the 21 Century. Integrated reporting should also achieve the simplification of accounts. The aim of integrated reporting that the document promoted was to demonstrate the linkage between strategy. copyrights. Capital Financial Funds available for use in production obtained through financing or generated through operations Manufactured Manufactured physical objects used in production or service provision:  Buildings  Equipment  Infrastructure Human Skills. software and organisation systems  Brand and reputation 38 Business Analysis . In particular they should make a meaningful assessment of the long-term viability of the organisation's business model and its strategy. Investors and other stakeholders should better understand how an organisation is really performing. how the organisation uses those capitals and its impact upon them. with excessive detail being removed and critical information being highlighted. businesses should be able to take more sustainable decisions. governance and financial performance and the social. helping to ensure the effective allocation of scarce resources. Integrated reporting is designed to make visible the capitals (resources and relationships) on which the organisation depends. Category Aspect Economic Economic performance Market presence Indirect economic impacts 4. environmental and economic context within which the business operates. By making these connections. experience and motivation to innovate:  Alignment and support for organisation's governance framework and ethical values  Ability to understand and implement organisation's strategies  Loyalties and motivations for improvements Intellectual Intangibles providing competitive advantage:  Patents.10.

minerals and forests E R  Biodiversity and eco-system health Social Institutions and relationships within each community stakeholder group and network to 1 enhance well-being:  Common values and behaviours  Key relationships  Social licence to operate A number of guiding principles underpin the content and presentation of an integrated report: Strategic objectives Insights into strategic objectives. and also the extent to which sustainability considerations are embedded into strategy to provide clear advantage  Governance and remuneration  Performance against strategic objectives. challenges and barriers. impacts on resources and relationships and external factors impacting on performance  Future outlook. Responsiveness and stakeholder inclusiveness Insight into organisation's relationships with stakeholders and how organisation takes account of and responds to their needs. Conciseness.and long-term interests. Future orientation Management expectations about the future and other information to help organisation's users assess prospects. where organisation will go and how it will get there. including risks and opportunities. reliability and materiality Provision of important and reliable information with less significant information being disclosed elsewhere. land. Information should include balancing of short. and critical enablers. Report also how organisation uses resources and relationships. actions required and uncertainties Strategic analysis 39 . Connectivity of information Links between different components of business model. repercussions of future plans. resources and relationships  Strategic objectives and strategies including risk management.Capital C H Natural Input to goods and services and what activities A impact: P T  Water. external factors and resources and relationships upon which organisation depends. Examples include how changes in market environment influence strategy and how strategies link to key performance and risk indicators and remuneration. including how well organisation is equipped to respond to future environment. The content elements follow on from the guiding principles:  Organisational overview and business model  Operating context. strategies and how they relate to other components in business model.

under an EU directive. The scheme aims to promote improvements in company environmental performance and to provide the public with information about these improvements. In practice environmental audits may cover a number of different areas. weaknesses. when the organisation has been examined in much more detail. this voluntary scheme will indicate those EU products which meet the highest environmental standards.4. Environmental auditing is also used for auditing the truth and fairness of an environmental report rather than the organisation itself. (b) Environmental surveys These are a good way of starting the audit process. opportunities. a company will have to comply with certain on-going obligations involving disclosure and audit. problems. known as the eco-audit scheme. (e) Eco-audit The European Commission has adopted a proposal for a regulation for a voluntary community environmental auditing scheme. (f) Eco-labelling Developed in Germany. which has indices for levels of water. (g) BS 7750 Environmental Management Systems BS 7750 also ties in with eco-audits and eco-labelling and with the quality BSI standard BS 5750. threats' analysis is useful as the environmental audit strategy is being developed. (a) Environmental Impact Assessments (EIAs) These are required. Such a strategy has been adopted by companies such as IBM. An environmental audit may be undertaken as part of obtaining or maintaining external accreditation. This helps to identify areas for further development. It is suggested that eco-audit must come before an eco-label can be given. by looking at the organisation as a whole in environmental terms. potential hazards and so forth. emissions. The scope of the audit will depend on each individual organisation. There are other specific aspects of the approach to environmental auditing which are worth mentioning. water management.11 Auditing environmental sustainability An environmental audit is an evaluation of how well an entity. for all major projects which require planning permission and have a material effect on the environment. Dow Chemicals and by the Rhone-Poulenc Environmental Index. its management and equipment are performing. air and other waste products. The EIA process can be incorporated into any environmental auditing strategy. with the aim of helping to safeguard the environment by facilitating management control of environmental practices and assessing compliance with entity policies and external regulations. Often the audit will be a general review of the organisation's environmental policy. probably as the result of an EQM system. such as the BSI's ISO 14001 standard. (c) Environmental SWOT analysis A 'strengths. (d) Environmental Quality Management (EQM) This is seen as part of TQM (Total Quality Management) and it should be built into an environmental management system. 40 Business Analysis . energy consumption) or particular locations. This can only be done later in the process. activities or processes. Once registered. On other occasions the audit will focus on specific aspects of environmental performance (waste disposal. (h) Supplier audits They ensure that goods and services bought in by an organisation meet the standards applied by that organisation. Achieving BS 7750 is likely to be a first step in the eco-audit process.

the more information provided. 5 Integrating the use of analysis tools in a complex scenario Section overview  In reality. 5. (g) True. However other aspects.11.1 Environmental audit stages C There are three main stages in most environmental audits. you are expected to have gained a detailed understanding of the tools that were reviewed in Section 1. fair and complete reporting of environmental activities.2 Auditor concerns (a) Board and management having good understanding of the environmental impact and related legislation of the organisation's activities in areas such as buildings. for example public perceptions. At the Advanced stage. illustrating how business strategy integrates with financial strategy. (d) Adoption and review of progress against quantifiable targets. However measuring against a E number of metrics could result in a costly audit. products. Some metrics will be objective. there are some fundamental questions you should ask when reading through the scenario you are faced with in the exam. R (b) Measuring planned or desirable performance against actual performance This is an important aspect of a system.11. However. in particular whether the organisation's annual report should include a report by the auditors. (b) Adoption and communication of adequate policies and procedures to ensure compliance with relevant standards and laws. (e) Assessment of whether progress is being made economically and efficiently. packaging and waste. (f) Implementation of previous recommendations of improvements to processes or systems. cannot be measured objectively and may therefore be difficult to measure precisely. 4. The case study also contains financial elements. H A (a) Establishing the metrics P T The greater the variety of metrics. The important skills you are now required to demonstrate are how to apply these models in a complex scenario and integrate them with other strategies in order to mirror a real life situation.1 Preparing to tackle a case study Companies encounter complex scenarios all the time in real life. transport. analysis tools will not be used in isolation. (c) Reporting the results of the audit Important decisions will include the form of the report and how widely it should be distributed.  What is the company's main line of business?  What is its current strategy? Strategic analysis 41 . The important thing to remember is that no two cases are ever the same – each one must be treated on its own merits. you will be expected to demonstrate your ability to use several tools to evaluate a complex scenario. for example the level of 1 carbon emissions or plastic bag issues can be measured.4. (c) Adoption of appropriate environmental information systems. This section makes use of a lengthy exam-standard case study to integrate the use of a number of tools.  At this Advanced level of your studies.

so there is considerable potential for market growth. John and Kate borrowed heavily from the bank in order to purchase the business. the firm has also started to source products from European countries. Her popularity and close working relationship with clients has been a major contributor to sales growth. Malaysia and mainland China. growth or general financial health. 42 Business Analysis . Business is booming. more staff will be inevitable. Worked example: Body Beautiful John and Kate Dempsey are the joint owners and managers of Body Beautiful Ltd. whether certain decisions will contradict company strategy or affect market perception. make sure you use it. takes care of day-to-day operations. is in the ladies' body care business. whether to establish profit margins. the potential financial implications of different actions. Despite this. rather than the leased premises with which it started out. Kate. All but three of these employees are warehouse and distribution staff. most notably France and Spain. which was formed in 20X2. Look for the issues you would normally consider in a work situation. and is assisted by the three non-warehouse staff who concentrate on smaller clients. More recently. however. John. try to treat case studies as you would problems in your own workplace or that of a client – think about how decisions taken to solve one problem might impact on other areas of the business. and financial management. through which all their goods pass – this is owned on a freehold basis by the firm. buying products from various manufacturers based almost exclusively outside the UK. including administration. First. Body Beautiful's sales only account for approximately 45% of the market. through their accessibility and personal attention. the Managing Director.  What are its long-term objectives?  Are there any global issues to consider?  How is the company performing financially?  Are there any obvious areas for improvement?  Does the company have any particular strengths that could be further exploited?  Are there any limited resources that may affect the company's ability to fulfil its objectives?  What are competitors doing?  Are there any potential conflicts between objectives – for example. including Japan. and whether proposed courses of action will align with company culture. The firm operates very efficiently with a total of 25 staff (excluding John and Kate). The firm concentrates mainly on smaller value items such as body lotions. using her contacts from her previous role as senior salesperson in the body care subsidiary of a large group of companies. As the business continues to grow. Customer loyalty is encouraged by the excellent customer service that Kate and John provide. Kate is an expert marketer with numerous contacts in the trade. 5. particularly to support the distribution function. Due to the success of Body Beautiful. the other director. and have expanded their premises considerably. Body Beautiful's success can be attributed to several factors. and it is estimated that the payroll will comprise 50 (non-director) employees within the next three years.2 Worked example The following case study is an example of how different analytical tools can be used in a business situation and illustrates the need to use financial information to evaluate company performance. The firm. warehouse and distribution operations. Sales are now in excess of £15 million per annum. the result of a steady growth of approximately 30% each year and there are no indications that this will not continue. an increase of 60% on initial employee numbers. Its customers are mainly wholesalers and spa facilities in the UK. If you are given financial information. nail care products and facial treatments. financial strategy versus marketing strategy? As much as possible. they have managed to pay off this initial loan. The main premises are now a state-of-the-art warehouse and distribution centre. is concerned solely with the marketing side of the business. which is based in the UK.

Although margins are small. foot spas and face steamers) or the increasingly lucrative men's products. Body Beautiful has had to incur significant investment costs. Most of their products are priced in US dollars and the weakness of this currency P against sterling has prevented John negotiating low prices. they are concerned that the rapid growth enjoyed by the firm in the last five years is not sustainable and they are therefore looking for other ways to expand. Some also sell spa furniture such as massage tables and mobile product trolleys. The currency situations are always subject to T change however. Body Beautiful has registered its own brand name for its main products and repackages them in its own distinctive green and gold wrapping. Body Beautiful is in the fortunate position of having no immediate competitors. taking advantage of the relative strength of C sterling against the euro for European supplies. Kate and John believe that strategy is not necessarily about beating the competition but in serving customers' needs. Body Beautiful often has exclusive access to certain products. increased inventory-holding costs. driven more by an appetite for enhanced personal reputation rather than wealth accumulation. volume more than makes up for this. providing its clubs with good quality. low cost body lotions and shower gels to be sold under their own- brand label. The success of and demand for this product has further encouraged customer loyalty. These companies do not see Body Beautiful as a threat. Several large international companies who manufacture body care products also buy merchandise from Body Beautiful but sell it to high street retailers for domestic consumer purchase rather than directly to wholesalers and spas. The firm has also established a strong relationship with a leading chain of health clubs. A number of small firms have even left the industry altogether. Strategic analysis 43 . Many of the small competitors in the body care industry have opted to concentrate on other aspects of the business. upgrading computer systems to handle customers orders. R Kate has developed strong links with suppliers and until recently has tried to maintain only a small number to keep lines of communication and control as simple as possible. One example is its sole UK distribution rights to a French anti-wrinkle cream whose excellent results in product trials have made it a very sought after product. Most of the products are outsourced. However. and despatch vehicles such as larger delivery lorries and fork-lift trucks for the warehouse. it has been essential to keep a close eye on currency rate movements. Their accountant has produced the following information for them to consider. John has been especially astute. Kate and John are still keen to pursue further growth. given their relative sizes. Most of the suppliers have 1 been linked with the firm since its inception in 20X2. There have been more problems with the Asian H A suppliers however. thus providing Body Beautiful with reliable and good quality products. inventory control and financial matters. Despite the firm's obvious success so far. The directors have found that this has generated even more customer loyalty and has even allowed them to charge a premium price. Kate realises that as customer demand for all of their products increases the firm will have to find additional suppliers and has already started sourcing products from new manufacturers. Such expenditure could not be financed from operating cash flows but the firm's bank was willing to lend the necessary funds given its ability to pay off previous loans ahead of schedule. Both Kate and John believe that part of the firm's success has been down to spending minimal amounts on administrative expenses. with value being added mainly through branding and high levels of customer service. including building the new warehouse facilities. Rather than using the manufacturers' own brand names and packaging. Due to the considerable increase in sales. and it is John's task to take appropriate action to protect Body Beautiful from major E fluctuations.As all products are purchased from foreign manufacturers. such as the supply of small electrical items (for example.

(d) At the moment.064 Cost of sales 5. Also be prepared to identify possible strategic action that could be taken to resolve any issues and its potential impact on the data in future.538 Total staff (incl.825 8. Solution This is a large case study with a lot of information in it. Skills at this level should include analysis and interpretation which explains the data in operational.295 1.200 20.474 10. Analysis should extend beyond the calculation of financial ratios. financial and strategic terms to the full extent of the available information. the firm appears to have been growing steadily and successfully.513 5.287 2. It is clear from a glance at the data table that sales. Two minutes with a calculator will reveal the relative rates of increase.064 1.192 16.8 7. Make sure you analyse and apply the quantitative data properly. You will need to look carefully at the table of data in order to get a good grip on this question.9 Requirements You are Kate and John's accountant. should be avoided. 44 Business Analysis .495 1. cost of sales and borrowing have all risen rapidly and are expected to continue to rise.297 7.216 1.128 Operating profit 1.826 14. which are very significant indeed.126 1.404 Administration 100 113 167 321 Interest on loans 0 281 432 1.008 1. Identify reasons for potential corporate decline and suggest ways that Kate and John could avoid them in the context of the case study.124 3.854 Inventory 840 1. You might find that SWOT would form a good basis for thinking about the information you are given.088 12.745 Long-term loan 0 3.428 Marketing 840 970 1. One thing you should always check is whether interest rates change from year to year and/or as loans get larger.203 Distribution 1.8 11.580 Non-current assets 1. (b) Prepare a report for Kate that identifies and assesses the strategies they might consider in their quest to further develop the firm. directors) 20 23 27 40 Number of suppliers 20 30 60 80 Range of products 40 95 120 145 Operating profit % 13.402 11.5 9. (c) Kate and John appear to be very keen for the firm to grow even more.826 4. The question calls for a report: make sure you write and set out your answer in a suitable format. Body Beautiful Ltd – Financial and operational details 20X5 20X6 20X7 20X8 (forecast) £'000 £'000 £'000 £'000 Sales 8. Demonstrate how Kate and John have managed to achieve this success using value chain analysis.259 15.157 1. (a) Prepare a report which evaluates the current position of the firm and highlights any financial and strategic issues concerning future development that you believe should be brought to the directors' attention. Obvious and unsupported statements such as asserting that a particular ratio has increased.

either by a start-up business or by an established company seeking further growth. The relative rise in cost of sales may be caused. While the level of marketing costs may be regarded as subject to some discretion. Administration. Distribution and marketing costs have risen much more slowly than cost of sales and slower even than sales. Distribution and marketing.8%. but the interest payments have risen to 2. Body Beautiful is not significantly challenged by competitors: larger body care product companies sell into the consumer market and smaller ones specialise in other product ranges.(a) To: Managing Director. 2. This is unlikely to be the case. presumably reflecting the bank's perception of increasing risk as the company's borrowing expands. but has led to relatively slow growth in profits as compared to the growth in sales.6% of the much increased sales forecast for 20X8.3 Suppliers The expansion of your product range means that you now deal with four times the number of suppliers you bought from three years ago.8% of sales and are expected to rise to 5. this trend is also forecast to continue. Finance costs. In the event of a recession. which has increased by more than 400% since 20X5. The effect of this disproportionate rate of increase has been ameliorated by lower rates of increase in other costs. Also. Administration remains the smallest category of cost. The expansion of the business has largely been financed by borrowing. Total indebtedness is comfortably lower than the value of non-current assets alone. Body Beautiful Ltd From: Accountant C Date: December 20X7 H A Subject: Body Beautiful Ltd – current position and prospects P 1 Current situation T E Trading R The last three years' trading results show impressive growth in sales. This is partly because borrowing itself will more than double. holding distribution costs down to an increase of only 39% when sales have more than doubled is a significant achievement. though these costs are expected to increase in line with turnover presumably as a result of the intended growth in staff numbers. You have not so far encountered a downturn. In fact. Much of your trade is in superior quality. but there is also an increase in the rate of interest forecast. cost of sales. If you were able to supply them. which is forecast to continue into 20X8. it is likely that your customers would seek to contain or reduce their costs by buying cheaper goods. Costs Cost of sales. as cost of sales contains some fixed costs. the number of lines having more than trebled since 20X5. It would not be wise to plan for the future on the basis that this will continue indefinitely. at least in part. whereas in 20X5 it was 13. branded products for which you are able to charge premium prices. which is by far the largest expense item. This may also have a desirable effect on the amount of capital tied up in inventories. one would expect – all other things being equal – that cost of sales would increase more slowly than sales as the business expands. it will not be long before the company is challenged. The company's relationship with the health club chain will already have brought it to the attention of the larger players.2 Business cycle You have argued that your market segment is recession-proof. It might be worth examining the margins achieved on each line to establish whether the product range might be trimmed. 2. your margins would be eroded. This should be borne in mind if further expansion of premises is considered: leasing may turn out to be cheaper. if you were not you would lose the business altogether. Part of your success has been built Strategic analysis 45 . Even if the current rate of growth is not maintained. by the expansion of the product range. has 1 risen at an even faster rate.9% in 20X8. Unfortunately. the operating profit percentage is forecast to be only 7.1 Competition At the moment. 2 Issues for the future 2.

5 Currency exchange rates Most of your purchases are paid for in foreign currency. These effects are particularly likely to occur if competitors enter your chosen markets.4 Management The company has expanded to a size many times larger than it was when it was set up. Management structure is another matter that needs consideration. and other aspects of personnel management are likely to become more and more time consuming. If you focus only on the short term. You should give some thought to the possibilities of recession. but your cost structures might benefit from close attention. This is particularly true of cost of sales and finance charges. It would also be appropriate to consider the potential for ill-health to affect the smooth operation of the business: having greater managerial capacity would provide the organisation with the flexibility to deal with absence through ill-health. The dollar and euro exchange rates have been reasonably stable. Body Beautiful Ltd From: Accountant Date: December 20X7 Subject: Body Beautiful Ltd – possible development strategies 1 Current limitations At the moment you have 45% of your chosen market. 2. Make sure you also integrate potential strategies by considering the financial implications – for many companies. it may become practical for you to use your bank's services to hedge against unfavourable exchange rate movements. While there is still some potential for further organic growth in like-for-like sales. It is important to discuss longer-term strategies as well as quick. This could also have the advantage of releasing some of your own time to allow consideration of strategic issues in greater depth. I have already remarked on the recent rapid growth in the number of products you offer and recommended a review of profitability: this might lead 46 Business Analysis . It is probably time to think about taking on at least one person who can undertake some of the more routine management and administrative functions. but this may not be the case in the future. but you may feel that there are more inviting routes to growth than further market penetration based on a cost- focus. The scenario gives a lot of detail that is relevant when considering the various possible routes to growth. the discounts you receive and your access to newly developed premium products. There are also a number of possible developments in the business environment that could affect the continuing success of the business. there is also the whole field of human resource management to consider. It seems unlikely that this can continue much longer. This may affect the reliability of your deliveries. To: Managing Director. recruitment. before leaving this topic completely. this suggests a lack of appreciation for business planning. you are probably justified in doubting that this could be a major source of expansion. on strong relationships with your suppliers: these relationships will be difficult to establish with the new suppliers simply because there are so many of them. Focusing on the long-term future of the business is more realistic and will demonstrate your business acumen. but the management structure has remained the same. tactical courses of action. (b) This question lends itself to an answer based on the various strategic option models that you should be very familiar with. 3 Conclusion Your business continues to expand. finance is often the stumbling block when putting development proposals together. The volume of transactions alone is likely to generate a scale of managerial work that two people cannot handle. It is likely that you would have to base such growth on price competitiveness: you may be able to do this reasonably profitably if you can exploit purchasing economies of scale. selection. As the volume of your business expands. 2. However. it is worth mentioning the possibility of a differentiation focus strategy. which must be deemed as a dominant share. Payroll administration. adverse exchange rate movements and increased competition. Staff numbers are planned to increase by 50% in 20X8. so a fairly careful answer plan would be a good idea here.

These items would complement your existing range. However. If you contemplate manufacturing. You would. you sell a range of body care items to wholesalers and spa facilities. of course have to consider how this might affect your relationship with your existing retail chain customer. Such a move would require you to learn all the skills involved in retailing and to source a much larger range of products. This strategy could also be applied to supermarket and department store chains. This would require some careful market research to assess such things as distribution chains.3 Diversification Diversification is a high risk strategy and none of the options seems appropriate for you. You have no experience of retail operations. It is possible that you could find and exploit a manufacturing niche. this means that you would have to build the new business by organic growth. perhaps by entering into outsourcing agreements. such as selling a line of hair care products. which would necessarily be a slow process. Second. mostly for trade use. A move upstream into manufacturing would put you in competition with your current suppliers. A vertical move up or down the value system has more to recommend it. More adventurous product development. since you would be able to build on your current market experience. but you have already found that the volumes make up for this: an expansion should increase your purchasing power and enhance your margins by reducing your purchase costs. you to concentrate much of your attention on the high margin items you sell under your own brand. you might consider international expansion. It would be inappropriate for you to contemplate a move into spa furnishings. you might consider providing other health club chains with goods to sell under their own brands. perhaps producing a small number of similar lines that you currently have difficulty in sourcing.1 Product development R At the moment. unbranded supplies. but there is considerable potential here. Attendance at one of the many European beauty care industry trade fairs would be a good way to start. You could aim for a two component business: branded goods selling at high C prices and your supply of own-brand items in high volumes to your main health club H customer. You would not be operating on the same scale as them and therefore you would expect your costs to be higher. A move downstream into retailing would be even more difficult. You would probably have to establish completely new supplier relationships and the items themselves may incur significant costs in fitting and after-sales service. but this does not seem to offer much prospect for achieving your aim of continued substantial growth. so your bank would be unlikely to provide the capital to acquire a chain of outlets. 2. but there would be significant disadvantages to such a move. 2. Strategic analysis 47 . First.2 Market development There are two principal new markets you might consider. but needs careful consideration. would put you in competition with major international companies. such as small electrical goods and men's products. This would significantly reduce the capital requirement. This option should not be discarded. you should certainly think in terms of off-shore production. This would be low margin business. but there could well be product safety issues to contend with. Possible scope 1 for product development lies in the category of goods sold into your market by your smaller competitors. any future introduction of new products should only be contemplated in the light of the review of profitability already recommended. your product range includes goods sold both under your company's brand and some sold as own brand items by a leading health club chain. competition and consumer preferences. You might be able to source low cost. A P 2 Product-market options T E 2. A move into a completely new market with new products would not build on any of your strengths and would expose you to established competition. since these high-value items are so very different in nature from your existing range.

Much research has been done on why successful businesses decline and fail: for example. The consequent increase in fixed costs makes the business much less resilient. is likely to become less appropriate as the business expands. They must pay close attention to cash flows and reduce inventories as far as possible. This might be an attractive option for expansion within your existing markets and as an alternative to the product development route mentioned above. (c) The question emphasises 'the context of the case study' scenario. Currency stability is unlikely to last – it is important that John is seen to be addressing this issue through the employment of a financial manager and the use of currency hedging techniques to reduce inevitable risks. thus spreading its costs and creating scale economies from the increased rate of use. He should consider the possibility of employing a specialist financial manager to deal with such matters and the day-to-day financial issues that arise. The only diversification strategy that seems worthy of further examination seems to be the development of a manufacturing niche.1 Acquisition I have already mentioned the relatively slowness of organic growth. Acquisition could also be a means of implementing this idea. Acquisition could also be a route to rapid implementation of the international expansion and manufacturing niche strategies. 48 Business Analysis . 4 Conclusions Either a cost focus or a differentiation focus could be a route to further market penetration. though growth by these means would probably be slow. More rapid growth can often be achieved by the acquisition of an appropriate existing business. The difference between the two concepts is that the former involves the creation of a new. A joint venture might be arranged with an existing customer or supplier. which might not be an attractive prospect. The drawback of these vehicles from your point of view would be that you would have to share control. The bank has already expressed some reservations over the increase in debt by charging higher interest rates. jointly owned business entity. while the latter is based on the shared use of an asset. Another obvious point to make is that Kate's management style. The consequent rise in operational gearing means that they will be poorly placed if their business turns out to be less recession-proof than they believe it to be. this rate may also be reflecting the firm's greater exposure to currency movements as purchases increase to cope with demand. 3 Methods of growth 3. implementing the product line review already discussed. There do not seem to be good prospects for expansion based on product development. A high level of gearing and overtrading are two management mistakes that are made regularly: there seems to be some danger that Kate and John are on course to fall into these errors. for example. It was mentioned earlier that hedging foreign currency may become necessary if currency rates become more volatile – this will require specialist knowledge that John is unlikely to have. the profitability of the business appears to be declining. This is a pretty clear indication that your answer should not be confined to a discussion of theory! Significant increases in inventories and debt have taken place as part of Kate and John's pursuit of growth. Given that all of Body Beautiful's supplies come from overseas. 3. Either of these approaches could be a relatively low risk route to international expansion. Altman's Z score offers a rule of thumb for predicting failure from key financial ratios. which will make servicing debt more difficult. In any case. Acquisition or joint venture might be worth further examination as means to the latter end. while a form of strategic alliance might be created by the use of a foreign commercial agent. while highly suitable to a small business. You may wish to look more closely at the two possibilities for market development I have described: further manufacturing for own brand retailers and a foreign venture. We have already noted that Kate and John's drive for expansion has led them to very significant increases in borrowing and in the level of inventories.2 Joint venture/strategic alliance A joint venture or strategic alliance might be an alternative route to expansion.

but no doubt prompt attention to returns. the chain may decide to cut the margins they allow in the same way that the UK supermarkets do to their suppliers. The company's products are generally too simple to require very much of this. Several symptoms of poor top management relate to a general situation of dominance by one powerful individual. They have been very fortunate in that they have encountered little competition so far. but staff numbers are expected to double over the next three years and it is therefore unlikely that this will continue. We might consider operations and both inbound and outbound logistics together. resting in her hands as it does. for example. Wisely. must be regarded as a major source of the company's success. market knowledge and H A tactical agility of the typical entrepreneur. international trade regulation and national culture to do so successfully. which offers enhanced margins and a bulk. an over-strict interpretation of the question requirement is not always a good idea. They need help and the business needs more structure and systems that will support its routine 1 operations without hampering its agility and innovation. Kate and John will also have to keep a close eye on the conditions in their chosen markets. the relationship with the health club chain for which they produce own-brand goods is unequal. Secondary activities Procurement is also an activity into which Kate has put considerable effort and from which the company derives great advantage. The final primary activity is service. own-brand supply to a chain of health clubs. not least by her determination to provide excellent service. The development of the product range continues apace. (d) The question emphasises Kate and John's success and it would make sense. Do not be afraid to add a few sentences that might seem to be marginal to such an interpretation. having negotiated a number of favourable prices. contributes to its overall reputation. The continuing development of systems and utilisation of resources (such as those in the warehouse) has allowed the company to expand its operations smoothly and without constraint. these qualities are rarely combined with P the ability to plan and control the operations of the much larger business they aspire to. It would be easy for a large company to drive them out of business. to confine an answer to those parts of the value chain that have been managed in a way that contributes to that success. which is a good sign. Technology development at Body Beautiful has two aspects. Marketing and sales is an obvious place to start among the primary activities. However. However. Kate has invested substantially in storage and packing facilities and John has managed the company's staff so as to provide a high quality of service: we must presume that this includes accurate and prompt deliveries. Kate sources products entirely from outside the UK and has overcome problems of foreign exchange. this activity continues to need careful management if it is not to become an important weakness. They should not count on this continuing indefinitely: one of the major international companies may consider it worthwhile to attack the spa market. as discussed earlier. but there must be some C doubt about their ability to put them into action. therefore. All three of these activities form an important basis for the company's success. but they may not be temperamentally suited to working in this way. as Kate is basically a very successful saleswoman. Similarly. they have taken advice on possible future courses of action. John will have to pay careful attention to Strategic analysis 49 . Kate and John's desire to promote the growth of the business seems to be their principal strategic idea. She has also successfully established both the Body Beautiful brand. Human resource management is also an activity worthy of some attention. This might be counted a mixed success for this reason. Overall. when required. perhaps by offering a wider range of products or better prices. Primary activities Kate is a very successful saleswoman and the marketing and sales activity of the company. T E The business has grown to the point at which they need good quality management support and R advice. which gives volume sales and the advantages of bulk purchasing. possibly to the extent that some rationalisation is required. in the sense of after-sales service. unfortunately. Staff turnover has been low. She has created good relationships with key customers. there is some concern about the level of debt and thus fixed costs that has developed. They display the drive.

In recent years. recruitment and training and be prepared for a higher level of turnover as numbers increase. 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. quality management. and concentration of resources towards more focused research and development. WG plc regards itself as a global company.1 General observations about the worked example There are no definitive answers to case study questions. financial control and. They have also explained that WG plc aims to work towards eliminating those diseases for which the company is engaged in providing treatments. It is also important to use the data in the question to support the argument and advice being given. Given that Body Beautiful had already taken on additional debt and was considerably exposed to currency rate risk. It employs approximately 50. This might include quantitative analysis of the data in order then to provide a richer qualitative explanation of what is happening in the business. Asia. There is also the problem of managerial capacity already discussed: the business needs increased managerial support of a high calibre. a growing need for more in-house capacity for such activities as planning. 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'. WG plc and other pharmaceutical manufacturers have encountered public and governmental challenges to their high levels of profitability. You are not being tested on how many theories you can memorise – it is your ability to apply appropriate theories to particular situations and integrate them with other aspects of the business that the examiner is interested in. You can probably think of other issues that could be discussed in the Body Beautiful Ltd case study above. 5. Achievement of the 50 Business Analysis . distribution networks. High research and development costs present a major obstacle to potential competitors tempted to enter the industry. bought in as required. formal financial management procedures are necessary to secure the firm's continued success in the future. 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. The company declared that its earnings and dividends per share in the same period increased by 15% over the previous financial year. the United States of America and Africa. They argue that this is necessary to meet their high research and development commitments.000 people worldwide and has developed a wide portfolio of products. There is however. WG plc encounters strong competition from other world-class pharmaceutical manufacturers but these are few in number. Its profits before tax last year increased by 20% and represented approximately 35% of revenue. as the scale of operations increases. Firm infrastructure in terms of specialist services such as legal advice is. Interactive question 3: WG plc [Difficulty level: Intermediate] Introduction WG plc was formed four years ago following the merger of two large pharmaceutical companies. With operating outlets in Europe. The directors have confirmed their main objective is to sustain profitability while achieving the company's overall mission.2. You should concentrate on how various analytical tools can be used to assess the business position and how potential strategies interact with one another in the context of the case. no doubt. You will notice in the case study above that frequent reference was made to financial management issues – this is very important. It was mentioned that two of the most common managerial mistakes were overgearing and overtrading – this is often the case because managers focus too much on business strategy and not enough on the financial implications. possibly.

However. C H Product development A P A large proportion of the company's turnover in recent years has been derived from one particular drug. the Asia Pacific region. Both drugs are available over the counter from pharmacies.profitability objective is continually threatened by patents coming to the end of their lives. This means that the company is donating batches of the drug to the health organisations in these areas. WG plc has established a 'donation programme' for the new drug in virulent areas for the disease. The directors of WG plc are optimistic that Coffstop will become very popular because of its improved effectiveness over other market products. Market development WG plc has experienced slow growth in its mature markets of Western Europe. North America and Japan. The company has encountered a rapid sales increase in its expanding markets of Eastern Europe. A new product. It is in competition with a similar drug.50 per bottle. 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. These markets contribute 80% of overall revenue but their governments have reduced expenditure on pharmaceutical products in recent years. The company also aims to eliminate disease. Much research is sponsored by national governments and world health organisations. use and sell a new product for a limited period. The retail market price of Coffstop is £1. South America. 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.6 times the level of gross contribution per bottle compared with Coffstop.40 per bottle and £0. It is estimated that the cost to the retailer of holding Coffstop is £0. Coffstop. the sales of this drug produced almost half the R company's entire revenue. compared with £10 per bottle of Peffstill. Medical research and opinion has concluded that Coffstop is generally more effective than Peffstill in treating the condition for which they are intended. Peffstill. (c) (i) Demonstrate whether Coffstop can provide a higher contribution to the retailer than Peffstill by using: (1) Cost Volume Profit analysis. T The patent for this drug expires next year and it is expected that its sales at that time will represent no E more than 10% of total revenue. Patents give the sole right to make. 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. Discuss the nature of the five competitive forces (identified by Porter) which are exerted on WG plc in satisfying both these objectives at the same time.50 and £7. The shelf area occupied by each bottle of Coffstop is 18 square centimetres and 60 square centimetres for each bottle of Peffstill.40 for Coffstop and Peffstill respectively. 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.80 for Peffstill. Requirements (a) Evaluate the nature and importance of the market threat which WG plc would face if it failed to provide sufficient resources for product development. Strategic analysis 51 . (b) WG plc's main objective is to sustain profitability through developing innovative medicines and services for treating patients worldwide. The availability of shelf space is a limiting factor for most retailers. Africa and the Middle East. Four years ago. has now completed its rigorous development phases and is being marketed to 1 pharmaceutical stores throughout the world by WG plc. The bought-in costs per bottle to the retail pharmacist are £0. 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. WG plc has the largest research and development organisation of all pharmaceutical companies worldwide. the recommended dosage of Coffstop is six times more than that for Peffstill. India. Research and development Almost 15% of WG plc's revenue last year was spent on research and development. produced and marketed by a direct competitor of WG plc. taking account of the gross contribution per limiting factor.

(d) Discuss the practical issues which the directors of WG plc would need to consider if the company entered a strategic alliance with a competitor for the joint development of future pharmaceutical products. (ii) Explain how WG plc can market Coffstop to improve its competitive position. See Answer at the end of this chapter. 52 Business Analysis . (2) Direct Product Profitability analysis after charging holding costs.

Summary and Self-test C H A P T E R Summary 1 Strategic analysis 53 .

Initially the company was a regional producer focusing on markets in Central England but over the next 75 years Two Wheels transformed itself into a national company. most of the sales being made on a direct basis. the grandson of its founder. Initial concentration on a few major suppliers has ensured that Pamper Products has been able to have exclusive access to some products. The shares are totally owned by the family. Members of amateur cycling clubs contact the company directly with their orders and this minimises distribution costs. The initial bank loan was paid off according to its terms by 2001 but recently a further loan has had to be taken out in order to finance the expansion. Peter and David Sample. He has tried to limit the number of suppliers. The company buys nail care and cosmetic products from a variety of suppliers in order to supply chemists and other retailers. it is able to charge premium prices for these products as a result of having created a trusted brand. Most of the purchases are from either the Far East or Europe. The company has also expanded physically and has recently rented a new warehouse. which still account for 16% of its volume output. but is concerned that possibly other non-financial measures might be just as important. Peter has a similar commitment to his suppliers. This has led to an increased number of suppliers and an increase in staff from seven in 1996 to 22 currently. Most of these bicycles are very expensive to produce. Self-test 1 Pamper Products Ltd Pamper Products Ltd was purchased as part of a management buy-out in 1996 by two brothers. but as the company has grown he has been forced to deal with a growing supplier base. When the company was founded. He has continued to deal with the financial and administrative areas of the company whereas Peter is totally involved with suppliers and customers. It is managed by Darius Young. Two Wheels took advantage of changes in fashion and periodically introduced new models focusing on different market segments. Two Wheels' 54 Business Analysis . As an accountant David is happy with the financial controls and performance measures that he has built into the system. Peter Sample was the Sales Director of the business before the buy-out and David was an accountant working in practice at the time. the bicycles were targeted mainly at people who could not afford to buy motor vehicles – then a relative luxury – but who needed transportation to get them to work or for local travel. Requirements (a) Explain to David the most common reasons why companies may fail and suggest ways in which Pamper Products Ltd could avoid them. the rest being held by other members of the family. Peter is committed to even further expansion but David is concerned that the company's systems and finances cannot keep up with the rate of sales growth and would prefer a period of consolidation. particularly as the company continues to expand. They are made of specialist light-weight metals and are often custom-built for specific riders. Peter was always an excellent salesman and his commitment to customer service is second to none. The company has gone from strength to strength in the years since the management buy-out with revenue increasing on average by over 20% per annum. suggest other non-financial performance indicators that Pamper Products Ltd could use to monitor its overall performance as it continues to expand. so making these machines more affordable to the customers. The company buys its products from a variety of manufacturers but markets them under its own brand name. He deals personally with all of the major customers and has an excellent relationship with them. 2 Two Wheels Two Wheels is a private UK company founded in 1932 which produces bicycles for the general market. with Darius and his wife controlling just under half of the shares. David organised the finance by re-mortgaging both of their houses and borrowing further from the bank. investing in a state of the art inventory control system and a new computer system. Its first diversification was into making racing bicycles. (b) Using the balanced scorecard approach.

Darius has looked at the profile of his products and wonders whether any rationalisation could help to improve performance. with few differentiating features. currently the company will not attract bidders unless it is at a low price.) There are now very few UK manufacturers of bicycles who concentrate solely on producing bicycles. The main product group for the company was still its basic bicycle – it is the entry model for most families who are buying bicycles for teenagers and for those people who still use bicycles as a means of transportation as distinct from seeing them as entertainment or fun machines. It is surviving basically because it has built up a strong reputation for reliable products and because the Young family has. China alone supports a bigger market for bicycles than the whole of Europe and North America. Darius Young has examined ways to improve the profitability of the company. The company had historically made reasonable profits and most of these were re-invested in the company's production facilities. Darius decided to visit some of these markets and he has returned Strategic analysis 55 . The company has seen no reason to change its branding policy and these products are still sold under the 'Two Wheels' brand name. T E were relatively cheap and were aimed at families with teenage children and who could not afford R to spend large sums of money on the more sophisticated models. but also because of increased competition from foreign suppliers. Two Wheels has seen its market being eroded. although about 25% of these mountain bikes sales are made through a national retail chain 1 of bicycle and motor vehicle accessories stores. The bank will now only make loans if Two Wheels can find a suitable strategy to provide it with a higher and more acceptable level of profit. during this period Two Wheels actually increased its share of domestic output. These machines were sold at a premium price but they still accounted for only 4% of total volume sales of the company. These bicycles in fact are built for the retail chain and marketed under their brand name. Its only experience is within the bicycle industry and therefore it appears to be logical that it should stay in this field in some form or other. the mountain bikes were also sold under the Two Wheels brand. This segment. These products. If the company is to retain its independence (and it is questionable whether any company will really want to acquire it in its current position) it has to consider radical change. it is now becoming apparent that unless some radical action is taken the company cannot hope to survive. About 80% of this segment is sold through the same national retail chain mentioned above with reference to mountain bike sales. It now has a debt to the bank of £7 million.reputation has been enhanced by this highly profitable product. throughout the late 1990s. increasing capacity substantially. Having examined statistics on current world production and sales statistics he has identified that the real growth areas for bicycles are in the Far East. however. (Table One gives some financial information about the recent performance of Two Wheels. However. India and Pakistan have also developed a significant demand for bicycles. although robust and stylish. having been unable to pay for all recent. However. However. The product is standardised. in addition. until recently. C H During the 1980s the company responded to the demand for more sporty leisure machines. Two Wheels has continued to focus entirely on this specialised product range. and as such can be produced relatively cheaply. new capital expenditure out of retained earnings. By early in the year 20X8 the company has seen its profits continue to fall. However. mainly because the total United Kingdom market for bicycles has been in decline. He is of the opinion that if Two Wheels becomes more successful it could become a desirable acquisition for other companies. is now seeing increasing competition from cheaper overseas imports. Sales have fallen gradually. Apart from those sold via this retail network. Surprisingly. This appears to be advantageous to Two Wheels because it guarantees them a given level of business without their being responsible for either distribution or promotion. been content with a level of profits which would be unacceptable to a public company that had external shareholders to consider. Most have a diversified portfolio and can count on other product groups to support the bicycle sector when demand is poor. The company is currently selling nearly 30% of its output to this market segment. The high value of sterling has encouraged imports. Most of the sales are through specialist bicycle shops. a few UK producers had decided to exit the market and move into other. A Mountain bikes had become the fashion and Two Wheels designed and produced some models P which appealed to the cheaper end of the market. under the retail brand name. This is due to the fact that it has been prepared to accept lower margins so as to maintain sales and. He has also decided to look at the potential for overseas marketing. more attractive product lines. With the advent of fitness clubs the company saw an opening for the provision of cycling machines for the health club and gymnasium market.

600 3. The other shareholders are not quite so enthusiastic.080 9. Wage rates.5 1. full of enthusiasm for committing Two Wheels to operate in these Far Eastern markets or in India and Pakistan.600 3.000 Direct costs £'000 4. Whilst Darius considers that exporting from the UK might be a viable option. using appropriate theoretical models to support your analysis.850 Standard bicycles Volume 45.590 4. 56 Business Analysis .986 Revenue 10.280 9.560 7. They also believe that diversification into other non-bicycle products might be less risky than venturing overseas.000 36. including social costs in China appear to be about 25% of those in the UK and these costs account for approximately 30% of the total production costs. They know the UK market but overseas is an unknown area. Darius has decided that it is time he sought some professional advice for the company.412 Racing bicycles Volume 14.259.360 7.800 3. given the attractiveness of these overseas markets.312 Revenue 4. he is concerned about the discrepancy between labour costs in the United Kingdom and in China. They want to improve the position within the United Kingdom market first rather than leap into the unknown.200 Direct costs £'000 7.000 22.456 Interest on loan 560 560 Profit before tax £'000 1.234 1.224 1.450 Direct costs £'000 1. Furthermore. bicycles in China.967 369 (166. Darius has summoned a meeting of all the shareholders to persuade them to agree to plan to manufacture.137.800 13.400 12.155. (b) Identify and explain the key factors which should be taken into consideration before Two Wheels decides on developing manufacturing/assembly facilities in China.25 Indirect costs £'000: Distribution 282 290 362 Promotion 484 407 346 Administration and other 1. A management consultant.050 3.75 Revenue £'000 1.277.600 3. has been retained.780 3.000 Direct costs £'000 3.200 3. or at least assemble. (c) Write briefing notes to the shareholders. They feel that this strategy is too risky.5 1. He estimates that costs for shipping and insurance could add about 20% to the final selling price. Table One: Information concerning Two Wheels' current sales and financial performance Financial years to 31 March 20X6/20X7 20X7/20X8 20X8/20X9 (estimated) Mountain bikes Volume 27.500 3.209 1. he has become increasingly attracted to manufacturing in the Far East. The other shareholders are more in favour of a gradual process. She is a qualified accountant who also has an MBA from a prestigious business school. particularly in China. explaining the advantages to the company of concentrating solely on the production of bicycles and also the opportunities which may be available by pursuing a strategy of diversification.5) Requirements Acting in the role of Molly Dunn: (a) Write a report. Darius is convinced that the bank will lend them the necessary capital.500 3. He believes that transportation costs could prove to be a disadvantage to exporting for Two Wheels.000 24.900 Exercise bicycles Volume 3.000 40. Molly Dunn.410 Revenue £'000 4.062 1. The company has never been involved in overseas business and now they are being asked to sanction a strategy which by-passes the exporting stage and commits them to significant expenditure overseas. evaluating the current strategies being pursued by Two Wheels for its different market segments.

however. A decline in profits is not always accompanied by a decrease in sales volume. If a company is seemingly successful. Management So far we have considered largely financial reasons for company failure. There are many reasons why companies fail and in 1 most cases it will be due to a combination of such reasons. if a company expects increases in sales volume that do not materialise. Also. considering the past policy of only dealing with a few of those available. Argenti argues that many causes of corporate failure are due to poor management. Suppliers and customers A company can appear to be successful. This occurs when sales are increasing and therefore.Answers to Self-test C H A P T 1 Pamper Products Ltd E R (a) There have been many attempts to find a methodology to predict corporate decline. there is always the issue of complacency. an autocratic chief executive. An important implication of this for Pamper Products is that a close eye must be kept on costs of all kinds. in staff. which will eventually lead to a loss of market share and declining revenues. This calls for close management attention. The loss of a major customer means a significant fall in turnover and cashflow. If a principal supplier fails. this will also cut profits if the company has invested further. As sales fall. Pamper Products has expanded rapidly and has avoided this problem so far. This can significantly increase the risk of the company and in extreme cases if the loans or debentures are not serviced they could be called in and the company put into liquidation. so they should take great care over this. the same level of fixed costs must be paid from reduced revenue. Sales and profitability Declining profitability is a clear reason for the eventual failure of a company. for example. One particular problem here is where seemingly growing companies fall foul of overtrading. The implications for Pamper Products are obvious. Gearing and liquidity As a company's borrowing increases. This interest in the subject means that the main reasons for corporate decline are heavily documented. plant and inventories. Strategic analysis 57 . so are inventory-holding costs and payments to suppliers but these costs are not being matched in cash terms by money received from customers. a passive board of directors and a weak finance director is a common scenario of corporate failure. but if it is over-reliant on a few suppliers or customers then the failure of one of these parties can have a disastrous knock-on effect. this will have a major effect on the ability of the company to supply its own customers. Allied to this problem is that of a decrease in liquidity. growth and innovation. The Sample brothers have borrowed extensively. so do the costs of servicing loans. but the brothers must continue to take care of their cashflow. A company can still be profitable but if it cannot pay its debts as they fall due then eventually it will fail. inevitably reducing profits. then senior management may become complacent about performance. The need to seek out low cost suppliers may be of particular relevance. or companies at risk of decline. Finally. For example. but this is often the case.

however.) A balanced scorecard considers performance indicators for a business within four perspectives:  The financial perspective  The customer perspective  The internal business perspective  The innovation and learning perspective While these four categories may be regarded as widely applicable. 58 Business Analysis . As David is quite happy with the financial performance measures we will concentrate on the other three perspectives. it is important to understand that different organisations will require different measures for each if the approach is to be useful. For example. Possible performance measures might include:  Sales returns levels  Percentage of customers who do not return for repeat business  Levels of customer complaints Internal business perspective This perspective is concerned with the efficiency of the company's internal systems. a woodworking business would almost certainly be very concerned about the safe use of its machinery: this would hardly be a topic of concern for most financial service businesses. Managing Director From: Molly Dunn. Possible performance measures might include:  Time taken to introduce a new product  Percentage of sales revenue generated by products introduced within the last year  Extent of management training undertaken 2 Two Wheels (a) Report To: Darius Young. Possible performance measures might include:  Percentage of products returned to suppliers  Percentage of sales of products exclusive to Pamper Products  Labour turnover levels  Total number of suppliers Innovation and learning perspective This perspective is concerned with how the business is developing and moving forward. both in the exam and in the real world. Make sure you have learned and understood the nature of the four perspectives and expect to have to suggest relevant possible measures for each one. Customer perspective Performance measures in this area should measure how satisfied the customers are with the quality of product and level of service provided by the company. (b) (The balanced scorecard is a useful and popular model. Management Consultant Date: x-x-xxxx Subject: Evaluation of Two Wheels Company strategies Introduction This report is designed to consider the different strategies that Two Wheels is following in its different markets and to evaluate each of these individual strategies given the information provided for the last two years and the current year's estimated figures. dealing as it does in cosmetics. Product safety is likely to be an important concern for Pamper Products. both in its products and in its methods.

Direct costs are an increasingly large proportion of sales revenue and are H A expected to reach 86% of revenue in the current year. the margins in this sector are still healthy with clear potential for volume and revenue growth.6%. The remaining sales are made through a national retail chain of bicycle and motor vehicle accessories stores under the retailer's own brand name.967.500 by 20X8/X9. This sector is by far the most profitable of Two Wheels' market areas. Despite the cost increases. health clubs and basic bicycles – with distinctly different strategies being followed for each market. However. Racing bicycles Two Wheels has been making racing bicycles for many years and this area currently accounts for approximately 16% of its volume output and almost 50% of its sales revenue. Any potential for increasing UK market share in this area or diversifying into sales of racing bicycles overseas should seriously be considered as this is clearly the most successful part of the current business. Background Two Wheels is a private. However. a rise of over five percentage points P over the period. Strategic analysis 59 .000 in 20X6/X7 being turned into an E expected loss of £166. 1 therefore I will consider each market in turn. although anticipated revenue has fallen by 2% over the period considered and direct costs of production have increased by an expected 5. the distribution costs in this sector are minimised by the policy of taking direct orders from amateur cycling clubs. This area of the business could be described as a cash cow according to the BCG growth- share matrix as Two Wheels' market share is relatively high and the market is growing slowly. The overall UK market for bicycles is in decline and this has been made worse by the high value of sterling encouraging imports from foreign suppliers.In overall terms Two Wheels has seen a decline in demand for its products. This is the only sector of Two Wheels' business where the volume of sales is expected to increase this year. R Two Wheels has four distinct market sectors – racing bicycles. Two Wheels concentrates its efforts solely on the bicycle market and has a strong reputation for reliable products. Two Wheels appears to have followed a successful strategy of premium pricing in this market and has differentiated the product by the policy of producing custom-made bicycles.6% by 20X8/X9. Mountain bikes Two Wheels moved into this fashion area in the 1980s producing relatively cheap models and currently this sector accounts for 30% of Two Wheels' output but only 23% of revenue. direct costs of production have increased each year and are anticipated to be 89% of revenue for mountain bikes in the current year. The volume of sales is expected to decline by 19% over the period considered and revenue to decline by 16%. Some of its products are sold under its own brand name whereas others are sold through a national retail chain under its retail brand name. this area still remains profitable and although the bicycles are expensive to produce. mountain bikes. These racing bicycles are marketed under the Two Wheels brand name and have enhanced its reputation. However. Despite increases in costs and decreases in revenue this sector remains relatively profitable in relation to other market sectors of the business. during this period Two Wheels has been able to increase its share of domestic output by accepting lower profit margins in order to maintain sales. with demand expected to fall by 17% from the period 20X6/X7 to 20X8/X9. Revenue is expected to fall by C 9. This performance is unacceptable. some being custom-made. About 75% of these mountain bike sales are made under the Two Wheels brand name through specialist bicycle shops. family-owned company which is now a national producer of bicycles. Each individual market that Two Wheels operates in will now be considered in turn in the light of this background information. Over the last few years Two Wheels has seen its market being eroded with increasing competition from cheaper overseas imports. Together with a dramatic expected increase in indirect costs of 38% over the T period this has resulted in Two Wheels' profit of £1.

Prices are coming down and costs are rising. Health clubs are a completely different type of customer from those for the other sectors. this sector has been consistently profitable over the period. Two Wheels might consider diversifying into production of other fitness equipment such as running machines and cross trainers. This market sector is different from Two Wheels' other areas as it is a diversification into a different line of business. This area of the business is now being subsidised by the other more profitable but smaller markets. As Two Wheels has been so successful in its premium pricing policy in the racing bike market. This market appears to be potentially profitable but currently Two Wheels is too small a player to take advantage of it in full. Exercise bicycles The health club market for exercise bicycles plays only a small part in Two Wheels' business currently with only 4% of total volume sales. The increases in direct costs will tend to invalidate this policy as Two Wheels does not appear to have the production capacity to achieve the economies of scale necessary to maintain profit margins as sales volumes decline and cheaper foreign imports pose a threat. at 24%. in order for this to be successful. from 10% two years ago. If the mountain bikes produced are promoted as being of high quality based upon the well- respected brand name of Two Wheels in the racing bike market. According to the BCG growth-share matrix the basic bicycle market could be categorised as a dog as the UK market in this area does not appear to be growing and Two Wheels appear to have a relatively low market share. The exercise bicycles will have some similarities to the other bicycles manufactured but the market characteristics are very different. which the market seems to prefer in its suppliers. however. Part of the reason for the fall in profitability is. 60 Business Analysis . Sales volume has decreased by 20% over the past two years but sales revenue has fallen by even more. Sales volume is expected to show a slight fall in the current year since Two Wheels do not produce a full range of exercise equipment.9%. although margins have reduced to an expected 8% for the current year. and the majority of the mountain bikes are also marketed under the Two Wheels brand name. This area of Two Wheels' business certainly appears to have potential but if changes in both the stabilisation of costs and marketing and pricing policy are not made it would appear that profits from this sector will continue to decline. the escalation of costs which in the current year represent 92% of the sales value of the exercise bicycles. accounts for about 50% of the output volume and is therefore still the core of the business. Two Wheels needs to be able to compete on costs. In 20X6/X7 the production cost per bicycle was £90 but this has increased to £92 per bicycle in the current year. as with other areas of the business. the standard bicycle. Unfortunately. Two Wheels' pricing policy of charging relatively low prices for the mountain bikes is a strategy of penetration pricing. As Two Wheels is heavily dependent upon the retail chain it may be that the retailer is forcing prices down using its buying power. the company should consider moving away from the low price market for mountain bikes. Therefore it might be difficult for Two Wheels to disassociate itself from the retailer and sell directly. About 80% of these bicycles are supplied to a national retail chain supplying bicycles and motor accessories and marketed under the chain's own brand name. it appears not to have worked. although it may be possible to build on the brand association from the racing bicycle market. As this is a niche market it is possible to have a premium pricing policy. the company may be able to attract customers prepared to pay a higher price due to the quality of the product. the margins in this area are the main cause of Two Wheels' overall fall in profitability. In addition to this the selling price has reduced from £100 two years ago to just under £95 currently. as a result of reducing price in an attempt to maintain sales levels in the face of increasing competition from cheaper overseas imports. Two Wheels' strategy in this market appears to have been one of competing on both cost and price. There is no real brand association with the basic bicycles as the majority is sold under the retailer's brand name. In the current year the margin has fallen to 2. However. Therefore. Standard bicycles The main product of the group.

You would have to cover the same ground. Conclusion Two Wheels currently has a wide range of strategies. T E Indirect costs R A further worrying area of the business is in the escalating indirect costs. Operations Let us first consider the operational aspects of the development of a manufacturing or assembly facility in China. appears unusual. It would appear that Two Wheels' strengths lie in its strong reputation and brand association in the racing bicycle market. then this could produce significant improvements in the mountain bike market.70 times. then it may be necessary to consider withdrawal from this market. which has not succeeded. If this can be extended to the mountain bike market and a premium pricing policy introduced here with market differentiation based upon the quality of the product. but you may find this approach more fruitful if you are wondering just how to get started. and an attempt to be a cost leader at the lower end of the market with its basic and mountain bikes. Administration costs have also increased by 20% over the last two years which. C Withdrawal from this market could be considered although as it is such a significant element H A of the business this may be a dangerous strategy and should only be considered when all P other options have been examined. A further potentially successful market is that of the health club equipment if the production range can be extended. Distribution costs are up by 28% although this may be understandable given the nature of the direct sales of the racing 1 bicycles and exercise bicycles. however. the view of the market appears to be that of the managing director and there is no evidence that any market research activities have been carried out. probably move away from dependence on the retailer and attempt to differentiate its product in some way. an unsustainable level in the long run. The basic bicycle market could be improved with more control of direct costs but as the UK market is not expanding and the strategy has been one of cost leader. fallen and this must be rectified if Two Wheels is to capitalise on its brand name and increase sales volumes. given the decrease in sales volumes. It would appear that the future of ABC lies with the quality products as Two Wheels does not appear to have the production capacity to achieve the cost economies necessary for a successful cost leader strategy at the lower end of the market. Promotion costs have. Loan interest is unavoidable but worryingly high as in the current year interest cover is only 0. (b) (To some extent our answer is unstructured. What type of bicycles is in demand in China and can Two Wheels produce bicycles that satisfy this demand? If the bicycles required are not the same as those currently manufactured by Two Wheels there may be significant costs involved in re-design and changes to the manufacturing processes. a premium pricing policy for racing bicycles and exercise bicycles. Over the two years there has been a staggering increase of 38% in total indirect costs. As far as the demand for bicycles is concerned. you could use the PESTEL and Porter's Five Forces concepts to produce something like an environmental analysis. The proposal is based upon the large demand for bicycles perceived in the Far East. If Two Wheels is to improve profitability in this market it must decrease costs. Production costs must be brought under control before any rationalisation of strategies can be considered.) When considering any potential investment many factors must be taken into account but when considering such a major change in strategy as the managing director is proposing then there must be a wide ranging review of the key factors. the cheaper labour which would reduce production costs and the reduction in transportation costs. Strategic analysis 61 . addressing salient points in no particular order. If you prefer a more structured approach.

How does it propose to raise the finance necessary for such a major investment? Would the finance be raised in this country or in China? Are there opportunities for a UK company to raise major finance in China? Would a joint venture with a Chinese company be a viable option? Further financial problems will concern the remittance of funds back to the UK and any foreign exchange risks that Two Wheels may face. interest rates and availability of finance. are they encouraged or are there sanctions which will make operations more difficult and expensive? Analysis Many of the key factors involved in this proposal can be addressed through a PESTEL analysis (social. However. These skills might not necessarily be easily transferred to other markets such as production of other fitness equipment. 62 Business Analysis . let alone setting up a full scale operation in one. From the technological viewpoint. economic. Two Wheels must consider other operational aspects of setting up a manufacturing facility in China. Risk Political risk is a further important area that should be considered. How stable is the Chinese government? What is their attitude to foreign investors. Finance Two Wheels must also consider financial aspects. particularly one as distant and unknown as China. albeit of different types.  The fact that Two Wheels specialises in the production of bicycles. inflation rates. The labour cost aspect must be put into perspective. The transportation costs of bicycles from the UK to China are obviously significant. would argue that the company obtains some economies of scale from just this type of production. Economic factors will help to define the demand structure. does the technology exist in China or must it be exported? (c) Briefing notes on advantages of concentration on bicycle production or diversification Advantages of concentrating on bicycle production  Two Wheels has been in the bicycle manufacturing business for many decades and therefore has the skills and competences necessary to operate in this area. political and technological aspects). contracts for setting up a factory and employment issues. Labour costs only account for 30% of the total production cost therefore the cheaper labour would only lead to a maximum decrease in production costs of 22. Can the correct components be purchased at a competitive price and be delivered on time? What type and amount of marketing expenses will there be? Two Wheels must also question its ability to run such an operation as it has no experience in even trading with other countries. Political issues will be of great importance in a country such as China which has large state control. This internal transportation cost should not be ignored. Legal factors will include dealing with suppliers. if the proposed facility is set up in China instead there are still likely to be significant transportation costs since China covers a vast area and demand is likely to be spread widely. As direct costs are increasing there is some doubt about these economies of scale but diversification into another field may reduce margins even more. The labour issue should be considered further – how does the productivity of bicycle manufacturing employees in China compare to that in the UK? If productivity is significantly lower in China then this could wipe out any cost benefit. Two Wheels should also consider the foreign exchange risks that are associated with any form of trade with foreign countries. legal.5%. Analysis of social factors will help to define the market. Many countries restrict the amount of their currency that can be taken out of the country and as Two Wheels is so short of funds it will clearly require any profits to be remitted back to the UK. If the Chinese currency moves against sterling then Two Wheels could be subjected to large foreign exchange losses. particularly if there is a demand for Two Wheels' more high-tech products. determine the type of bicycle required and clarify the potential customer and method of marketing and sale. The company has very low profit levels currently and a large debt outstanding. such as the racing bicycle.

a move into a new area is enticing. may offer higher gains than the bicycle market although the risks may also be greater because of factors such as changes in technology. This will also be of benefit in C developing value chain relationships. given its core expertise. H A  By remaining within the bicycle industry the Two Wheels brand name can be cultivated. Strategic analysis 63 . T E Advantages of diversification R  If the bicycle market is in decline or faced with significant competition from cheaper foreign imports then there may be gains to be made in other markets. It could be argued that Two Wheels should stick to its core activities and not be side- tracked into other areas in which it has limited experience. such as the health and fitness club market.  It is possible that Two Wheels could use its current distribution networks in order to market a different range of products. Conclusion The theory behind diversification for large companies is that there is no need for a company to do this simply to reduce the risk of just being in one industry as the shareholders are quite capable of doing this on their own behalf by owning a portfolio of shares. For Two Wheels.  If Two Wheels were to diversify. However.  New products may have greater potential to provide technological or commercial advantages to the company. for a private family-owned company that is experiencing problems with profitability. diversification should only be considered if it is believed that there are no future gains to be made from its current markets and that moves into non-core areas are likely to be successful. 1  Other markets. P Its value in other sectors must be doubted. this would reduce the risk of becoming involved in an individual market area that may decline and would give the company greater flexibility to deal with changes in fashion and technology.

therefore it is important to establish how sophisticated competitors' strategies are and hence how much threat they are likely to pose. which means that the product is not differentiated from those of all the other tea- growers. Although there are many manufacturers of branded cosmetics. 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. If. this particular tea-grower could market directly to the consumer. 64 Business Analysis . for example. Customer bargaining power is high. as such a process can be designed to address specific objectives. The knowledge gained from conducting a formal competitive analysis will allow LBG to adjust its strategy to meet the challenges posed by competitors' behaviour. as both new and existing competitors are one of the main elements in its immediate task environment. many of these will be aimed at the high street customer. (b) One possible strategy would be to 'get in touch with the consumer' directly. Even if it decides to maintain its current strategy. competitive rivalry is high because of the difficulty of stockpiling products. it should focus only on those firms that produce similar products aimed at the same market. The tea grower should not be too ambitious with this new project too early. An excellent strategy for doing this is to appeal directly to the consumers themselves. Reliance on information gathered on an opportunistic basis is unwise. One way of doing this could be the use of a mail order system. The philosophy that 'knowledge is power' certainly applies here. but supplier power is low: all it needs is capital. In an industry with vast over-supply. Once LBG has established who its main competitors are. Answers to Interactive questions Answer to Interactive question 1 (a) Here are some ideas. but should also maintain its practice of selling some of his tea at auction. given the need to set up reliable ordering and distribution systems. or whether it would prefer to maintain its reputation for quality. offering specialist teas delivered directly to the consumer. (b) The first stage in the competitor analysis process is the identification of who the main competitors are. 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. magazines sent out to premier credit card customers). it is essential that LBG knows who and what pose potential threats to its current position – it is only through this knowledge that LBG will be able to take steps to counteract these threats. As the profitability of a firm is influenced by the competitive environment. A formal process of information gathering and analysis provides the best route to thorough coverage without unnecessary duplication. Different firms in the same industry will have different strategies. LBG should be careful here as it is operating in a specialised niche market. The service could be advertised in magazines – initially those with a moderate distribution aimed at the type of customer who is likely to purchase specialist teas (for example. such as financial 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. the right sort of land and labour. Rather than selling tea at auction. premium products. As LBG manufactures specifically for the theatre and movie industry. as there is no guarantee that LBG will obtain the specific information it requires. Barriers to entry are high. attitude to risk and whether managerial beliefs affect their companies' goals. In a maturing industry. LBG would have to decide whether competing on price is a strategy it would like to pursue. Answer to Interactive question 2 (a) LBG should gather as much information as possible about its competitors. tea growers must increasingly focus on how to make their product more attractive to the market. it is only through understanding this environment that LBG can hope to continue its success. There are plenty of substitute products (coffee). it should focus on competitors' goals. competitors are attempting to reduce margins to attract customers. This should guarantee a minimum income whilst the new venture is being developed.

and LBG may have to rely on opportunistic behaviour to gather details. the use of new technologies to develop and bring new and improved products to market is particularly important. Are they just a sideline. (ii) Competition. Our answer includes a reference to the importance of inventory turnover in the analysis. Nobody expects scientific or medical research to stand still while there are still diseases that need cures. In the case of WG. (a) Product development and market threat (i) Growth. A successful business must develop its products and manufacturing methods on a regular basis if it is to maintain market share. in which case the products may be subsidised P by the more profitable main product lines. This is linked to the relative importance of the industry to competitors' overall strategy. or are they the main focus of the business? T E Establishing competitors' assumptions about the industry is essential as this will play a large part in R determining their future activity. Part (b) calls for application of the five competitive forces. Sales from previously central products will fall. the competitor may be more inclined to 'walk away' and concentrate its resources elsewhere. or where existing cures are being resisted by new strains. This does not necessarily call for an assessment of the advantages and disadvantages of such alliances. enjoys high profitability and seems to give little back will at the very least suffer a grave image problem. If movie and theatre cosmetics 1 are only a sideline. If possible. C What is important for LBG to establish is the relative importance of the movie and theatre industry H A markets to their competitors. For example. Its stated objectives include to develop innovative medicines and services. In the movie and theatre cosmetics industry. (iii) Innovation. although an analysis along these lines may have been appropriate and would have earned marks if it clearly addressed practical issues. such as the high street. This calls for strategic decisions on the part of WG plc. a product which previously accounted for nearly half its revenue is expected to contribute only 10% in future. You should have few difficulties in applying the marketing mix for part (c)(ii). to allow knowledge-building of how new techniques can affect the effectiveness of the cosmetics. The expiry of patents and the opening up of a product and its market to competitors also highlights the danger of lack of innovation. As such assumptions exist mainly in the heads of senior managers. a competitor that strongly believed that the industry was reaching over capacity might consider leaving the industry altogether. The ability to work closely with companies responsible for new cinematic techniques is also essential. including changes brought about by LBG's own potential future strategies. and the question even tells you it is Porter's model in case you need a memory jogger! The numerical analysis in part (c) points you in the direction of contribution per limiting factor. Establishing the extent to which competitors have these is the next stage in the investigation. Answer to Interactive question 3 In our answer to part (a) we have referred to product development in connection with the Ansoff matrix. If WG's existing products were to fall in price and it did not have new products (such as Coffstop) to fall back on. which it can only do by investing in development. competitive advantage depends largely on the possession of unique competences and assets. 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. Part (d) requires a discussion of the practical issues surrounding strategic alliances. catwalk. it should be able to begin the process of predicting how competitors might behave in a range of possible future circumstances. A company that rests on its laurels. it may be difficult to obtain. Product development has the advantage that it forces competitors to innovate and discourages newcomers with significant barriers to entry. In a specialist industry such as the one that LBG operates in. LBG should try to establish the aims and objectives of its competitors. theatre and movie industries. its profitability would suffer. Failure to invest in research and development in such an innovative and dynamic sector is therefore of paramount importance. Many cosmetics companies market to various sectors. Strategic analysis 65 . Once LBG has gathered the information above.

such as the donation of the malaria treatment. as well as recognition of wider social responsibility. If they are successful in getting this. will impact on profits. so a straight repetition of the model is not enough. Public and government challenges to high levels of profitability reflect the fact that WG is expected to contribute to furthering knowledge. Staple products are known as 'cash cows' – they have a high market share in a stable market. investment is crucial in maintaining market share and the appropriate resources must be allocated. WG's profitability will be affected. that product will go through stages of cash generating ability. This model demonstrates that. World class pharmaceutical manufacturers are few in number. For the reasons outlined above. This will do a great deal to enhance WG's reputation worldwide. WG does have significant production facilities. (ii) Bargaining power of customers. The overall corporate mission aims to reflect a short-term responsibility to shareholders. and can provide the cash resources to invest in the development of 'stars'. WG has built up a good reputation for its products and is likely to have strong customer loyalty. when balancing long and short-term performance issues. When product quality is important to the customer. You need to consider which of the forces are most applicable to the company and their effect on objectives. perhaps via collaboration with universities or research institutes. and WG must make sure that there are others in the pipeline. low-price supply contract. It may take several years for the benefits of investment to be felt on sales and profits. The investment in research into malaria treatments has paid off. but will also want to see more immediate profitability. Customers usually want better quality products at the lowest possible price. If all disease was eradicated. especially when patent restrictions are lifted. The pharmaceutical industry is one such profitable sector. (b) Conflicting objectives and the Five Forces This part of the question was concerned with application of Porter's Five Forces model. because competition is relatively restricted by the significant levels of research and development that are required. This is not a significant threat for WG. Access to sources of raw materials on favourable terms may include a long-term. It has to concentrate its efforts on creating a strong brand image so that customers are not tempted to shop around. and patent rights give it breathing space to develop further products. in that the company is able to donate supplies of the medicine to overseas areas. Some industries have bigger profit potential than others. This will reduce WG's profitability while new products and markets are developed. as discussed above in part (a). be taken into account. Manufacturing and research facilities operated by WG are amongst the largest in the industry and its distribution network is global. as it is likely to be 66 Business Analysis . (iv) Shareholders in a pharmaceutical company should expect to see investment in research and development. then WG would have no market in the long term. so the products chosen for development must be carefully selected. and the elimination of disease. The expense and the risks associated with significant investment in research and development must. Investment in developing markets overseas. The price awareness of customers will vary. Its brands may crowd out the opposition. The decision about the relative size of investment and payments for shareholders each year is a trade-off that the directors will have to make. are contradictory when taken to the logical extreme. however. Competitive forces and their applicability to WG's objectives (i) Threat of new entrants. but it will be aware of the latest developments and should be able to capitalise on them in the future. depending upon a product's individual life cycle. (v) Cash flows contributed by the products in WG's portfolio can be illustrated using the Boston Consulting Group Growth Share Matrix. which are those products which achieve a high market share in a high growth market. The twin aims of sustained profitability through development of innovative medicines. Porter's model of the five competitive forces shows those factors which collectively determine the potential of the industry as a whole. It is the product of a merger and enjoys significant economies of scale that a competitor is unlikely to be able to match. A new entrant would have to build up a large market share very quickly to be able to sustain its cost structure and hence profitability. Coffstop may have the potential to become a star. with much of its research being sponsored.

The development of innovative products and working towards the eradication of disease does depend very strongly upon an adequate supply of technical specialists and expertise. in the market for medicines. new products. advertising battles. Competition can help an industry to expand by stimulating demand. A retailer who stocks both products should give as much space to Coffstop as possible. Competition is likely to be centred on innovation and research activities. 1 Where there are just one or two dominant suppliers.50 Contribution per bottle 2.00 1. A supplier is unlikely to be able to demand higher prices from WG. but will arise when patents run out and competitors can start making their own version of a successful product. and firms will try to avoid competing on price. which could be limited in supply.50 Cost per bottle for retailer 7.00 for Coffstop. Competitor activity usually means price competition. (v) Substitute products. This analysis ignored the fact that Peffstill comes in a bigger bottle and so takes up more shelf space. improved levels of service and provision of guarantees or warranties. the customer is likely to be less price sensitive and so WG will be more profitable. Again. T E (iii) Bargaining power of suppliers. There are only a few players in WG's market.33 5. sales promotion campaigns.60 1. These are unlikely to come from another industry. Peffstill Coffstop £ £ Selling price 10. The few world-class companies will be competing for the best human resources. but if such long running products are 'cash cows' they P may also be able to contribute towards development of disease-eradicating 'stars'. Strategic analysis 67 . (1) Retail pharmacists prefer Peffstill because they calculate that it achieves a £2. The level of competition found in the pharmaceutical industry is likely to be less intense than that found in other sectors. C H Customer demand for long running profitable products may divert production resources from A developing more innovative products. (iv) Existing levels of competition. and how important a particular supplier's products are for WG.56 Coffstop generates the most contribution per unit of limiting factor for the retailer.60 contribution compared to £1. as has already been discussed. WG can access supplies on a global basis and is therefore R unlikely to be controlled by an individual supplier. they may be able to charge monopoly prices. Coffstop also sells more per week on average. Research scientists are likely to be able to exert some bargaining power over WG when negotiating salaries. the vital importance of research and development must be stressed. This depends on factors such as the technical specification of the products being supplied. This keeps WG ahead of the competition and moves it further towards the eventual eradication of disease. (c) CVP and DPP analysis (i) The calculations in this part of the question are very simple.00 Sq cms shelf space per bottle 60 18 Contribution per sq cm in pence 4. but do not confuse CVP and DPP. Cost volume profit analysis demonstrates the contribution achievable with regard to the limiting factor (retailers' shelf space) as follows.40 0.

or at least reduce their stocks of Peffstill while Coffstop is introduced to the customers. indicating that Coffstop should still be the preferred product of the retailers.80 0. Both drugs are available over the counter from pharmacies and so it is possible to start selling Coffstop through supermarkets. but free trial packs could be a suitable promotional tool when introducing the product to doctors. thereby taking all costs into account: Peffstill Coffstop £ £ Contribution per bottle as above 2. making the comparable prices £9 and £10 respectively. for example) will be a task for WG's marketing or design department.160 sq cm The total weekly contribution £36.00 Holding costs 0. This will enable WG to reach an even larger market. (ii) The marketing strategy of Coffstop can be planned with reference to the marketing mix. often on a seasonal basis. but customers have come to expect discounts for buying in bulk. The fact that Coffstop is cheaper as well as being a better product than Peffstill would appear to give it a significant advantage. who sell cough medicines (assuming that Coffstop is a cough medicine – the scenario is not specific) and often have their own in-house pharmacies. Peffstill may respond by dropping its price. Product Medical research and opinion has shown that Coffstop is the more effective product. Giving medicines away to the general public may be frowned upon. Making the packaging attractive while containing the expected safety features (child-proof caps.00 Per unit of shelf area 3. and free trial sizes are all possible promotional activities. The shelf area required per week is the minimum that should be allocated to each product by reference to average sales. Promotion The promotion campaign should highlight price and product benefits. thereby halving the amount of space needed to support the same sales volume. which Coffstop should be linked with in the customer's perception. coupons. (2) Applying direct product profitability to weekly sales. It should be noted that inventory turnover is also a relevant consideration – WG plc may offer to replenish the retailer's shelves twice a week. on price Coffstop has an advantage. WG plc has a strong reputation with a wide portfolio of products. Radio advertising.200 sq cm 2.60 Contribution % of sales price 18% 40% Shelf area required per week 60 sq cm  20 18 sq cm  120 bottles bottles = 1. The customer must have six times as much dosage of Coffstop as Peffstill. especially if Coffstop should be carefully administered. Literature and posters detailing Coffstop's benefits could be distributed to doctors' surgeries and pharmacies. Place Retailers may decide to stock Coffstop instead of Peffstill. Television advertising for cough and cold medicines is common. Price Coffstop is cheaper per bottle.33p This analysis gives the same result for the retailer as cost volume profit analysis.00 £72. 68 Business Analysis . which will encourage customers to purchase it. This will increase the amount of contribution per scarce resource.00p 3. and therefore brings a better 'package of benefits' for the customer. or promoting the convenience of having to buy only one bottle. if only on a trial basis. so this may be an appropriate product launch medium.40 Net contribution per bottle 1. Therefore.60 1.80 0.

Joint ownership of patents for products that are developed by an alliance could be fertile ground for arguments about fair share of returns. The alliance must be entered into on a contractual basis so that each party is clear about its rights and responsibilities. so the funding of expensive research via an alliance can spread the risks. It may take a while for trust to be built up. Without going so far as another merger or takeover. which has enabled it to achieve economies of H scale. (v) Partnership. resources invested. Management issues also involve staff considerations. unless the agreement is carefully and thoroughly worded. (vi) People. and the venture may be subject to investigation before it is allowed to go ahead.(d) Strategic alliances C (i) Efficiency. New technology offers many uncertainties as well as 1 opportunities. Disagreements may arise over profit shares. (iv) Reputation. but the benefits of such an alliance are likely to make the practical considerations a hurdle worth clearing. but also intangibles such as expertise. Practical considerations include potential conflicts of interest between the parties. products to be developed and marketing strategy. management issues (including project management and resource management). and confidentiality of individual business processes may be threatened. Staff loyalty may be tested. The parties to the alliance must make sure that they have fully researched the implications of their venture for the industry to be able to present their case favourably to the regulator. Strategic analysis 69 . Alliances can also be a learning exercise for each partner. (iii) Goal congruence. with WG taking on trainees or work experience placements from the science faculties. WG's expertise in production and research P may be supplemented by the other's marketing and distribution facility. Regulatory bodies may be concerned that a strategic alliance between dominant market players could be anti-competitive. for example in the value chain. a strategic alliance may offer A benefits to WG. Complementary T E competences can be exploited to mutual advantage. Resource investment includes consideration of share of expenses and tangibles such as capital contribution. An alliance with a university would provide a good example. Such alliances may therefore involve significant legal bills. R (ii) Knowledge. WG is the product of a merger.

70 Business Analysis .

CHAPTER 2 Business risk management Introduction Topic List 1 A review of risk management issues 2 Enterprise risk management 3 Risk management and control systems 4 The risk management process 5 Establishing the context 6 Risk identification 7 Risk assessment 8 Risk profiling 9 Risk quantification and consolidation 10 Risk responses 11 Implementation of plans 12 Risk monitoring and control Summary and Self-test Answers to Self-test Answers to Interactive questions 71 .

its framework and its benefits 72 Business Analysis . Introduction Learning objectives Tick off  Demonstrate a detailed understanding and application of risk assessment issues  Demonstrate a detailed understanding and application of the various steps involved in constructing a risk management plan. including establishing context. identifying risk and the assessment and quantification of risk  Demonstrate a detailed understanding of the limitations of risk management  Demonstrate a detailed understanding of enterprise risk management.

the rates of interest it pays on its loans. Business risk management 73 . Organisational attitudes may be influenced by significant losses in the past. but also management perceptions or appetite to take risk. their business strategy. whether genuine or perceived.2 Response to shareholder demand Shareholders demand a level of return that is consistent with taking a certain level of risk.  Shareholders can spread risk over a number of investments. 1. Many areas of risk and T uncertainty are exogenous – that is.1 Risk Risk is sometimes used to describe situations where outcomes are not known. C H 1.3 Risk appetite Because risk management is bound up with strategy. how organisations deal with risk will not only be determined by events and the information available about events. riots and civil commotion' from their insurance cover.) 1. but their probabilities can 2 be estimated. E R 1. and these are not necessarily just a response to shareholder concerns. (This is the underlying principle behind insurance. although this is unlikely to be the most important influence on appetite.3.3. 1.1.1 Risk and uncertainty A P Risk and uncertainty must always be taken into account in strategic planning.  The risk of an organisation. and internal management's attitude towards it. or even changing views of the benefits risk management can bring. 1. 1. These factors will also influence risk culture. and therefore the types of projects it can pursue. Managers will respond to these expectations by viewing risk-taking as a key part of decision-making. has a considerable bearing on the way in which different organisations conduct their business – that is. 1. 1 A review of risk management issues Section overview  Risk.  Managers' careers tend to be bound up with the success or failure of one particular company. changes in regulation and best practice.3 Organisational influences Organisational influences may be important. has a direct effect on a firm's cost of capital.1 Personal views Surveys suggest that managers acknowledge the emotional satisfaction from successful risk-taking. the values and practices that influence how an organisation deals with risk in its day-to-day operations.  This section reviews the risk management issues that were covered in the Business Strategy paper at the Professional stage. many insurance companies exclude 'war damage.2 Uncertainty Uncertainty is present when the outcome cannot be predicted or assigned probabilities. outside the control of the organisation. For example.3.1.2 Risk and managers It is worth noting that shareholders and managers have different approaches to risk. so managers are therefore likely to be more risk averse than shareholders might be.

even if the resulting risk level is also higher. and guides an organisation's decision-making. value creation and resource utilisation. and not enough on strategy and building a business.  Aversion focuses on the risk level. 1. 1. Viewpoints Features Fatalists Think they have no control over their own lives and hence risk management is pointless.1. management and reporting processes and that the organisation is working effectively and efficiently to achieve its goals. Often found in charities and public sector. Surveys suggest that attitudes to risk vary nationally according to how much people are shielded from the consequences of adverse events. IFAC's 2004 report Enterprise Governance. Will emphasise risk reduction through formal risk management procedures.5 Conformance and performance The International Federation of Accountants (IFAC) has highlighted two aspects of risk management which can be seen as linking in with risk aversion and risk seeking. An organisation should not undertake an activity if it results in higher risk. fiduciary responsibilities. IFAC guidance states that risk management should seek to reconcile performance and conformance – the two enhance each other. Egalitarians Loyal to groups but have little respect for procedures. (a) Conformance focuses on controlling pure (only downside) strategic risks. and hence risk management too will be informal. It also includes ensuring the effectiveness of the risk analysis. with formal structures and procedures.4 Risk aversion and risk toleration Aversion and seeking are two different attitudes towards risk. 1. it cannot ensure success.5 Cultural influences Adams argued that there are four viewpoints that are key determinants in how risks are viewed.  Seeking focuses on the return level. prefer sharing risks as widely as possible. unless the higher level of return that compensates for the risk is acceptable.3. Individualists Seek to control their environment rather than let their environment control them. 74 Business Analysis . or transfer of risks to those best able to bear them. accountability and the provision of assurance to stakeholders in general. Case studies and surveys commissioned by IFAC have shown that many people believe that organisations focus too much on compliance. if indeed it is considered at all. Hierarchists Most likely to exist in a bureaucratic organisation. It includes policies and procedures that focus on alignment of opportunities and risks. (b) Performance focuses on taking advantage of opportunities to increase overall returns within a business. strategy.3. It highlights compliance with laws and regulations. Often found in small. best practice governance codes. Getting the balance right showed that though compliance is necessary to avoid failure. single-person dominated organisations with less formal structures.4 National influences There is some evidence that national culture influences attitudes towards risk and uncertainty. non-profit making activities. An activity should be undertaken if it results in higher returns.

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.)
See Answer at the end of this chapter.

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

Physical Earthquakes, fire, flooding, equipment breakdown. In the long term, 2
climatic changes: global warming, drought (relevant to water firms).

Economic Assumptions about the economic environment may be incorrect. Not
even the government forecasts are correct.

Business Lowering of entry barriers (eg new technology); changes in
customer/supplier industries leading to changed relative power; new
competitors and factors internal to the firm (eg culture);
management misunderstanding of core competences; volatile cash
flows; uncertain returns; changed investor perceptions increasing the
required rate of return.

Product life cycle Different risks exist at different stages of the life cycle.

Political Nationalisation, sanctions, civil war, political instability – all of these
can have an impact on the business.

Financial Can be affected by changes in interest rates, economic climate,
gearing, bad debt risk, liquidity, insolvency.

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

Business risk management 75

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

1.7 Business risk and financial risk
1.7.1 Business risk
Business risk, as the name suggests, is the risk associated with the day-to-day operations of a particular
company. It relates to the variability of operating cash flows, the company's exposure to markets,
competitors, exchange rates and so on. It is part of the company's overall systematic (or undiversifiable)
risk and can be divided into:
 Strategic risk
 Operational risk
 Hazard risk

Case example: Clinton Cards

Strategic risks are risks that relate to the fundamental decisions that the directors take about the future
of the organisation. These can include adopting the wrong strategy at the wrong time or failing to
adopt the right strategy quickly enough.
In May 2012 Clinton Cards, the high street chain specialising in greeting cards, was forced to go into
administration. Although aggressive tactics by its principal supplier, American Greetings, precipitated its
failure, it was also a consequence of the increasing pressure that Clinton had come under from

76 Business Analysis

supermarkets and on-line retailers, such as Funky Pigeon and Moonpig, that sell personalised on-line
greetings cards.
At one stage Clinton owned 1,145 shops and controlled 25% of the greetings card market. However it
rapidly declined from a pre-tax profit of £24.1m in 2009 to a loss of £10.6m in 2011. Clinton failed to
adapt quickly enough to the demand for e-cards, relying for too long on the belief that most people
preferred sending and receiving real cards in the post. By the time it launched its own e-card business, it
was up against firmly established rivals such as Moonpig. Clinton also relied on a large high street
presence, reinforcing it by buying up high street rival, Birthdays. Its logic was that cards were a
secondary purchase and it therefore had to be where shoppers went. Again however it failed to realise
the implications of increased online shopping early enough and kept expanding for too long. The result
was a £80m a year rental bill.
Nevertheless there still appeared to be some life in the model Clinton followed. Ironically a subsidiary of
C
American Greetings acquired the brand, assets and about half the stores that were still open in June H
2012. A
P
T
E
1.7.2 Financial risk R

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

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

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

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

Business risk management 77

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

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

Case example: The global credit crunch
A credit crunch is a crisis caused by banks being too nervous to lend money to customers or to each
other. When they do lend, they will charge higher rates of interest to cover their risk.
One of the first obvious high-profile casualties of the recent global credit crisis was New Century
Financial – the second largest sub-prime lender in the United States – which filed for Chapter 11
bankruptcy in early 2007. By August 2007, credit turmoil had hit financial markets across the world.
In September 2007 in the UK, Northern Rock applied to the Bank of England for emergency funding
after struggling to raise cash. This led to Northern Rock savers rushing to empty their accounts as shares
in the bank plummeted. In February 2008 the UK Chancellor of the Exchequer, Alistair Darling,
announced that Northern Rock was to be nationalised.
Years of lax lending on the part of the financial institutions inflated a huge debt bubble as people
borrowed cheap money and ploughed it into property. Lenders were quite free with their funds –
particularly in the US where billions of dollars of 'Ninja' mortgages (no income, no job or assets) were
sold to people with weak credit ratings (sub-prime borrowers). The idea was that if these sub-prime
borrowers had trouble with repayments, rising house prices would allow them to remortgage their
property. This was a good idea when US Central Bank interest rates were low – but such a situation
could not last. In June 2004, following an interest rate low of 1%, rates in the US started to climb and
house prices fell in response. Borrowers began to default on mortgage payments and the seeds of a
global financial crisis were sown.
The global crisis stemmed from the way in which debt was sold on to investors. The US banking sector
packaged sub-prime home loans into mortgage-backed securities known as collateralised debt
obligations (CDOs). These were sold on to hedge funds and investment banks that saw them as a

78 Business Analysis

good way of generating high returns. However when borrowers started to default on their loans, the
value of these investments plummeted, leading to huge losses by banks on a global scale.
In the UK, many banks had invested large sums of money in sub-prime backed investments and have
had to write off billions of pounds in losses. On 22 April 2008, the day after the Bank of England
unveiled a £50 billion bailout scheme to aid banks and ease the mortgage market, Royal Bank of
Scotland (RBS) admitted that loan losses hit £1.25 billion in just six weeks. In August 2008, RBS
reported a pre-tax loss of £691 million (after writing down £5.9 billion on investments hit by the credit
crunch) – one of the biggest losses in UK corporate history. At the beginning of 2009, RBS announced
that it expected to suffer a loss of up to £28 billion as a result of the credit crunch. On 3 March 2008, it
was reported that HSBC was writing off sub-prime loans at the rate of $51 million per day.
A number of critics went back to basics and highlighted lending by banks to customers who could not
supply sufficient assurance that they could repay debt. To quote Paul Moore, former Head of Group
C
Regulatory Risk at HBOS: H
A
'There must have been a very high risk if you lend money to people who have no jobs, no provable
P
income and no assets. If you lend that money to buy an asset which is worth the same or even less than T
the amount of the loan and secure that loan on the value of that asset purchased, and then assume that E
asset will always continue to rise in value, you must be pretty much close to delusional.' R

Some critics have focused on the doubtful quality of the CDOs and other investments. These products
appear to have been imperfectly understood by many in the financial sector. However they created
2
positions in the trading books of banks that were hugely vulnerable to shifts in confidence and liquidity.
Others have focused on the increasing complexity in the financial sector caused by the variety of the
securities sold. The 2009 Turner review highlighted a complex chain of relationships between multiple
institutions. However the results were that 'most of the risks (were still left) somewhere on the balance
sheets of banks but in a much more complex and less transparent fashion.' Turner also highlighted the
growth of the relative size of the financial sector, accompanied by very high growth in the debt and
leverage of financial institutions, which increased the impact of financial sector instability on the real
economy.
Other experts highlighted the role of governance. The 2009 Walker report commented that 'why
different banks operating in the same geography, in the same financial and market environment and
under the same regulatory arrangements generated such massively different outcomes can only be fully
explained in terms of differences in the way they were run.'
In June 2010 the Independent Commission on Banking in the UK (the Vickers Commission, chaired by
economist Sir John Vickers) was set up by the incoming Coalition government. It produced its final
report in September 2011. The report recommended that UK banks' domestic retail operations
(operations concerned with customer deposits, business lending and the transmission of money) should
be ring-fenced from their wholesale and investment operations. Retail banking activities should be
carried out by separate subsidiaries within banking groups, with the ring-fenced part of the bank having
its own board and being legally and operationally separate from the parent bank. Ring-fenced banks
should have a capital cushion of up to 20%.
Non-retail parts of banking groups should be allowed to fail. The report anticipated that this would
mean that their cost of capital went up. However the lack of guaranteed government support for
investment activities should mean that banks were less likely to take excessive risks in this area.
Banks were given until 2019 to implement these requirements fully, a period felt by some
commentators to be very lengthy. The time period was set to coincide with the international capital
requirements changes being introduced by the Basel regulators.

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

Business risk management 79

Case example: Tesco
Tesco has the following approach to interest rate and foreign currency risk management.
'Interest rate risk management – Our objective is to limit the impact to our profit and loss from rising
interest rates. Forward rate agreements, interest rate swaps, caps and floors may be used to achieve the
desired mix of fixed and floating rate debt.
'Our policy is to fix interest rates for the year on a minimum of 40% of actual and projected debt
interest costs of the Group excluding Tesco Bank. At the year-end the percentage of interest-bearing
debt at fixed rates was 75% (2012 90%). The remaining balance of our debt is in floating rate form.
'Foreign currency risk management – Our principal objective is to reduce the effect of exchange rate
volatility on operating margins. Transactional currency exposures……are managed, typically using
forward purchases or sales of foreign currencies and currency options…...we only hedge a proportion of
the investment in our international subsidiaries as well as ensuring that each subsidiary is appropriately
hedged in respect of its non-functional currency assets…'
Source: Tesco Annual Report and Financial Statements, 2013

2 Enterprise risk management

Section overview
 Enterprise risk management provides a coherent framework for organisations to deal with risk,
based on such components as internal environment, objective setting and event identification.
 The framework is designed to identify potential events that may affect the entity and manage risks
to be within its risk appetite.

2.1 Nature of enterprise risk management

Definition
Enterprise risk management is a process, effected by an entity's board of directors, management and
other personnel, applied in strategy setting and across the enterprise, designed to identify potential
events that may affect the entity and manage risks to be within its risk appetite, to provide reasonable
assurance regarding the achievement of entity objectives. COSO

The Committee of Sponsoring Organisations of the Treadway Commission (COSO) goes on to expand
its definition. It states that enterprise risk management has the following characteristics.
(a) It is a process, a means to an end, which should ideally be intertwined with existing operations
and exist for fundamental business reasons.
(b) It is operated by people at every level of the organisation and is not just paperwork. It provides a
mechanism helping people to understand risk, their responsibilities and levels of authority.
(c) It is applied in strategy setting, with management considering the risks in alternative strategies.
(d) It is applied across the enterprise. This means it takes into account activities at all levels of the
organisation from enterprise-level activities such as strategic planning and resource allocation, to
business unit activities and business processes. It includes taking an entity level portfolio view of
risk. Each unit manager assesses the risk for his unit. Senior management ultimately consider these
unit risks and also interrelated risks. Ultimately, they will assess whether the overall risk portfolio is
consistent with the organisation's risk appetite.

80 Business Analysis

(e) It is designed to identify events potentially affecting the entity and manage risk within its risk
appetite, the amount of risk it is prepared to accept in pursuit of value. The risk appetite should be
aligned with the desired return from a strategy.
(f) It provides reasonable assurance to an entity's management and board. Assurance can at best be
reasonable since risk relates to the uncertain future.
(g) It is geared to the achievement of objectives in a number of categories, including supporting the
organisation's mission, making effective and efficient use of the organisation's resources, ensuring
reporting is reliable, and complying with applicable laws and regulations.
Because these characteristics are broadly defined, they can be applied across different types of
organisations, industries and sectors. Whatever the organisation, the framework focuses on
achievement of objectives.
C
An approach based on objectives contrasts with a procedural approach based on rules, codes or H
procedures. A procedural approach aims to eliminate or control risk by requiring conformity with the A
rules. However, a procedural approach cannot eliminate the possibility of risks arising because of poor P
management decisions, human error, fraud or unforeseen circumstances arising. T
E
R

2.2 Framework of enterprise risk management
The COSO Framework consists of eight interrelated components. 2

 Objective setting
 Event identification
 Risk assessment
 Risk response
 Internal environment or control environment
 Control activities or procedures
 Information and communication
 Monitoring

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

Business risk management 81

2.3 Benefits of enterprise risk management
COSO highlights a number of advantages of adopting the process of enterprise risk management.

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

2.4 Risk architecture
In its 1999 report Enhancing Shareholder Wealth by Better Managing Business Risk the International
Federation of Accountants argued for the development of a risk architecture within which risk
management processes could be developed. The architecture involves designing and implementing
organisational structures, systems and processes to manage risk. This is a slightly different
framework to that of enterprise risk management.
IFAC argued that developing a risk architecture is not just a response to risk but marks an organisational
shift, changing the way the organisation:
 Organises itself
 Assigns accountability
 Builds risk management as a core competency
 Implements continuous, real-time risk management
Best practice, IFAC argued, is to develop a highly integrated approach to risk management, using a
common language, shared tools and techniques and periodic assessments of the risk profile for the
entire organisation. Integration is particularly important when most units have many risks in common,
and when there is significant interdependency between units. It is vital when managers are trying to
achieve a shared corporate vision.
The risk architecture developed by IFAC has eight components:
 Acceptance of a risk management framework
 Commitment from executives

82 Business Analysis

 Establishment of a risk response strategy
 Assignment of responsibility for risk management process
 Resourcing
 Communication and training
 Reinforcing risk cultures through human resources mechanisms
 Monitoring of the risk management process
IFAC identified four components of risk management:
 Structure to facilitate the identification and communication of risk
 Resources – sufficient to support implementation
 Culture – reinforcing decision-making processes
 Tools and techniques developed to enable organisation-wide management of risk
C
H
2.5 The Turnbull report A
P
The Turnbull report (published 1999, revised 2005) aims to provide guidance on risk management and T
control systems to supplement the broad outlines set out in the Combined Code (now the UK E
R
Corporate Governance Code). Turnbull emphasises the importance of the evolution of a system of
internal control to take account of new and emerging risks, control failures, market expectations or
changes in the company's circumstances or business objectives. Evolution requires regular and
systematic assessment of the risks facing the business. 2

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

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

Business risk management 83

3. The chief executive must consider in particular the risk and control environment. the board's role in 'setting the tone' and demonstrating clearly that they respect the need for effective control systems is a very important part of risk management.  Different board committees are appropriate for different industries. the Financial Reporting Council undertook a review of how boards were approaching their responsibilities. focusing amongst other things on how his or her example promotes a good culture. This includes respecting the need for separation of duties between managers carrying out executive duties.1 Review of board's role Following on from the revisions to UK corporate guidance in 2010. As well as explicit responsibilities. A risk committee is appropriate for companies in the financial sector and separate committees are commonly used by companies in the pharmaceutical and extractive industries.' Ownership of the risk management and internal control system is a vital part of the chief executive's overall responsibility for the company.  The Turnbull report stresses the importance of embedding risk management and control systems within business processes.  The board's risk committee and the risk management function are also key players in managing risk. The decision on appropriate committee structure should be left to individual boards rather than making a risk committee compulsory for everyone. but this did not necessarily mean less risk taking as risk taking is essential to entrepreneurship.  There are various methods that can be used to promote awareness of risk and control issues within a company. 84 Business Analysis . The chief executive should also monitor other directors and senior staff. with a view perhaps to revising the Turnbull guidance originally published in 1999. The main points arising from the consultation included the following:  Boards should aim for better risk taking. the board must oversee its establishment.  Consideration of risk issues should be an integral part of board agendas. The consultation found that boards' focus on risk had changed significantly over the last decade and the approaches and techniques that they used were developing rapidly. particularly those whose actions can put the company at significant risk. 3 Risk management and control systems Section overview  This section discusses the underlying features of risk and control systems.1 Board responsibilities If effective risk management is to be embedded within a company. environmental or regulatory risks. which are exposed to significant safety. The board should consider on a regular basis:  The nature and extent of the risks facing the company  The extent and categories of acceptable risks  The likelihood of the risks materialising  The company's ability to reduce the incidence and impact of risks that do materialise  The costs of operating particular controls versus their benefits The Walker report in 2009 highlighted that the monitoring role of the board in financial sector institutions was particularly important because of the speed and scale of change in this sector: 'The whole board needs to be attentive to developments in the risk space to a degree far exceeding that in non-financial business. and non-executive directors and staff responsible for monitoring them. Examples in these industries include compliance committees and corporate responsibility committees.1. 3.

Boards need to have robust crisis management plans. (b) As a key role of the audit committee will be to liaise with the external auditors. C H  Organisations need transparency and clear lines of reporting and accountability. Investors also want to know how E R companies' exposure to risk is changing. to the UK House of Commons' Treasury Select Committee.' 3. If the board doesn't have a separate committee. strategy. There is no doubt that you can have the best governance processes in the world but if they are carried out in a culture of greed. the FSA.  Boards need to focus on individual risks capable of undermining the strategy or long-term viability of the company or damaging its reputation. Morris in An Accountant's Guide to Risk Management suggests that written terms of reference might include the following:  Approving the organisation's risk management strategy and risk management policy. non-executive Chairmen and Directors. with responsibility for monitoring and supervising risk identification and management. However if there are doubts about the competence and good faith of executive management. before risk management policies are implemented. whereas an audit committee will have a purely monitoring role. risk. Business risk management 85 .  Responsibility for monitoring internal controls and risk management could be delegated to board committees. much of their time could be focused on financial risks.  Boards should not just focus on net or residual risk. for example an integrated T discussion of business model. compliance and internal audit. it will be more appropriate for the risk committee to be staffed by non-executive directors. Consideration of risk certainly falls within the remit of the audit committee. shareholders and politicians. However there are a number of arguments in favour of having a separate risk committee. whereas an audit committee under corporate governance best practice should be staffed by non-executive directors.  Reviewing reports on key risks prepared by business operating units. (a) A risk management committee can be staffed by executive directors. Reputation risk requires greater attention. management and the board. unethical behaviour and indisposition to challenge they will fail. checking that a satisfactory risk management policy exists.2 Risk committee Boards also need to consider whether there should be a separate board committee. but the whole board should retain strategic responsibility for risk decision-taking.  Monitoring overall exposure to risk and ensuring it remains within limits set by the board. partly because failures can be publicised widely and quickly in the global information environment.  It could be difficult to decide how much information about risks boards need. but need to understand exposure to the combination of risks faced. former head of the group regulatory risk at HBOS. A P  Investors are increasingly seeking more meaningful reporting on risk. under the UK Corporate Governance Code the audit committee will be responsible for risk management. (c) A risk committee can take the lead in driving changes in practice. and in particular when a particular risk should be brought to the board's attention. key risks and mitigation. external auditors. Boards need to understand how risk exposure might change as a result of changes in strategy and the operating environment. Moore commented: 'There has been a completely inadequate “separation” and “balance of powers” between the executive and all those accountable for overseeing their actions and “reining them in” ie internal control functions such as finance. Case example: HBOS 2 The issue of separation of duties was highlighted in February 2009 by the testimony of Paul Moore.

He will ensure that the client understands what safety measures are required and he will see that they are put into practice. and the establishment of a supportive risk culture. 3. They frequently employ agents to help manage some of their risks. the company's Risk Working Group. interest rate and currency risk. ownership and actions. takes an active role in overseeing the most significant risks to IHG. The committee should have a majority of non-executive directors.  Providing early warning to the board on emerging risk issues and significant changes in the company's exposure to risks. before final presentation to the audit committee and Board. A variety of measures should be used. Case example: Intercontinental Hotel Group (IHG) The board of IHG has of course.1 Risk committees in the financial sector The Walker report recommended that FTSE-100 bank or life insurance companies should establish a risk committee. Reasons for this recommendation included the need to avoid over-burdening the audit committee. risk management and internal control and reviewing their effectiveness. and perhaps specialist risk management personnel. The risk committee should also advise the remuneration committee on risk weightings to be applied to performance objectives incorporated within the incentive structure for executive directors. A specialist advising on management of personal risks can work only as well as the client allows. 3. prior to endorsement by the board. reviewing the company's statement on internal control with reference to risk management. A good specialist will ask for information and for co-operation with the expert surveys that enable him to provide a proper service.  Assessing the effectiveness of the organisation's risk management systems. 86 Business Analysis . Major risks are discussed to gain agreement on the risk descriptions. The application of risk management policies will then be the responsibility of operational managers. and to draw a distinction between the largely backward looking focus of the audit committee. credit/counterparty risks and other market risks. Note that the focus is on supervision and monitoring rather than the committee having responsibility for implementation of policies. The audit committee carries out an annual review of the risk management system. Risk Management and Internal Audit. to ensure these risks are appropriately managed and emerging risks are identified. ultimate responsibility for the group's strategy. liquidity risk.  In conjunction with the audit committee. and the need for forward-looking focus of determining risk appetite and from this monitoring appropriate limits on exposures and concentrations. The Risk Working Group monitors changes to the major risks and the progress of actions on a quarterly basis. Risks identified in the regions and corporate functions are consolidated.3. refined and calibrated against a strategic view of risks by the Risk Working Group.3 Risk management personnel 3. still less for searching the market for the most suitable insurances. Walker recommended that the committee should concentrate on the fundamental prudential risks for the institution: leverage. Having a separate risk committee can aid the board in its responsibility for ensuring that adequate risk management systems are in place. It should advise the board on current risk exposures and future risk strategy. Any executive risk committee should be overseen by the board risk committee.2.1 Risk specialists Most individuals have little time for looking after their personal safety and security. In addition. which is chaired by the Company Secretary and comprises the Global Heads of Strategy. The committee should regularly review and approve the measures and methodology used to assess risk.

3.3.2 Risk manager
The risk manager will need technical skills in credit, market, and operational risk. Leadership and
persuasive skills are likely to be necessary to overcome resistance from those who believe that risk
management is an attempt to stifle initiative.
Lam (Enterprise Risk Management) includes a detailed description of this role, and the COSO framework
also has a list of responsibilities. Combining these sources we can say that the risk manager is typically
responsible for:
(a) Providing the overall leadership, vision and direction for enterprise risk management.

(b) Establishing an integrated risk management framework for all aspects of risk across the
organisation, integrating enterprise risk management with other business planning and
management activities and framing authority and accountability for enterprise risk management in C
business units. H
A
(c) Promoting an enterprise risk management competence throughout the entity, including P
facilitating development of technical enterprise risk management expertise, helping managers align T
E
risk responses with the entity's risk tolerances and developing appropriate controls.
R
(d) Developing risk management policies, including the quantification of management's risk appetite
through specific risk limits, defining roles and responsibilities, ensuring compliance with codes,
regulations and statutes and participating in setting goals for implementation. 2

(e) Establishing a common risk management language that includes common measures around
likelihood and impact, and common risk categories. Developing the analytical systems and data
management capabilities to support the risk management programme.

(f) Implementing a set of risk indicators and reports including losses and incidents, key risk
exposures, and early warning indicators. Facilitating managers' development of reporting
protocols, including quantitative and qualitative thresholds, and monitoring the reporting process.

(g) Dealing with insurance companies: an important task because of increased premium costs,
restrictions in the cover available (will the risks be excluded from cover) and the need for
negotiations with insurance companies if claims arise. If insurers require it demonstrating that the
organisation is taking steps actively to manage its risks. Arranging financing schemes such as self-
insurance or captive insurance.

(h) Allocating economic capital to business activities based on risk, and optimising the company's
risk portfolio through business activities and risk transfer strategies.

(i) Reporting to the chief executive on progress and recommending action as needed.
Communicating the company's risk profile to key stakeholders such as the board of directors,
regulators, stock analysts, rating agencies and business partners.
The risk manager's contribution will be judged by how much he increases the value of the organisation.
The specialist knowledge a risk manager has should allow the risk manager to assess long-term risk and
hazard outcomes and therefore decide what resources should be allocated to combating risk.
Clearly certain strategic risks are likely to have the biggest impact on corporate value. Therefore a risk
manager's role may include management of these strategic risks. These may include those having a
fundamental effect on future operations such as mergers and acquisitions or risks that have the potential
to cause large adverse impacts such as currency hedging and major investments. In financial institutions
the Walker report highlighted the assessment of whether product launches or the pricing of risk in a
particular transaction was consistent with the risk tolerance determined by the risk committee.
The Walker report stressed the need for provisions enhancing the independence of the chief risk officer,
for example rights of access to the chairman of the risk committee and removal from office to require
the agreement of the whole board.
Walker highlighted the need for effective reporting. The risk committee's report should be a separate
report in the annual accounts and include details of risk exposures and risk appetite for banking and
trading exposures, and the effectiveness of the risk management process. Some detail should be given
of the stress-testing of risk.

Business risk management 87

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

3.3.3 Risk management function
Larger companies may have a bigger risk management function whose responsibilities are wider than a
single risk manager or risk specialist. The Institute of Risk Management's Risk Management standard lists
the main responsibilities of the risk management function:
 Setting policy and strategy for risk management

 Primary champion of risk management at a strategic and operational level

 Building a risk aware culture within the organisation including appropriate education

 Establishing internal risk policy and structures for business units

 Designing and reviewing processes for risk management

 Coordinating the various functional activities which advise on risk management issues within an
organisation

 Developing risk response processes, including contingency and business continuity programmes

 Preparing reports on risks for the board and stakeholders

3.4 Procedures for embedding risk
Employees cannot be expected to avoid risks if they are not aware that they exist in the first place.
Embedding a risk management frame of mind into an organisation's culture requires top-down
communications on what the risk philosophy is and what is expected of the organisation's employees.

88 Business Analysis

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

3.4.1 Human resource procedures
The COSO framework also recommends certain organisational measures for spreading ownership of risk
management.
(a) Enterprise risk management should be an explicit or implicit part of everyone's job description.
(b) Personnel should understand the need to resist pressure from superiors to participate in improper
activities, and channels outside normal reporting lines should be available to permit reporting such
circumstances.
(c) Managers should provide appropriate incentives. This may entail setting performance targets and
tying results to performance pay.

3.4.2 Training
Aside from practical matters like showing employees which buttons to press or how to find out the
information they need, training should include explanation of why things should be done in the way
that the trainer recommends. If employees are asked to carry out a new type of check but are not told
why there is every chance that they won't bother to do it, because they don't understand its relevance.
It just seems to mean more work for them and to slow up the process for everyone.

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

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

Business risk management 89

3.5 Control systems
The Turnbull report emphasises the importance of control systems in effectively managing risks. The
report provides a helpful summary of the main purposes of an internal control system.
Turnbull comments that internal control consists of 'the policies, processes, tasks, behaviours and other
aspects of a company that taken together:
(a) Facilitate its effective and efficient operation by enabling it to respond appropriately to significant
business, operational, financial, compliance and other risks to achieving the company's objectives.
This includes the safeguarding of assets from inappropriate use or from loss and fraud and ensuring
that liabilities are identified and managed.
(b) Help ensure the quality of internal and external reporting. This requires the maintenance of proper
records and processes that generate a flow of timely, relevant and reliable information from within
and without the organisation.
(c) Help ensure compliance with applicable laws and regulations, and also with internal policies with
respect to the conduct of business.
The Turnbull report also summarises the key characteristics of the internal control systems. They should:
 Be embedded in the operations of the company and form part of its culture.
 Be capable of responding quickly to evolving risks within the business.
 Include procedures for reporting immediately to management significant control failings and
weaknesses together with control action being taken.
The system should include control activities, information and communication processes and processes
for monitoring the continued effectiveness of the system of internal control.
The Turnbull report goes on to say that a sound system of internal control reduces but does not
eliminate the possibilities of losses arising from poorly-judged decisions, human error, deliberate
circumvention of controls, management override of controls and unforeseeable circumstances. Systems
will provide reasonable (not absolute) assurance that the company will not be hindered in achieving its
business objectives and in the orderly and legitimate conduct of its business, but won't provide certain
protection against all possible problems.

4 The risk management process

Section overview
 This section introduces a commonly used framework for assessing and managing risk.
 The individual steps in the process will be discussed in detail in following sections.

Another commonly used framework for assessing and managing risk involves the following processes.
 Establishing the context
 Risk identification
 Risk assessment
 Risk profiling
 Risk quantification
 Risk responses
 Implementation of plans
We will consider these processes in the next few sections. In real life, none of these processes are easy –
what is considered to be a risk by some might not be seen as such by others which can lead to disputes
over which risks should be given priority. Quantification of an item that is essentially subjective is never
going to be straightforward – in itself, putting a value on different risks is a subjective process.

90 Business Analysis

5 Establishing the context

Section overview
 This is the first stage in the risk management process.
 This step includes establishing both the internal and external contexts, the risk criteria and the
structure for risk analysis.
 By performing this step, you are laying the foundations on which the entire risk management
process is based.

Before any risk can actually be identified, you have to establish the context within which risk will be C
assessed – that is, you have to determine the domain within which assessment will take place. For H
example, management may only be interested in identifying financial risks, which means that those A
P
responsible for gathering information will concentrate on that area of risk only.
T
E
5.1 Establish the internal context R
Risk is essentially the chance that an event will occur that will prevent the company from meeting its
objectives. Therefore, in order to understand the risks, you must first identify the objectives. By doing
so you will ensure that decisions taken to reduce risk still support the overall goals of the organisation 2
which encourages long-term and strategic thinking.

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

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

Business risk management 91

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

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

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

5.5 Define the structure for risk analysis
The final stage in the establishment of context is to define the structure for risk analysis. This involves
isolating the risk categories that need to be managed, which can then be assessed individually. This will
allow for greater depth and accuracy when identifying important risks.

6 Risk identification

Section overview
 Before being able to establish risk management processes, you must identify the risks that your
organisation actually faces.
 Some risks may be familiar to the organisation; others may not.
 This step is a continuous process; as the business environment changes, so do the risks faced by
organisations operating in that environment.

No-one can manage a risk without first being aware that it exists. Some knowledge of perils, what items
they can affect and how, is helpful to improve awareness of whether familiar risks (potential sources
and causes of loss) are present, and the extent to which they could harm a particular person or
organisation. The risk manager should also keep an eye open for unfamiliar risks which may be present.

92 Business Analysis

Actively identifying the risks before they crystallise makes it easier to think of methods that can be used
to manage them.
Risk identification is a continuous process, so that new risks and changes affecting existing risks may be
identified quickly and dealt with appropriately, before they can cause unacceptable losses.

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

6.2 Event identification
A key aspect of risk identification, emphasised by the Committee of Sponsoring Organisations of the
Treadway Commission's report Enterprise Risk Management Framework, is identification of events that
could impact upon implementation of strategy or achievement of objectives.
Events analysis includes identification of:
(a) External events such as economic changes, political developments or technological advances.
(b) Internal events such as equipment problems, human error or difficulties with products.
(c) Leading event indicators. By monitoring data correlated to events, organisations identify the
existence of conditions that could give rise to an event, for example customers who have balances
outstanding beyond a certain length of time being very likely to default on those balances.
(d) Trends and root causes. Once these have been identified, management may find that assessment
and treatment of causes is a more effective solution than acting on individual events once they
occur.
(e) Escalation triggers, certain events happening or levels being reached that require immediate
action.
(f) Event interdependencies, identifying how one event can trigger another and how events can
occur concurrently. For example, a decision to defer investment in an improved distribution system
might mean that downtime increases and operating costs go up.
Once events have been identified, they can be classified horizontally across the whole organisation and
vertically within operating units. By doing this management can gain a better understanding of the
interrelationships between events, gaining enhanced information as a basis for risk assessment.

7 Risk assessment

Section overview
 The fundamental difficulty in assessing risk is determining how often this particular risk may occur.
Statistical information is not available on all manner of past incidents.
 The financial benefits of risk management are dependent on how and the frequency with which
risk assessment is performed.

Business risk management 93

It is not always simple to forecast the financial effect of a possible disaster, as it is not until after a loss
that extra expenses, inconveniences and loss of time can be recognised. Even then it can be difficult to
identify all of them.
Organisations will probably keep more detailed records of their activities and the unit costs involved, but
it is unlikely that any organisation can predict the full cost of every loss that might befall it with
certainty.

8 Risk profiling

Section overview
 It is important for organisations to group risks according to their likelihood and potential impact.
 This process is very useful when setting priorities for putting risk mitigation processes in place.

This stage involves using the results of a risk assessment to group risks into risk families. One way of
doing this is a likelihood/consequences matrix.

Consequences
Low High
Loss of suppliers Loss of senior or specialist
staff
Low Loss of sales to competitor
Loss of sales due to
Likelihood

macroeconomic factors
Loss of lower-level staff Loss of key customers
Failure of computer systems
High

This profile can then be used to set priorities for risk mitigation.

9 Risk quantification and consolidation

Section overview
 The quantification of risk is necessary to estimate how much the organisation stands to lose in the
event of a particular risk occurring.
 For physical assets, quantification is often fairly straightforward; however exposure of financial and
intangible assets is more difficult to put a monetary figure on.
 The individual risks that have been identified in different parts of the business must be
consolidated (ie aggregated) to establish the risk at the corporate level.

Risks that require more analysis can be quantified, where possible results or losses and probabilities are
calculated and distributions or confidence limits added on. From this exercise is derived the following
key data.
 Average or expected result or loss
 Frequency of losses
 Chances of losses
 Largest predictable loss

94 Business Analysis

to which the organisation could be exposed by a particular risk. The risk manager must also be able to
estimate the effects of each possible cause of loss, as some of the effects that he needs to consider may
not be insured against.
The likely frequency of losses from any particular cause can be predicted with some degree of
confidence, from studying available records. This confidence margin can be improved by including the
likely effects of changed circumstances in the calculation, once they are identified and quantified. Risk
managers must therefore be aware of the possibility of the increase of an existing risk, or the
introduction of a new risk, affecting the probability and/or possible frequency of losses from another
cause.
Often quantification of losses will not involve statistical techniques, but a simple single estimate of what
would be lost if adverse events or circumstances occur. For example, if an accountancy firm had a client
that generated a fixed fee each year, the loss would be the contribution (fees lost less labour and other
C
variable costs saved). H
A
Ultimately the risk manager will need to know the frequency and magnitude of losses that could place
P
the organisation in serious difficulty. T
E
R
9.1 Exposure of physical assets
Exposures with physical assets may include:
2
 Total value of the assets, for example the value of items stolen from a safe.
 Costs of repair, if for example an accident occurs.
 Change of value of an asset, for example property depreciating in value because of a new airport
development nearby.
 Decrease in revenues, for example loss of rent through a rental property being unlettable for a
period.
 Costs of unused capacity, costs incurred by spare capacity that is taken as a precaution but does
not end up being used.

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

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

Business risk management 95

could be the future value of their expected income stream.4 Risk consolidation Risk that has been analysed or quantified at the division or subsidiary level needs to be aggregated at the corporate level and grouped into categories.2 Key persons Certain individuals may make a significant contribution to the office because of their knowledge.1 Death or serious injury The most severe risk to employees is the risk of death or serious injury.3 Business discontinuation losses If a director. Once risks have been identified. The loss to the employee's family. partner or senior employee dies or departs. the ways in which they respond to these risks can differ significantly. The process of risk categorisation also enables the risks categorised together to be managed by the use of common control systems. 96 Business Analysis . 9. 9. 9.3 Exposure of human assets 9. retention and transfer. Alternatively it could be measured by the expenditure required to fulfil the needs of the deceased's dependent family. including even the costs of dissolution if local law requires termination of a partnership on the departure of a single partner. for example loss of any available tax allowance. transfer and acceptance. decisions must be taken as to how to respond to these risks. 10 Risk responses Section overview  Although organisations operating in the same industry may face similar risks. assessed and quantified. mitigated by any benefits available but enhanced by other losses that arise as a result of death.3. reduction. skills or business contacts. 9. for which the organisation may be liable. For less serious injuries.  Risk responses depend on such factors as the potential impact of the risk on the organisation and management's attitude towards risk.3. the costs of medical care may be the relevant figure. This aggregation will be required as part of the overall review of risk that the board needs to undertake. Risk response can be linked into the likelihood/consequences matrix and also the organisation's appetite for risk-taking. there may be costs of having to cope with the disruption. Indirect costs may include the effect on other staff of the loss of the key person (decreased productivity or indeed the costs of their own departure). reduction. Methods of dealing with risk include avoidance.3.  The four main responses to risk are: avoidance. One measure of this loss will be the present value of the individual's contribution (attributable earnings less remuneration).

Reduction of severity of risk will of dealing with risks unlikely minimise insurance premiums. 10. The process has three basic constituents. where the risks of launching a new product can be reduced by market research. Although Toyota's actions aimed to resolve the risks to health and safety. advertising and so on.1 Contingency planning Contingency planning involves identifying the post-loss needs of the business. The group has developed data rights management standards and monitoring programs. Case example: Pearson Pearson highlights the risks to its intellectual property and proprietary rights as potential major constraints on its ability to grow. Likelihood Reduce or manage Avoid or control Take some action. Commentators highlighted an initial reluctance to admit the problem and poor communication of what it intended to do to regain control of the situation. The impact threatened car sales and share price. Pearson also monitors in each market developments in copyright and intellectual property law. Business risk management 97 . Pearson seeks to mitigate these risks through general vigilance.2 Reduction of risk Often risks can be avoided in part. eg frequency of losses. co- operation with other publishers and trade associations. and has established a piracy task force to identify weaknesses and remediate breaches. insurance. Insure risk or implement contingency Low Keep under review. Take immediate action to reduce High insurance to deal with severity and frequency of losses. P T E 10. but costs plans.1 Avoidance of risk R Organisations will often consider whether risk can be avoided and if so whether avoidance is desirable – that is. Sales of a number of models were suspended in the USA. advances in technology and taking legal action. Other risk reduction measures include contingency planning and loss control. will the possible savings from losses avoided be greater than the advantages that can be gained by not taking any measures and running the risk? 2 An extreme form of avoiding business risk is terminating operations altogether – for example. Consequences Low High Accept or absorb Transfer Risks are not significant.2. operations in politically volatile countries where the risks of loss (including loss of life) are considered to be too great or the costs of security too high. This is true of many business risks. 10. eg self. drawing up plans in advance and reviewing them regularly to take account of changes in the business. or reduced. to be worth the benefits. with investors reluctant to hold Toyota shares because of the level of uncertainties involved. Case example: Toyota Toyota responded to concerns over the safety of its cars by recalling millions of models worldwide during 2009 and 2010. charging higher prices to C H customers or ultimately abandoning A activities. but not avoided altogether. it may have been less effective in mitigating the risks to its reputation.

A full-scale test may not always be possible.2. 10. for example. to discourage people from taking similar decisions in the future. up to a point. Such exercises are vital to test the way in which. it will suffer the full loss. using hundreds of 'extras' to play the parts of injured members of the public. The decision of whether to retain or transfer risks depends firstly on whether there is anyone to transfer a risk to. risks can be transferred – to other internal departments or externally to suppliers. the emergency services will deal with terrorist attacks. because:  Individuals have more small risks than do organisations and the administrative costs of transferring and carrying them can make the exercise impractical for the insurer. because rectification could be as expensive as paying any claims from disgruntled customers. Usually held at weekends.3 Accepting risks Risk acceptance or retention is where the organisation bears the risk itself. the London emergency services have held regular simulation exercises of how they would react in an emergency situation. 98 Business Analysis . fire extinguishers. 10. 10. It is not enough however to install such devices. Every person in the business should be made aware that losses are possible and that they can be controlled. and if an unfavourable outcome occurs. Practice Unless the plan has been tested there is no guarantee that it will work. and how quickly. Information How. and individuals do not. escape stairways. there will always be some unexpected risk. burglar alarms and machine guards are obvious examples. The answer is more likely to be 'no' for an individual than for an organisation. Case example: London emergency services Before and since the London bombings in 2005. is in fact a decision to transfer the risk to the customers without their knowledge: it may not take into account the possibility of courts awarding exemplary damages to someone injured by the product.4 Transfer of risk Alternatively. organisations usually have customers to pass their risks or losses to. They will need to be inspected and maintained regularly. and  The individual has smaller resources to find a carrier. A decision not to rectify the design of a product. Responsibilities The plan should lay down what is to be done by whom. Risk transfer can even be to the State. Decisions to transfer risk should not be made without careful checking to ensure that as many influencing factors as possible have been included in the assessment. Other reasons for risk retention are that the risk is considered to be insignificant or the cost of avoiding the risk is considered to be too great compared with the potential loss that could be incurred. In the last resort.  The key psychological factors are awareness and commitment. Risk retention is inevitable to some extent. customers or insurers. these simulation exercises often take place in tube stations. do you turn off the sprinklers once the fire is extinguished? All the information that will need to be available during and after the event should be gathered in advance.2 Loss control Control of losses also requires careful advance planning. however. simulations. However good the organisation's risk identification and assessment processes are. Sprinklers. There are two main aspects to good loss control: the physical and the psychological. should be as realistic as possible and should be taken seriously by all involved.  There are many physical devices that can be installed to minimise losses when harmful events actually occur.

10. Internal risk transfer can also cause problems if it is away from departments with more 'clout' (for example.4. Although the company is profitable.2 Limitation of liability Some contracts. Requirement Assess the risks associated with the decision to outsource to the Far East. the first in the 25 year history of the company. C H 10.4.4. and briefly recommend ways in which these risks can be controlled.1 Hold harmless agreements A hold harmless agreement is an agreement between two or more parties defining an obligation to make good the liability. Examples are contracts for carriage of passengers or goods by air or sea.4. for R example. in which one party accepts strict liability up to a set limit. 10. follow very ancient customs. that may be presumed to downplay risks excessively. and the company has a reputation for being a good employer with specific focus on maintaining and enhancing benefits for its employees. This depends on the trading relationship between the firms concerned. loss or damage incurred. Risk-sharing arrangements can be very significant in business strategy. and how great is your need for the item? 10. the recent management accounts show falling margins with the possibility of a loss being made next year. See Answer at the end of this chapter. An example is an insurance policy. The main reasons for the falling profits have been identified as increasing competition from manufacturers in the Far East. 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 administration and marketing functions would remain at their current location. Movement of production systems to the Far East is seen as a particular problem for VSYS. sales) and towards departments. Business risk management 99 . About 20% of the working population are employed at VSYS.4 Risk sharing 2 Risks can be partly held and partly transferred to someone else. each participant's risk can be limited to what it is prepared to bear. the Board is confident that the move will be successful and looks forward to a positive response from workers and shareholders. E and not a little on economics: how many suppliers could supply the item or service in question. or liability which is wider than the law would normally impose.3 Legal and other restrictions on transferring risks A P The first restriction is that a supplier or customer may refuse to enter a contract unless your organisation T agrees to take a particular risk. For example. 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. where the insurer pays any losses incurred by the policyholder above a certain amount. 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. in a joint venture arrangement. and ongoing quality control issues with several key manufacturers. such as finance.

This step should be ongoing. Requirement Identify potential risk strategies that could be adopted by the airline's management. The implementation process helps to ensure that you get the best risk protection for the amount invested in the risk and other management processes. if some turn out well others will turn out badly. clear planning. 10.  Implementation should be treated as a separate project with clear objectives and success criteria. One means of diversification may be geographical diversification across countries at different stages of the trade cycle. What an organisation has to do is to avoid having all its risks positively correlated which means that everything will turn out extremely well or extremely badly. In addition. The implementation process focuses on the process itself rather than the risks of a particular project. See Answer at the end of this chapter. Market research has shown that despite these problems there is considerable demand for low cost flights to this country. the company may have insufficient expertise in the product or geographical markets into which it diversifies and it may be vulnerable to competition from other companies that focus on a specific market or product type. Case example: Tesco – Principal risks In the Corporate governance section of its 2013 Annual Report and Financial Statements. or if strategic direction is not effectively communicated or implemented. 11 Implementation of plans Section overview  Once risks have been identified. Risk pooling or diversification involves creating a portfolio of different risks based on a number of events. Organisations need to treat the implementation stage as a separate project with clear objectives and success criteria. assessed and quantified. and the average outcome will be neutral. focusing on the performance of the risk management process and the way in which it is integrated with other processes relevant to the project in question. The principal risks identified are: Business strategy risk – if the Group follows the wrong direction. where public spending on such facilities as airports is often withdrawn without warning. the business may suffer. although diversification may sound good in theory. which. There is also a history of foreign planes being grounded for no apparent reason and being forbidden to leave the country for several days. 100 Business Analysis . You may remember that portfolio theory is an important part of an organisation's financial strategy. but its principles can be applied to non-financial risks as well. 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. proper resourcing and effective monitoring and control. Tesco provides a summary of the principal risks it faces.5 Risk pooling and diversification Risk pooling and diversification involves using portfolio theory to manage risks. Implementation of the risk management process helps to clarify what ongoing actions should be taken beyond the planning stage to ensure that the process is implemented in a manner that is beneficial to the management team. and the approaches to risk have been decided. and for each risk it identifies key controls and mitigating factors. the task of putting the plans into action begins.

could have an impact on staff and customer safety. customers and employees increases. or to manage interest or exchange rate fluctuations could limit the Group's ability to trade profitably. and political developments relevant to domestic trade and the retail sector. Business continuity and crisis management – A major incident. challenges may arise in relation to finding suitable sites. Source: Tesco Annual Report and Financial Statements. Competition and consolidation risk – failure to compete on areas including price. The consolidation of competitors. Failure to invest appropriately in IT could increase its vulnerability to attack. IT systems and infrastructure – Any significant failure in the IT processes of Tesco's retail operations would impact its ability to trade. quality and service in increasing UK and overseas retail markets could impact on the Group's market share and adversely affect its financial results. and could therefore affect the Group's ability to recruit and retain good staff. a decline in customer base. Tesco Bank – the impact on the Group of financial risks taken by Tesco Bank. and credit risk. Tesco's financial risks are separately identified as: funding and liquidity. with the right capabilities at all levels could limit the Group's ability to succeed. Reputational risk – Failure to protect the Group's reputation and brand in the face of ethical. R Economic risks – In each country where it operates. interest rate risk. Group Treasury – Failure to ensure the availability of funds to meet the needs of the business. compliance and internal controls – As the business develops new platforms and grows both in size and geographical scope. foreign currency risk. Fraud. or activism. affecting Tesco's customer base and therefore financial results. retain. and fail to safeguard personnel. constrain the growth of the business. Product safety – Failures to ensure product safety could damage customer trust and confidence. 2013 Business risk management 101 . and that business fails to meet the stated strategy. legal and moral challenges could lead to a loss of trust and confidence. People – Failure to attract. key geographical areas or markets through mergers or trade agreements could also adversely affect Tesco's market share. or the Group's ability to trade. Pensions – The Group's IAS 19 deficit could increase if there is a fall in corporate bond yields which is not offset by an increase in the pension scheme's assets. Tesco could be affected by legal and regulatory changes.Financial strategy risk – risks relate to an incorrect or unclear financial strategy and the failure to achieve financial plans. T obtaining planning or other consents. the potential for fraud and dishonest activity by our suppliers. develop and motivate the best people. H A Property risk – Continuing acquisition and development of property sites carries inherent risk. supplier or customer data. product range. 2 Political and regulatory risks – In each country in which it operates. There are also risks of legal and regulatory changes introducing more burdensome requirements. and compliance with design and construction standards in E different countries. increased scrutiny by competition authorities. Tesco is affected by the underlying economic environment and the fiscal measures which apply to the retail sector. targets to P deliver new space may not be achieved. Performance risk in the business – Risk that business units underperform against plan and against C competitors.

where expected and actual results are compared and recommendations made for any remedial action to be taken. evaluating and managing them.  The effectiveness of the management and internal control systems in the management of risk. Once the standards and benchmarks have been established.  Whether the results indicate that internal control should be monitored more extensively. Risk monitoring is a continuous process. otherwise the process would never be completed.1 Monitoring of risk management plans All risk management plans must be monitored to ensure that they are achieving the desired results and that changes to the project's risk profile are reflected. 12. Turnbull suggests that boards should regularly receive and review reports and information on internal control. risk management monitoring does not take place only on an annual basis. 102 Business Analysis . To assess the effectiveness of risk management plans. in particular how risks are monitored and how any weaknesses have been dealt with.  This step can be thought of as an audit of the overall risk management process. 12. In order to determine when adjustments to performance should take place.  Just because risk management procedures are in place does not mean that companies are immune from the effects of risk – such procedures may reduce the impacts of risk but will not eliminate them completely. Various tests will be carried out to determine whether individual controls are working properly and recommendations made in the light of results. you need to establish standards and benchmarks against which results should be measured. 12 Risk monitoring and control Section overview  The risk management process is an on-going one – risks must be continually monitored to determine any change in profile which may lead to procedures to control these risks being altered. the board needs to have procedures in place for reviewing the effectiveness of systems taken as a whole. Standards can come from such sources as industry regulations or the industry leader. Managers and stakeholders in the risk management process should consider such areas as:  How successful was the plan and were the benefits and costs at the predicted level?  In the light of the above. the risk management plan can be measured continually against them over time to allow actual performance to be compared with expected performance which in turn can be used to adjust below-standard results.  It is important to know when sufficient risk management procedures are in place.  Whether actions are being taken to reduce the risks found. However. are any changes needed to improve the plan?  Would the plan have benefited from the availability of additional information? You can think of risk monitoring as being similar to an audit of the risk management process. unlike auditing. evaluation of risk management plans is essential to ensure they are performing to expectations. Risk management is a continuous process and those responsible for handling risk should be prepared to treat it as such.2 Board monitoring of control systems As well as monitoring specific plans. concentrating on:  What the risks are and strategies for identifying. you should establish a threshold (or 'trigger point') which represents a sufficient change in risk exposure to warrant another risk analysis being carried out. As with any process.

and the company's ability to respond to changes in its business environment. C H  The effectiveness of the public reporting processes. A P T Case example: Basel Committee E R Since 1974 the Basel Committee on Banking Supervision has made important recommendations affecting risk management and internal controls operated by banks.  Significant controls.  The extent and frequency of reports to the board.In addition. or consideration of the need for an internal audit function if the company does not have one. in particular it should cover:  The changes since the last assessment in risks faced. The Committee stressed the importance of banks having an operational risk management function that develops strategies. Banks' risk assessment systems (including the internal validation processes) must be subject to regular review by external auditors and/or supervisors. The regular review of the overall risk management process should cover:  The adequacy of the documentation of the risk management system and process  The organisation of the risk control unit  The integration of counterparty credit risk measures into daily risk management  The approval process for counterparty credit risk models  The validation of any significant change in the risk measurement process  The scope of counterparty credit risks captured by the risk measurement model  The integrity of the management information system  The accuracy and completeness of position data  The verification of the consistency. timeliness and reliability of data sources used to run internal models. It is particularly important for banks to establish and maintain adequate systems and controls sufficient to give management and supervisors the confidence that their valuation estimates are prudent and reliable. The board or senior management should understand and approve control systems such as credit rating systems. The Committee highlighted the need for boards to treat the analysis of a bank's current and future capital requirements in relation to its strategic objectives as a vital element of the strategic planning process. Control systems should relate risk to the bank's required capital levels. Banks should use methods such as value at risk models that capture general market risks and specific risk exposures of portfolios. and of the work of internal audit.  The scope and quality of management's monitoring of risk and internal control. including the independence of such data sources  The accuracy and appropriateness of volatility and correlation assumptions  The accuracy of valuation and risk transformation calculations  The verification of the model's accuracy through frequent testing and review of results Business risk management 103 . failings and weaknesses which have or might have material impacts upon the accounts. codifies policies and procedures for the whole organisation and designs and implements assessment methodology and risk reporting systems. The Basel II accords were particularly important in establishing risk management and capital adequacy 2 requirements. This should be wider-ranging than the regular review. the Turnbull report states they should conduct an annual review of internal control. when directors are considering annually the disclosures they are required to make about internal controls.

Risk Mitigation R and D not delivering Reorganisation of R and D department into smaller units. Basel III established higher minimum capital levels and tightened the rules on the definition of capital. in particular litigation processes to ensure successful enforcement and defence of patents. firstly ensuring that banks have enough liquidity to survive an 'acute stress scenario' lasting one month. to commercial new products encourage entrepreneurialism and accountability. Case example: GlaxoSmithKline – risk management We have already discussed the key risks facing GlaxoSmithKline (GSK) according to its 2012 annual report. The US Federal Reserve announced in December 2011 that it would implement virtually all of the Basel III rules.  There should be a process to deal with the internal control aspects of any significant problems disclosed in the annual report and accounts.  An ongoing system should be in place for identifying. Basel III. evaluating and managing significant risks. The second objective is concerned with the longer-time horizon. noting that the difficulties experienced by banks were sometimes due to lapses in the basic principles of liquidity risk management. In particular it focused on raising capital requirements for trading and complex securitisation processes. published in December 2010 and updated in June 2011. aiming to limit the risk of destabilising deleveraging processes and introducing additional safeguards against model risk and measurement error. biotechnology companies and other pharmaceutical companies and consultation with payers and patients.bis. and stated that publicly traded companies should report on the risks they faced and outline the risks.htm 12. which have been a major source of losses.  An annual process should be in place for reviewing the effectiveness of the internal control systems. creating incentives for banks to use more stable sources of funding. The report goes into detail about how risks are being managed. in particular promoting an enterprise risk management approach. The capital requirements were supplemented by a leverage ratio requirement. arising from banks' derivatives. repo and securities' financing activities. 104 Business Analysis . The most recent guidance. These include promoting disclosure of expected losses.  The governing body of the company (generally the board of directors) should acknowledge responsibility for internal control systems.org/list/bcbs/index. Basel III has been seen as building on the risk management requirements of Basel II. The liquidity standards have two objectives. conserving capital above the minimum requirements and adjustment of the capital buffer range when there are signs that credit has grown to excessive levels. Collaboration with partners in academia. Other requirements aim to limit the shocks caused to financial systems by the impact of cycles. The Report was intended to encourage best practices. Further details about the reports of the Basel Committee are on the website of the Bank for International Settlements: www. focused on capital and liquidity standards. Failure to protect intellectual Use of a global patents group to oversee processes and monitor property rights new developments in patent law. The Turnbull Report requires the following disclosures. The Committee also introduced for the first time global liquidity standards. It also introduced measures to strengthen the capital requirements for counterparty credit exposures.3 Reporting on risk management The Turnbull Report laid down minimum expected guidelines for disclosure on risk management and corporate governance.

prices Exploration of different pricing models for innovative products. avoidance of dependence on a single supplier. Alliances and acquisitions Due diligence procedures. Treasury risk is managed by a detailed set of management policies that is reviewed and approved annually by board. Interruption of product supply Assessment of standing of suppliers. GSK's treasury department does not act as a profit centre. Tax and treasury losses Monitoring of current debates to anticipate changes in tax law. Global anti-bribery programme that includes global policy. Exposure to political and Diversification mitigates exposure to local risks. Policies ensuring adherence to economic sanctions and export control laws. Inability to obtain adequate Demonstration. safety stocks and backup supply arrangements and. Assignment of quality staff to each business unit. Dedicated team drives implementation of programme. review of major transactions by difficulties management boards and management of integration by Corporate Strategy group. to reduce risks.Risk Mitigation Product quality failures causing Adoption of Quality Management System throughout supply risk to the patient or consumer chain and lifecycle of products. with integration team being appointed for each acquisition. Reduction of exposure in key countries. Failure to comply with anti. Procedures for review and sign-off across group and by senior management. Use of simplified intellectual property ownership model to give greater certainty in application of transfer pricing. guidance R and regulations. working with advisers to ensure Group up-to-date with latest developments. including exercising caution in counterparty exposures and proactively managing liquidity positions. if possible. shares experience and cascades what has been learnt over the group. corruption legislation ongoing training and requirements relating to due diligence. supported by extended team of functional experts. P T Non-compliance with laws and Continuously changing internal control framework to take into E regulations account changes in commercial model. which disasters has developed response plans to different European economic events. integrity and ethics. contracting and oversight. Business risk management 105 . particularly to governments of value of medicines. Oversight by a chief regulatory officer and regulatory governance board. marketplace. Financial reporting risks Testing of design and operating effectiveness of key management controls. Oversight by a Chief Product Quality Officer and Quality Council that examines emerging risks. use of compliance policies and procedures and engagement of advisers to review application. Stronger controls over interactions with government officials and business development transactions. C H Restructuring of business to take advantage of growth A opportunities. Assignment of a economic risks and natural cross-business team to manage European economic risks. Global code of practice for marketing and promotional activities. Involvement of Medical Governance Ethical Committee to ensure application of principles 2 of good medical science.

they are not static instruments. risk management processes must be continually monitored for any weaknesses – just like the business environment itself. review of policies and controls and routine training of employees. As a cost cutting move. and reporting in corporate responsibility report. Just as the human body loses its ability to fight infection if it is locked in a sterile environment for a long period of time. the directors are considering delaying LP's new range of clothes by one year. Such is the focus on risk and its consequences in today's business that there is a danger of management spending so long thinking about the negative aspects of projects that they forget about the positive aspects. so do businesses lose their resilience for dealing with risk if they become obsessed with trying to avoid it. PVO. Dispute management procedures aiming to resolve disputes early. This move is partly in response to environmental scanning which indicated a new competitor. At the other extreme. if a risk is highly unlikely to happen then it may be better to simply accept the risk and deal with any losses if and when they arise. 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. then a great deal of time and resources could be wasted in dealing with the risk of losses that in fact are highly unlikely to occur – time and resources that could have been more gainfully employed elsewhere. Credit risk from large customers Monitoring of financial information and credit ratings. The site will use some new compression software to download the large media files to purchasers' PCs so that the clothes can be viewed. Some organisations over-estimate what such processes should be able to achieve to the extent that work is suspended until the risk management process is considered to be complete. Risk Mitigation Adverse outcome of litigation Focus on patient safety in drug development. They are only as good as the information that is used to construct them in the first place – remember the old adage 'rubbish in rubbish out'? If risks are not assessed properly. However the systems and controls that GSK had in place failed to prevent a police investigation into corrupt activities by some of its Chinese executives. In order to increase sales. Medical governance and government investigations system involving Global Safety Board and Chief Medical Officer responsible. IT security breaches Assessment of changes in risk environment. and review of credit limits. Non-compliance with health. Complacency is one of the worst enemies of successful businesses. will be opening an unknown number of stores in the next six months. 12. Reduction of water and energy requirements consumption and hazardous waste. While it is possible for unlikely events to occur. regardless of their quality. 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. Emphasis on culture where employees feel valued. Sales are currently in excess of expectations and the directors are unwilling to move away from potentially profitable lines. Make sure you control risk – but do not let risk control you. As mentioned above. there are organisations who believe themselves to be immune from losses resulting from business risk simply because they have risk management processes in place. risk management plans have their limitations. along with safety and environment procedures to minimise hazards. amongst other things. 106 Business Analysis . for safeguarding human subjects in tests.4 Limitations of risk management plans As with all business processes.

Transocean was quoted by Associated Press as commenting: 'In both its design and construction BP made a series of cost-saving decisions that increased risk – in some cases severely. The report drew attention to the failure of BP's engineering team to conduct a formal. disciplined analysis of the risk factors on the prospects for a successful cement job and also the failure to address risks created by late changes to well design and procedures. with an estimated 4. Accreditations BP held included ISO 14001 at major operating sites. On the basis of what BP has published however. These were not subject to strict scrutiny that required rigorous analysis and proof that they were as safe as the more expensive regular procedures. and that its failures were systemic and likely to recur. reporting to GRI A+ standard and assurance by Ernst and Young to AA100AS principles of inclusivity. The consequences of the spill included the departure of BP's chief executive. that is BP and two other companies working on the T well. The report also blamed inadequate government oversight and regulation. would have a major effect on people and the environment. Problems highlighted by the BP report E included 'a complex and interlinked series of mechanical failures. The committee's work encompassed all non-financial risks. See Answer at the end of this chapter. Tony Hayward. focusing on the engineering review of the well design and paying far less attention to the decisions regarding procedures during the drilling of the well. if they occurred. with the agency responsible lacking staff who were able to provide effective oversight. engineering R design. Business risk management 107 . materiality and responsiveness. The report apportioned blame between the various companies involved. When BP contacted the agency to ask for a permit to set the plug so deep in the well.' Transocean. human judgements.' The US Commission that reported on BP in January 2011 found that BP did not have adequate controls in place. nor for testing the cement that was essential for well stability.9 million barrels of oil leaked before the well was capped in July 2010. The report highlighted the flawed design for the cement used to seal the bottom of the well. one of the other companies criticised in BP's September 2010 report. On 3 August 2010 the US government stated that the oil spill in the Gulf of Mexico was officially the biggest leak ever. the agency made the same mistake as BP. Case example: BP The impact of the oil spill in the Gulf of Mexico on BP was a significant news story in much of 2010. although both of the other companies criticised this report. The commission found that decisions were taken to choose less costly alternative procedures. ethics and environment assurance committee.Requirement Explain the business risks affecting LP and briefly describe how these risks can be managed. BP created a compensation fund of $20bn and had paid out a further $8bn in the clean-up campaign by C the end of 2010. operational implementation and team interfaces.' Critics have pointed to other operational problems BP has had. its risk management approach did not appear to differ greatly from other oil companies. BP's systems also received external backing. lack of communication and training and failure to integrate the cultures and procedures of the different companies involved in the drilling. The report highlighted failures of management of decision-making processes. that the test of the seal was judged successful despite identifying problems. H A The results of BP's own internal investigation were published in September 2010. It blamed a 'sequence P of failures involving a number of different parties'. Many aspects of control over drilling operations were left to the oil industry to decide. For example BP had sophisticated risk assessment processes in place. and from many other large organisations across the globe. and the workers' failure to recognise the first signs of the impending blow- out. also blamed BP for cost-cutting. CNN news quoted an employee who had worked at both locations as saying that no-one should be surprised by the 2010 disaster: 'The mantra was 'Can we cut costs by 10%. although it emphasised BP had overall responsibility. In 2007 it completed 50 major accident risk assessments. The assessments identified high-level risks that. from the explosion at its Texas City 2 refinery to the temporary shut-down at Prudhoe Bay. BP's monitoring procedures included the work carried out by the safety. There were no industry requirements for the test that was misinterpreted.

9bn loss in 2010. although it had been reduced by $4bn following settlements with partners in the venture. Kurt Mix. In April 2012. The company had however resumed drilling in the Gulf of Mexico. In February 2012 BP announced a 14% rise in dividends. Second quarter figures for 2012 showed a 35% fall in underlying profits. raising the potential cost to $38bn. BP set aside an additional $847m provision to pay for the 2010 disaster. former BP engineer. containing details about how attempts to cap the leaking well were going. however.8bn in compensation payments. compared with a $4. It's possible that BP relied on generally accepted risk management practices which had become less effective over time. The $38bn included $14bn in costs to restore over 4. In July 2012. 108 Business Analysis . was arrested on charges of intentionally destroying text messages between himself and a supervisor. BP also still faced 'significant uncertainty' as it had not yet reached a settlement with the US Department of Justice. after profits for 2011 of $23.000 miles of shoreline and $8.9bn.

Summary and Self-test Summary C H A P T E R 2 Business risk management 109 .

This venture involves the purchase of surplus 'Hercules' transport 'planes from the army. 2 HOOD HOOD sells a wide range of coats. As well as the standard employer and third party liability classes of insurance. Self-test 1 ANG ANG is a road haulage contractor. Requirements (a) Explain the elements of a risk management framework in an organisation. although the gross profit in some stores has declined recently for no apparent reason. Recent newspaper reports indicate that one of the chemicals used to waterproof garments releases toxic fumes after prolonged exposure to sunlight. The company specialises in collection and delivery of large or heavy items such as railway locomotives and sections of bridges from the manufacturer to the customer. Each store uses EPOS to maintain control of inventory and provides the facility to use EFTPOS for payments. The company is profitable. details of requirements being obtained from the daily management information provided by each store. However. (b) Explain the risk management strategies available to an organisation. placing the risks into suitable categories. the board of ANG believes that if any risks do occur. although there has been little innovation in terms of garment design in the last four years. The company owns 49 road vehicles of different sizes to enable transportation of the different goods. Main areas of responsibility for the company include:  Ensuring that the railway tracks are safe  Signalling equipment is installed correctly and works properly  Maintenance of overhead power lines for electric trains 110 Business Analysis . Marketing activities will commence next month. ANG also insures against damage to road infrastructure such as bridges and tunnels from its own vehicles or as a result of goods being carried becoming unstable and falling off ANG's lorries. (c) Evaluate the risk management strategy of ANG. but only where the owner accepts liability on their own insurance. The board of HOOD is investigating the claim. then ANG has sufficient vehicles to continue operations. Inventory is ordered centrally from head office. with stock arriving at each store approximately 10 days after the re-order level is reached. Orders are sent to suppliers in the post. The Board of ANG is also considering a new venture for the same day delivery of goods where the distance to travel is more than its existing fleet of road vehicles could travel in one day. ANG's risk management policy is based on taking out insurance. but is currently treating it with some degree of scepticism. Contingency planning is limited. describing how the impact of that risk may be minimised. waterproof trousers and similar outdoor clothing from its 56 stores located in one country. Explosives are carried. ANG's terms and conditions of carriage note that radioactive goods will not be transported under any circumstances. 3 LinesRUs The LinesRUs Company is responsible for maintaining the railway infrastructure for the rail network in a large European country. The board has recently decided to make the purchase of the 'planes because they are being offered at a substantial discount. The product range has generally sold well. (b) Discuss the potential effect of each risk on the organisation. Details of sales made and inventories below re-order levels are transferred to head office on a daily basis where management reports are also prepared. about 55% of all transactions are still made in cash. explaining any amendments that you think are necessary. Requirements (a) Identify the different risks facing HOOD. anoraks.

A lot of maintenance work is relatively simple (eg tightening nuts and bolts holding railway tracks together) but is extremely important as an error may result in a train leaving the rails and crashing. E and the national press are suggesting LinesRUs must be incompetent and are calling for a re. Business risk management 111 . Your answer should describe each strategy and explain how each might be applied in the case. Work is scheduled in accordance with the amount of income. The company is granted a sole franchise each year to provide services on the rail network. C However. One of the unforeseen P consequences of the crash has been a fall in the numbers of people using trains with a subsequent T fall in income for train operators. Initial investigations H A show that faulty maintenance was the cause of the derailment. and to provide LinesRUs with an acceptable operating profit. R evaluation of the method of providing maintenance on the rail network. (b) Using the Transfer Avoid Reduce Accept framework. Requirements 2 (a) Advise the directors of LinesRUs of the main stages of a structured risk analysis approach that will be appropriate to the company's needs. Any additional work over and above standard maintenance (eg due to foreseen factors such as bridges being damaged by road vehicles and unforeseen factors such as car drivers falling asleep and driving their cars onto railway tracks) is negotiated separately and additional income obtained to repair the infrastructure in these situations. recently a train was derailed causing the death of 27 passengers. The board of LinesRUs is aware of many of these risks and attempts to include them in a risk management policy.Income is fixed each year dependent on the number of train services being operated and is paid via a central rail authority. construct four possible strategies for managing the risk that rail crashes could occur. LinesRUs are being sued by the train operators for loss of income.

and then the budget should be spent on appropriate areas. Risk retention may also involve self-insurance. In an extreme situation. Tools and techniques Appropriate tools and techniques are available in the organisation to enable the efficient and consistent management of risks across an organisation. This means that the board of an organisation must allocate an appropriate budget for risk management. First. Risk reduction will also involve contingency planning to ensure that if a risk does crystallise. then the damage from that risk is minimised. then the organisation will suffer the full loss of that event. entire sections of the business may be closed down if the risk or loss is considered to be too great. Files will be backed-up regularly. where some risk occurs which the organisation's risk management policy did not detect. and alternative processing locations will be available if one centre becomes unavailable eg due to fire or flood. Answers to Self-test 1 ANG (a) Risk management structure The organisation needs a structure to facilitate and communicate information about risks. 112 Business Analysis . This means that funds are placed into some fund against risks actually occurring. The appointment of a risk management officer will help to ensure budgeted amounts are spent appropriately. For example. the risk of launching a new product can be reduced by obtaining market research on possible demand for the product prior to manufacture and launch. For example. then the activity may not take place. If the losses avoided appear to outweigh the benefits of carrying out the activity. Acceptance Risk retention is where the organisation bears the risk itself. allowing access to shared databases where information about risks can be stored. Having a risk avoidance culture will help to ensure that management decisions taken focus on and avoid important risks. Tools and techniques available may include obtaining appropriate insurance against risks and having a clear risk management policy in place. Second. Risk retention normally occurs in two situations. A system such as an intranet or groupware product would be suitable as it connects all the individuals in an organisation. where risk was classified as insignificant or the cost of the risk was deemed to be too great compared to the likelihood of that risk occurring. Resources Sufficient resources are required to support effective risk management. Reduction Risks are avoided in part but not reduced to zero. most companies will have a contingency plan against their computer systems failing. the organisation attempts to determine whether the possible losses avoided from not undertaking a risky activity are greater than the advantages that can be gained from carrying out the activity. Risk culture The culture of the organisation should be developed as far as possible to ensure employees are aware of risk and to act to avoid risks where possible. This means that if the unfavourable outcome occurs. (b) Avoidance In this situation.

then the damage caused H A could be considerable. The more carefully costs are allocated to each department. Detailed plans of site and buildings will show potential bottlenecks in fire escape routes. Risk acceptance There appears to be some risk in purchasing the transport 'planes prior to any market appraisal of the new venture. However. There has been some bad publicity about the transfer of radioactive goods by road. or escaping gas. E R Insurance Whether ANG needs to insure against damage to roads. ANG could probably withdraw this insurance and effectively transfer the risk to the government. However. Where haulage contracts are signed for time critical delivery of goods. which budgets will be affected and how quickly necessary funds can be made available. Some cost savings would accrue from this move. then some reciprocal agreement with another haulage company may be appropriate. there may be a minimal risk of errors occurring in some software. Physical inspection of buildings and machines (and perhaps of personnel. ANG would not be able to operate legally without this insurance. The board would normally be advised to check whether there was a demand for this service prior to expenditure being committed. risks may also be transferred to other third parties. often without the knowledge of that party. The cost of carrying out additional testing may be more than any compensation that may be payable if the error occurs and the customer makes a successful complaint. for example. (c) Transfer The overall risk management strategy of ANG appears to be one of risk transfer. a significant number of ANG's vehicles are destroyed in a fire or flood. it may be inappropriate in situations where. Transfer The last risk management strategy is to transfer the risk to a third party. the easier it should be to calculate additional costs which would be incurred in a given emergency. For example. This may be acceptable in the case of individual losses. Avoidance The decision by ANG to avoid risk completely in the transfer of hazardous materials seems sensible. and of their working practices) should take place on a regular basis. obstructions which might make difficulties for fire engines and problems of access which could occur for both the site and its neighbours from fire. For example. in the medical sense. explosion. Normally the risk of a new venture would be reduced by carrying out market research prior to significant expenditure being incurred. not only to the load itself. particularly if an accident occurred in an area of high population density. bridges and so on. risk has been transferred to the customer without the customer's knowledge. internal accounts and budgets are a fertile source of information. This is the policy adopted by most businesses and is wholly appropriate given the likelihood of many risks occurring is low. In this situation. T and so it is essential to obtain it. if a load did fall off one of ANG's lorries. Business risk management 113 . The government of the country is normally responsible for maintaining the transport 2 infrastructure. ANG would need to ensure that the contract for carriage clearly stated that the owner of the goods was responsible for insurance. Published accounts. ANG may also want to obtain a copy of the insurance contract to confirm this. but if they do occur then significant expenditure would be C involved. In the case of explosives. Self-insurance It appears that ANG effectively self-insures against loss of vehicles in respect of being able to provide a replacement vehicle at short notice. and the potential for claims. is unclear. could be excessive and the damage to ANG's reputation would be considerable. The most commonly used risk transfer policy is take out insurance against a risk occurring. people and even P the roads being used. but also to other vehicles.

Incorrect stock levels in turn can be caused by incorrect inventory counting or actual stealing of inventory by employees. (i) Accounting irregularities The unexplained fall in gross profit in some stores may be indicative of fraud or other accounting irregularities. 2 HOOD Risk can be defined as the possibility that events or results will turn out differently from what is expected. Similarly. Business risks External risks relate to the business. Given that fashions tend to change more frequently than every four years. re-ordering of inventory takes a significant amount of time. (ii) Systems Technical risks relate to the technology being used by the company to run its business. HOOD may experience falling sales as customers seek new designs for their outdoor clothing. (i) Macro-economic risk The company is dependent on one market sector and vulnerable to competition in that sector. (a) The risks facing the HOOD Company are outlined below. Failure of computer systems during the day will still result in loss of that day's transaction data. the average 10 days before inventory is received at the store could result in the company running out of inventory. (2) Delays in inventory ordering Although stock information is collected using the EPOS system. (ii) Product demand The most important social change is probably a change in fashion. HOOD may also be vulnerable to seasonal variations in demand. (ii) Event HOOD may be vulnerable to losses in a warehouse fire. Non-business risks These are risks that arise for reasons beyond the normal operations of the company or the business environment within which it operates. (i) Production The possibility of sunlight making some of HOOD Company's products potentially dangerous may give rise to loss of sales. However. loss of sales income could result from accounting errors or employees fraudulently removing cash from the business rather than recording it as a sale. they are essentially uncontrollable by the company. Low gross profit in itself may be caused by incorrect inventory values or loss of sale income. Transferring data to head office for central purchasing may result in some discounts on purchase. HOOD has not changed its product designs for four years indicating some lack of investment in this area. Operational risks These are risks relating to the business's day-to-day operations. (1) Backup Transferring data to head office at the end of each day will be inadequate for backup purposes. 114 Business Analysis . also stock recall.

details of one shop's sales could be lost for part of one day. this may be acceptable compared to overall loss of reputation. (ii) Systems (1) Backup The potential effect on HOOD is relatively minor. However. and hence what steps (if any) are desirable to mitigate or avoid the consequences. Non-business risks (i) Production The effect on HOOD is the possibility of having to reimburse customers and the loss of income from the product until the problems are resolved. R The risk can be minimised by introducing additional controls including the necessity of producing a receipt for each sale and the agreement of cash received to the till roll 2 by the shop manager. In the longer term. For the future. (2) Delays in inventory ordering The potential effect on HOOD is immediate loss of sales as customers cannot purchase the garments that they require. the cash from sales would still be available. HOOD can assess what the consequences might be. using an extension of the EPOS system. Operational risks C H (i) Accounting irregularities A P The potential effect on HOOD is loss of income either from inventory not being T available for sale or cash not being recorded. Additional procedures could be implemented to back up transactions as they occur. Profiling By identifying and profiling the effects of the risks. if stock outs become more frequent. Business risk management 115 . Loss of inventory may be identified by more frequent inventory checks in the stores or closed-circuit television. The risk can be minimised by letting the stores order goods directly from the manufacturer. (iii) Corporate reputation Risks in this category relate to the overall perception of HOOD in the marketplace as a supplier of (hopefully) good quality clothing. rather than ignoring it. The relative cost of providing these links compared to the likelihood of error occurring will help HOOD decide whether to implement this solution. this reputation could be damaged by problems with the manufacturing process and a consequent high level of returns. However. (b) The potential effects of the risks on HOOD and methods of overcoming those risks are explained below. using online links to head office. customers may not visit the store because they believe goods will not be available. limiting the actual loss. Costs incurred relate to the provision of internet access for the shops and possible increase in cost of goods supplied. The risk can be minimised by HOOD taking the claim seriously and investigating its validity. guarantees should be obtained from suppliers to confirm that products are safe and insurance taken out against possible claims from customers for damage or distress. However. The overall amount is unlikely to be E significant as employees would be concerned about being caught stealing.

once lost. and without some diversification. (ii) Event The main effects of a warehouse fire will be a loss of inventory and the incurring of costs to replace it. Managers need to maintain a list of known or familiar risks and the extent to which they can harm the organisation or people within it. fixed cost as a proportion of turnover. (iii) Corporate reputation As well as immediate losses of contribution from products that have been returned. undoubtedly cannot easily be regained. External risks (i) Macro-economic risk The potential effect on HOOD largely depends on HOOD's ability to provide an appropriate selection of clothes. 116 Business Analysis . In a severe situation. Managers also need to be aware that unfamiliar risks may exist and maintain vigilance in case these risks occur. This risk can be minimised by having a broad strategy to maintain and develop the brand of HOOD. inconvenience and loss of time can then be recognised. 3 LinesRUs (a) Risk identification Risks cannot be managed without first realising that they exist. even if they were not thought of in initial risk analysis. However. Potential losses of sales could be avoided by holding contingency inventory elsewhere. a reputation for quality. this will automatically affect the overall sales of HOOD. The potential effect of a drop in overall corporate reputation will be falling sales for HOOD. There will also be a loss of sales as the inventory is not there to fulfil customer demand. damage to the company's reputation could result in LinesRUs becoming bankrupt. so some sales will be expected. It can also look to reduce operational gearing. then commencing sales of other outdoor goods such as camping equipment may be one way of diversifying risk. resulting eventually in a going concern problem. The board must therefore allocate appropriate investment funds to updating the products and introduce new products to maintain the company's image. However. LinesRUs appear to have identified some risks in their risk management policy. and introducing processes such as total quality management. It is unlikely that demand for coats etc will fall to zero. and losses from the fire could be reduced by insurance. Risk assessment It may be difficult to forecast the financial effects of a risk until after a disaster has occurred. and perhaps also a loss of subsequent sales as customers continue to shop elsewhere. Not updating the product range would appear to be a mistake in this context as the brand may be devalued as products may not meet changing tastes of customers. an increase in competition may result in falling sales. HOOD faces the consequence of loss of future sales from customers who believe their products no longer offer quality. Risk identification is an ongoing process so that new risks and changes affecting existing risks may be identified quickly and dealt with appropriately before they result in unacceptable losses. Other clothing retailers have found this to be very serious. other risks do occur and managers within LinesRUs must be able to identify and respond to those risks quickly. HOOD can guard against this loss of reputation by enhanced quality control procedures. Areas such as extra expenses. Given that the company sells outdoor clothes. (ii) Product demand Again the risk of loss of demand and business to competitors may undermine HOOD's ability to continue in business. HOOD can minimise the risk in two ways: by diversifying into other areas.

As noted above. P T Likelihood Consequences E R Low High High Loss of lower level staff Loss of senior staff 2 Low Loss of suppliers Major rail disaster affecting reputation of company Major rail disaster not the company's fault Loss of computer data on maintenance work Loss of franchise The analysis will be incomplete for LinesRUs because not all risks can be identified. A H A consequence matrix is one method of doing this. Risk profiling C This stage involves using the results of risk assessment to group risks into families. Alternative methods of risk transfer may have to be considered including asking the state for some form of insurance. chances of losses and largest predictable loss to which LinesRUs could be exposed by a particular risk. the extent of which may not have been foreseen. In this situation. enabling management to monitor risks regularly and undertake annual reviews of the way that organisation deals with risk. The result of calculations will show average or expected result or loss. the adverse effects of the risk in terms of costs necessary to repair the rail infrastructure will be helpful. Systems should identify changes in risks as soon as they occur. However. (b) Risk responses Transfer The risk is transferred to a third party. many of the risks facing LinesRUs are significant. There is no information on the organisational structure of LinesRUs. LinesRUs is likely to be an independent legal entity to ensure that no other companies are adversely affected should LinesRUs go out of business. So while quantification can be enhanced by past events such as drivers falling asleep. there has been a loss of confidence in the company. this may not be possible if insurers are not willing to accept the risk. It is also uncertain what the additional time and cost of repairing the track will be and whether LinesRUs can claim additional income for this work. where possible. results and probabilities calculated. This aggregation will be required as part of the overall review of risk that the board needs to undertake. and. Given the risky nature of the company's business. enabling LinesRUs to ensure that appropriate insurance is available – effectively guarding against loss by transferring the risk. LinesRUs should file appropriate reports of physical inspection of track as evidence of maintenance work carried out. Risk consolidation Risks analysed at the divisional or subsidiary level need to be aggregated at the corporate level. This has resulted in additional expense in terms of lost passengers – legal advice will be needed to determine whether LinesRUs is liable and whether the company's insurance meets this liability. frequency of losses. Risk quantification Risks that require more detailed analysis can be quantified. they appear to be one-off situations meaning that the actual event may not occur again. Business risk management 117 . Unfortunately. Sources of information to ensure that the risk can be minimised may include obtaining regular reports from train operators on the state of the rail infrastructure and monitoring news feeds such as Reuters for early indication of potential disasters.

Acceptance This is where the organisation retains the risk and if an unfavourable outcome occurs it will suffer the full loss. Management should use other methods such as newsletters to raise awareness of the importance of work being carried out and the potential consequences of error. These may include hiring of lawyers to defend LinesRUs and release of publicity material on the work of LinesRUs showing extent of maintenance normally carried out. insurers may be unwilling to insure for this type of event. Reduction The risk can be reduced by taking appropriate measures. Given the uncertainties regarding the costs resulting from the unfavourable outcome. then the risk may crystallise. given that maintenance work must continue and that errors are always possible. LinesRUs may have to retain the risk if suitable insurance cannot be found. Avoidance LinesRUs may consider whether the risk can be avoided. The only method of avoidance would appear to be termination of operations. This again may not be appropriate given this would close LinesRUs's business. There should be maintenance and enforcement of appropriate disciplinary procedures where breaches of work practices have been identified. Avoidance is not possible. LinesRUs may also consider loss control options. 118 Business Analysis . However. In the case of the rail crash. In the case of LinesRUs these will include regular training for maintenance staff.

this will also result in declining sales or margins. it is unlikely that no modifications will Business risk management 119 . Answer to Interactive question 2 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. The extent of this risk will depend very much on the power of the brand. 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. 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. which could make marketing more difficult. There is potential for governments to restrict advertising of certain products and to impose additional taxes on confectionery and fizzy drinks. but there may be dips at other times of the year. 2  Competition – the confectionery and non-alcoholic beverages markets are highly competitive. Consumer tastes may change for health-related reasons. This could have a significant downward effect on sales and profits. possibly by hiring local solicitors. for example. If there is a particular product that contributes a large proportion of sales revenue.  Product recalls and incorrect labelling of merchandise – the confectionery industry is particularly susceptible to the risk of product recalls and incorrect labelling. Although product recalls are infrequent. heart disease and diabetes. 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. Internal audit will need to review any redundancy calculations on a test basis to ensure that employment law has been complied with. The necessary publicity given to the potential consequences of nut allergies. Risks inherent in establishing those systems may be minimised by exporting the systems currently being used in the USA.  Role of food in public health – with lots of publicity about levels of obesity. there is a considerable risk that a rival company will bring out a similar product and take some of the market share. T E  Supply of raw materials – sugar is a major raw material used in the manufacture of confectionery R and non-alcoholic beverages. 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. Easter and Christmas are major seasons for the confectionery business. However. there is a significant threat to the confectionery and fizzy drinks markets. their considerable impact is such that very tight internal controls are necessary to prevent their occurrence. The directors must ensure that the law in the country is understood. If the company is unable to respond. C H  Impulse buying – a large proportion of confectionery purchases are made on impulse. If economic A changes reduced the amount of impulse buying – due to consumers having less money to spend – P this could have a major effect on profits. There is the possibility of breach of employment law in processing and payment of pay. has led to much stricter regulation of labelling information.  Seasonality of business – most purchases are likely to be associated with seasons.Answers to Interactive questions Answer to Interactive question 1 Note: This is not an exhaustive list – you may have thought of different examples that are equally relevant. children's eating habits.

and the accompanying costs. be necessary. This new communication system will run risks such as communications being lost or intercepted en route. – 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. deals with local hotels to provide any necessary accommodation. Internal audit will need to review the systems in detail to try to minimise the errors that occur. it may be worth trying to lobby the country's government for a change in policy. – Have contingency plans in place to adequately deal with any operational problems while in the country – for example. an increase in visitors. 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. New systems always provide a risk of failure or incorrect reporting due to lack of adequate testing or implementation problems. – Consider setting up an alliance with an airline located in the country in question. Answer to Interactive question 3  Risk avoidance – The airline could abandon plans to offer services to this country. contacts with local coach company to ensure transport to hotels if passengers have to spend another night in the country before the plane can take off.  Risk reduction – Invite the host government to be a partner in the venture. for example. 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.  Risk transfer – Have adequate insurance in place to cover the cost of any planes being grounded. The board will need to ensure that appropriate encryption systems are introduced across the communication system to minimise these risks. The risk is that the new factory may manufacture the computer components correctly. – If the new service is likely to boost the country's economy due to. with the service being offered in that airline's name but with a codeshare arrangement. 120 Business Analysis . but fail to meet its own constraints regarding mix of components produced or timescales for production. To maintain adequate control.  Risk retention – Accept the possibility that airports may not be properly maintained or planes may be grounded. 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. as new systems will be necessary to meet the specific situation in the new location.

Business risk management 121 . fashions will change according to the season. Thorough testing procedures should have been built into the plan. and these should ensure that C the site is capable of coping with anticipated demand. LP should make sure that competitor activity is carefully monitored and responses are made to known or predicted competitor activity.Answer to Interactive question 4 Business risks These are risks that a company's performance could be better or worse than expected. LP should H A monitor the level of sales generated by obtaining customer feedback through the site. and P comparing sales generated with the costs of keeping the site updated. Budgets should have been established and actual expenditure regularly compared with budgets. If actual expenditure is unavoidably significantly in excess of budget. and look for evidence of falling sales and other evidence that its products are viewed as old-fashioned. Once the site is operational. and certainly in temperate 2 climates. (c) New competition The new company PVO appears to be aggressively attacking LP's market place. The board should also consider whether work on developing new products should continue to some extent. LP should monitor the performance of products in detail. so that new lines can be launched quickly if demand falls. There is a risk that not amending the style of products sold will reduce sales far in excess of the reduction in expenditure. However. 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. 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. T E (b) Product obsolescence R The decision to lengthen the time of sale for each product may appear to decrease development costs. having a new range of clothes available is likely to attract customers with little if any brand loyalty to LP. the board should consider whether the project should continue. the board of LP must also take into account demand for the goods. While the overall effect of the new competitor is difficult to determine. (a) The new business venture to sell clothes on the internet using 3D models to display the clothes. for an example an advertising campaign to counter new products being launched by the competitor. The fashion industry tends to issue new clothes and designs every few months. LP should have assessed the 3D project for feasibility. for example adverse customer or press comment. 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.

122 Business Analysis .

CHAPTER 3 Cost analysis and control Introduction Topic List 1 Overview of cost accounting techniques 2 Limitations of traditional management accounting techniques 3 Cost reduction 4 The supply chain 5 Business process re-engineering 6 Outsourcing Summary and Self-test Answers to Self-test Answers to Interactive questions 123 .

marketing and strategy 124 Business Analysis . quality. including the supply chain. business process re-engineering and outsourcing  Demonstrate a detailed understanding of the linkages between costs. Introduction Learning objectives Tick off  Demonstrate a detailed knowledge and understanding of the cost accounting techniques studied at the Professional stage  Demonstrate and apply knowledge of multi-product break even analysis through calculations and interpretation of results  Demonstrate a detailed understanding of the issues surrounding cost reduction  Demonstrate a detailed understanding of techniques that may be used in a strategy to reduce costs.

 Unlike single product analysis. Costs can be classified for various reasons.  Costing systems include direct. 1 Overview of cost accounting techniques Section overview  This section reviews some of the costing techniques that were covered in the Management Information paper at the Professional stage. C H 1. E R 3 Cost analysis and control 125 . the ratio in which different products are sold. costing systems. including cost classification. and control.  The main difference between multi. such as fixed. variable and semi-variable.  Cost classification is the separation of various costs into different categories. planning and decision-making. marginal and absorption costing for calculating unit costs. volume and profit at various levels of activity.  Break even analysis or cost-volume-profit (CVP) analysis is the study of the interrelationships between costs. there is no single break even point for multiple products – the answer will change depending on the assumed product mix. activity based costing (ABC) and break even analysis.1 Cost classification A P Probably the best way to revise cost classification is to revisit the table you were introduced to in your T Management Information studies.and single-product break even analysis is that the former relies on the product mix – that is. including inventory valuation.  ABC is a specific costing system for allocating overheads according to the activities that cause (or drive) the costs.

1 Absorption costing With absorption costing. The absorption cost of sales will include some fixed costs from a previous period (included in opening inventory) whilst all fixed costs are written off as expenses in the year of incurrence with marginal costing.2 Costing systems One of the purposes of the following costing systems is to calculate the cost of a unit of output which can ultimately be used to set the selling price. 1. control and decision-making Classification for planning Classification for control Cost objects and decision-making System of responsibility Requires knowledge of accounting segregates controllable Cost units cost behaviour patterns costs and uncontrollable costs Basic control unit for costing purposes Fixed cost Variable cost Semi-variable cost Classification for inventory Not affected by Changes in line Partly affected by valuation and profit measurement changes in activity with level of activity changes in activity Cost elements = materials. 126 Business Analysis . where only variable costs are included in the valuation of units. Financial information Management accounting Financial accounting Internal management Aggregate information for external reporting information for planning.2. the prime cost plus an absorbed share of production overhead costs. labour and other expenses Direct cost or Indirect cost or prime cost Product cost Period cost overhead Allocated to value Deducted as can be traced in cannot be traced in full to cost of inventory until expenses in a full to cost object object being sold particular period being costed costed Make sure you are familiar with all these classifications. All fixed costs are treated as period costs and written off against sales revenue in the period in which they are incurred. The difference in unit valuations using the two methods lies in the treatment of the fixed costs. a unit of output is valued at full cost – that is. 1. 1.2.2 Marginal costing Marginal costing is an alternative to absorption costing.

000 units 2.000 Engineering costs 45. the following details are available. See Answer at the end of this chapter. (b) Demonstrate why the profits under each method are different. Cost drivers – that is.2.000 171. those activities that cause C costs in the first place – are identified and overheads are assigned to products or services based on the H number of the cost drivers generated by each.000 £110. During the months of July and August. what is the most suitable cost driver for each overhead cost? (b) Calculate the total product cost for each of the four products. There were no opening inventories in July. which are absorbed on a per unit basis. the Feronda.000 Material handling 69.000. More than one cost might have the same cost driver.000 units Hamilton Ltd normally expects to produce 2. showing all workings. Product Alpha Bravo Echo Oscar Output (units) 500 300 400 200 Cost per unit (£): Material 60 42 80 100 Labour 32 20 35 50 Activities: Number of set ups 20 15 30 35 Number of times materials handled 3 4 2 6 Number of orders 11 12 16 25 Number of spare parts 15 20 10 15 required Total overhead costs (£) Set up costs 25.200 units and fixed production costs were budgeted at £110. The product costs resulting from ABC should be more accurate than those under T E absorption costing as overheads are allocated on a more objective basis.000 Requirements (a) Using the information in the question. Interactive question 2: Activity Based Costing [Difficulty level: Easy] 3 Tammy plc currently makes and sells four products. so A costs associated with the same driver are gathered into cost pools and then allocated using the P appropriate driver. cost and output details of which are below.500 units 3.000 Production 2. which has a selling price of £150 per unit and variable costs of £70 per unit.500 units Sales 1. Interactive question 1: Absorption and marginal costing [Difficulty level: Easy] Hamilton Ltd manufactures and sells a single product. See Answer at the end of this chapter. July August Fixed production costs £110. Requirements (a) Determine the profit for both July and August using (i) Absorption costing and (ii) Marginal costing.3 Activity Based Costing (ABC) ABC is an alternative approach to absorption costing. Try the question below to R make sure you remember the principles and procedures of ABC. Cost analysis and control 127 . 1.000 Ordering costs 32.

Selling price and variable cost details per pair is shown below. as overall profit will be reduced (or loss increased) if this contribution is lost. £ Selling price 55. 1. The study of break even analysis requires understanding.000 128 Business Analysis . such as make or buy decisions.000 Salaries 200.00 Variable costs 25.3 Break even analysis Break even analysis is the study of the inter-relationships between costs.000 pairs of roller skates per annum.000 Other 150. Breakeven analysis or Cost-Volume-Profit (CVP) analysis Contribution = Sales price – Variable cost Contribution ratio Breakeven point (BEP) Limiting factor Contribution = No profit and no loss = analysis Sales Fixed costs Fixed costs Maximise the BEP in units = BEP in £ = Contribution per unit Contribution ratio contribution per unit of limiting factor Margin of safety Make or buy Budgeted sales – BEP decision = × 100% Budgeted sales Break even chart Depicts the profit or loss over a range of activities Contribution break even chart Includes the variable cost line so that contribution is highlighted Interactive question 3: Break even analysis [Difficulty level: Easy] Bonzo plc manufactures and sells roller skates. application and interpretation of various formulae which are summarised below.00 Total fixed costs per annum are: £ Marketing 75. volume and profit at various levels of activity. Current sales volume is 20. Remember that the most important figure for decision making is contribution – if a product is making a contribution towards fixed costs then production should continue. You will notice from the chart that break even analysis is also used for decision making purposes where there are limiting factors.

00 60. which will give a total contribution towards total fixed costs of £190 (5  £20.00 E Variable costs 45.000 A P Per unit: £ £ T Selling price 65.00 60.000 units of the Gold Senator. C Silver Star Gold Senator H Sales volume in units 5. General fixed costs. the first thing to do is to establish the contribution per unit: Silver Star Gold Senator £ £ Selling price 65.00 30. For example.00 R Direct fixed costs are £40.00 Variable costs 45. Selling price of the roller skates will also increase to £65.000 3.000 for the Silver Star and £30. Cost analysis and control 129 .000 units of the Silver Star and 3. which can only be avoided if neither model is sold. the number of batches can then be converted into the number of units of each product that must be sold at the break even point.000 on marketing.00 + 3  £30. In this case we are told that Toodiloo sells 5. then the mix in which the two products are sold is 2:1.4 Multi-product break even analysis The key issue with multi-product break even problems is determining the mix in which the products are sold and reducing it to the lowest common denominator. which means spending an extra £40.00 90.000. The following information is available for the two models.00 The key to multi-product break even analysis is to look at the product mix.000.000 for the Gold Senator. are £63. 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. if 500 units of Product X and 250 units of Product Y are sold. Solution As with all break even questions. Worked example: Multi-product break even analysis Toodiloo Ltd manufactures and sells two types of microwave oven – the Silver Star oven and the Gold Senator combination oven and grill. A standard batch can therefore be assumed to comprise five Silver Star and three Gold Senator. Once this has been determined. This mix is used to define a standard batch which can be used to determine a break even point in terms of number of batches. If Bonzo plc wishes to make a profit of £25.00 90. giving a product mix ratio of 5:3.00). 3 Requirement Calculate how many units of each model would have to be sold for Toodiloo Ltd to cover all its fixed costs. 1. how much sales revenue must be generated from the sale of roller skates? See Answer at the end of this chapter.00 Contribution per unit 20.

Using the total contribution per standard batch.000 = 190 = 700 batches How many units of each model will have to be sold in order to break even? Remember that in every batch. five units of the Silver Star are sold and three units of the Gold Senator. an increase in the proportion of sales of products with a higher contribution will normally reduce the break even point.000 400. The sales and costs forecast for the next period are as follows.000 6.000 Total profit/(loss) NIL Note: You will have probably noticed that this break even number of batches and units will only work if the product mix remains at 5:3.000 £ £ £ £ Sales revenue 320.900 Net profit 89.00 30. in order to break even. we can calculate the number of batches that have to be sold in order to break even: Total fixed cos ts Break even point in batches = Contribution per batch 133.000 4.000 228.000 133.500 units Gold Senator: 3  700 = 2. McEnrova Grafassi Federdal Total Sales units 8.000 Variable costs 176.00 Total contribution 70. Toodiloo will have to sell: Silver Star: 5  700 = 3. 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? See Answer at the end of this chapter.000 280.000 360.000 Contribution 144.100 units Check: Silver Star Gold Total Senator £ £ £ Contribution per unit 20. As soon as the product mix changes you will have to calculate a new break even point. 130 Business Analysis . Interactive question 4: Multi-product break even analysis [Difficulty level: Easy] Netcord Ltd produces and sells three different types of tennis racquet – the McEnrova.000 132.000 Total fixed costs 306. Therefore.000 30.000 396.000 70. while an increase in the proportion of sales of products with a lower contribution will normally increase the break even point.000 Fixed costs: Direct 40.100 Total fixed costs can only be avoided if all models are eliminated.000 120.000 63. As you might expect.000 General 63. the Grafassi and the Federdal.

3 Backflush costing is one possible approach.2 Cost accounting methods A P Traditional cost accounting traces raw materials to various production stages via WIP. 2. In particular resulting in unnecessary cost increase. Many of these are produced too long after the event and are too narrowly focused. Measurement Response Consequence of action Purchase price variance Buy in greater bulk to reduce unit Excess inventories price Higher holding costs Quality and reliability of delivery times ignored Labour efficiency variance Encourage greater output Possibly excess inventories of the wrong products Machine utilisation Encourage more running time Possibly excess inventories of the wrong products Cost of scrap Rework items to reduce scrap Production flow held up by re- working Scrap factor included in Supervisor aims to achieve actual No motivation to get it right standard costs scrap = standard scrap first time Cost analysis and control 131 . C H 2. to the next stage T and finally to finished goods. 2 Limitations of traditional management accounting techniques Section overview  It has been argued that traditional management accounting systems are inadequate for a modern business environment that focuses on marketing. variances and so on. customer service.  This section summarises the main problems with the traditional systems that you have covered in earlier studies. However much of the output of traditional management accounting consists of short-term financial performance measures such as costs. 2. employee involvement and total quality. In addition these costs need to be compared with benefits. resulting in literally thousands of transaction entries. Cost accounting and recording systems must therefore be greatly simplified in the modern environment. production flows through the factory on a continual basis with near-zero inventories and very low batch sizes and so such transaction entries become needlessly complicated and uninformative. These may not necessarily be easy to quantify (for example shorter set-up times. The qualitative benefits can be extremely important (for example better product quality) and there may also be non-financial quantitative benefits.1 Short-term financial measures Pressures to keep costs under control have emphasised the need for relevant and informative cost data that is produced promptly. A much wider view is now necessary. With just-in-time E R systems. and this cannot just be done on financial grounds.3 Performance measures Traditional management accounting performance measures can produce the wrong type of responses. improved capacity utilisation).

3 Cost reduction Section overview  Cost reduction has become increasingly important in an increasingly competitive world. 132 Business Analysis . of course. Companies may be trading with certain customers at a loss but not realise it because costs are not analysed in a way that would reveal it. Management accountants. however. are largely determined at the design stage. not just on its reported financial results. It has been argued that controllable direct costs are about 10% of total costs. but conventional cost accounting does not recognise this. 2. The materials that will be used. In the car industry it is estimated that 85% of all future product costs are determined by the end of the testing stage. possibly of costing unit costs and/or over recover unwanted products overhead Cost centre reporting Management focus is on cost Lack of attention to activities centre activities. whereas controllable overhead costs represent about 27%. continue to direct their efforts to the production stage. the machines and labour required. debatable. strategy and quality. companies should be keenly aware of the effect that cost reduction has. but also on marketing. of the above criticisms are well founded is.7 The solution Whether all.5 Controllability Only a small proportion of 'direct costs' are genuinely controllable in the short term. not when it is in production. 2. It is a matter of what is most suitable for the company. however. What is indisputable.  Cost reduction should be viewed as an on-going exercise rather than being a panic reaction to a profit crisis.4 Timing The cost of a product is substantially determined when it is being designed. Measurement Response Consequence of action Traditional absorption Produce more output to reduce Excess inventories. companies have had to keep prices low and the only other way to influence the bottom line is to squeeze costs as far as possible. after-sales service and so on). It has been suggested that the reason why. not overheads where cost reduction possibilities might exist 2. is that changes are taking place in management accounting and business processes in order to meet the challenge of modern developments.6 Customers Many costs are driven by customers (delivery costs. discounts. accountants do not devote nearly three times as much effort to analysing overhead costs as they devote to direct costs is because overheads are more difficult to measure. or any. in spite of this.  In order that cost reduction programmes are successful. given its other objectives. In order to remain competitive.  There are numerous cost reduction programmes that a company can use and various ways in which they can be implemented. 2.

Companies try to reduce costs for many reasons. there are right ways and wrong ways to approach cost reduction. Across the board reductions could include the implementation of a new travel policy whereby all staff must travel economy class (as we have seen is the case with IKEA) while prioritised reductions may include a strategy to reduce pollution in order to avoid pollution tax. There are numerous ways in which companies can institute plans to reduce costs. Cost analysis and control 133 . Sections 4–6 examine some techniques that are used in the modern business world to address such issues as cost reduction and increased efficiency. This approach to cost reduction by the chief executive reinforces IKEA's market positioning strategy as a low cost. Whatever techniques are used. whether long or short haul. On a trip to the United States. Ultimately the aim is to maximise shareholders' wealth. the wrong ones could lead to costs being cut that are in fact necessary for the maintenance of quality and company value. no frills store. The colleague was expected to present the voucher to the car hire desk at their destination airport to obtain the discount. The only other way to affect the bottom line is to squeeze costs as far as possible and. Of course that is easier said than done but if employees can be educated to actively seek P ways to reduce costs then this will be a move in the right direction. the chief executive reportedly cut out a voucher for cut-price car hire in an in- flight magazine and handed it to his management colleague who was travelling with him. One of most quantifiable means of reducing costs is to tackle fixed costs. Effective cost reduction techniques start with establishing what the programme is trying to achieve. and the lengths some companies will go to in the quest to achieve them. C The best way to reduce costs is to develop a culture within the organisation whereby everyone thinks H strategically about cost reduction. How do you reduce costs? Quite simply by avoiding them as much A as possible. if they are the right ones they can teach a company to be more economical while maintaining its levels of service and quality. hopefully. By forcing companies to regularly review spending at all levels. Fixed costs are those costs that cannot be avoided regardless of activity levels – if you can find a way of getting rid of some of the sources of fixed costs permanently then you are on the way to a successful cost reduction programme. including across the board reductions. such as to allow the price of a product or service to be cut without affecting margins. In this section we will look at both cost reduction and cost control. If a company does not know why it is cutting costs then it will have no idea where to cut costs. There is often a fine line between necessary costs and unnecessary ones but taking a systematic approach to cost reduction can help managers stay on the right side of that line.2 Cost reduction techniques As with all business decisions. therefore it is important that the correct costs are targeted for reduction. We talked about fixed costs briefly in Section 1 and you will have dealt with them in detail in earlier studies. Case example: IKEA The chief executive of the IKEA furniture chain famously travels economy class on all flights. prioritised reductions and departmental reductions. more effectively than competitors. T E R 3. 3. The 3 right techniques will result in greater efficiency of company spending. As prices are slashed in a bid to remain competitive. cost reduction techniques allows companies to become more streamlined. to eliminate unnecessary spending and to create additional cash reserves. thus giving lower grades of director and manager no choice but to follow suit. companies have to find other ways of boosting profits.1 Introduction st Cost reduction has become the battle-cry of the 21 Century.

134 Business Analysis . notices posted next to light switches asking staff to 'switch off after use' are likely to be more effective than a dictatorial memo demanding that staff should be more careful about using power. If staffing levels are cut. stationery and telephone charges are all obvious targets. Ryanair initially stated that refunds would be limited to the same amount that passengers paid for their tickets. there is also the potential for seriously damaging the company's day to day operations and pursuit of objectives. while it had the lowest revenue per passenger out of the eight airlines with which it compared itself. (To be fair some other airlines also initially took a harsh stance towards passenger claims and later retreated. is well known for its cost cutting exercises. At its first quarter results presentation in 2006. postage. meaning that customer complaints had to be by letter. it also had the highest operating margin (18%). When asked in 2002 what was 'the gospel according to Ryanair'. dealing with departmental costs is more problematic. Ryanair recognised that the cost category with greatest potential for reduction was flight operating costs. The trick is to encourage all staff to participate. Whilst cutting such expenses as telephone charges and stationery can be fairly straightforward. Lawyers and consumer groups questioned the legality of this policy and Ryanair later backed down. If cutting the more obvious costs does not achieve the required effect. Overall Ryanair's cost reduction programme appears to have been successful over the last decade for the company with its operating costs repeatedly increasing at a slower rate than its passenger revenues. Case example: Ryanair Ryanair. saying it would refund all reasonable expenses to passengers. for example. not demand it. The Advertising Standards Authority ruled that the women's appearance. a low cost airline based in Ireland. In 2010 Ryanair announced a €319m profit and by 2012 annual profits had risen to €503m. fax or by phoning Ryanair's premium rate telephone number. Possibly the heaviest criticisms that Ryanair has faced were a result of the delays to flights caused by the Icelandic volcanic ash in April 2010. More generally Ryanair's policy of charging for a large number of optional extras has come under heavier criticism. it will be more difficult to maintain product or service quality. management will have to adopt a more innovative approach. but the easiest way to cut costs is to focus firstly on those expenses that are common to all companies. Cutting inventory levels too far could result in the company being unable to fulfil delivery promises. For example. However Ryanair's reputation has come under significantly more pressure over the last few years. Gas and electricity. Between 2000 and 2006. However Ryanair did not provide email contact details. In February 2012 two UK newspaper ads for Ryanair were banned after complaints that they were sexist and treated women as objects. In response to this Ryanair's cost cutting exercises have included charging passengers to check in bags in an attempt to reduce baggage handling costs and encouraging passengers to make greater use of web-based check-in.3 Which costs should be cut? This depends on the type of business you are in. Ryanair managed to reduce its unit operating costs by 40%. focusing on individual departments' spending. That is why management must understand how different costs affect profitability and the extent to which each cost category can be reduced before the company's operations are adversely affected. In March 2011 Ryanair was found to have breached European Union regulations that companies selling goods online must offer customers the facility to complain via email. Keeping costs down is part of Ryanair's overall strategy which means that when the company releases a statement of further cost cutting schemes no-one is surprised. the company's chief financial officer responded that it was to continually ask if Ryanair could do what it was doing at a reduced cost. However because it offers a prepaid booking service with a Mastercard prepaid card (not the most-used credit card) it is able to advertise cheap fares that don't include extra credit card charges. Ryanair has decided to remove check-in staff completely. The use of e-business helped to eliminate approximately 12% of turnover costs. Ryanair adds fees when customers use all but one type of credit card to pay online. including travel agents' commission. 3. the company revealed that. Not only do you have the issue that departments feel they are being victimised.) Ryanair has also been criticised by the Office of Fair Trading for being 'puerile and childish' over its credit card payment policy.

In June 2012 however Aer Lingus advised its shareholders to reject the bid. After the bid was made. In May 2010 Kraft announced it intended to cut £379 million from operational costs. and moved production to Poland. linked female cabin crew with sexually suggestive behaviour and thus breached the advertising practice code. An innovative approach is often H more successful than the usual 'we have to cut costs by 10% across the board' requirement. it is unlikely that extreme cost reduction programmes will be viewed positively either by customers or the financial markets. are ultimately implemented to improve profitability T without improving revenue figures. should only be undertaken to the extent that it adds value to the company. Always bear in mind that cost reduction. This was not the first time that Ryanair had fallen foul of the code in this area. not introduced on an ad hoc basis. Ryanair already owned 30% of Aer Lingus and the bid was prompted by the Irish government's plans to sell its 25% share in Aer Lingus. Aer Lingus. Kraft also completed the controversial closure of Cadbury's Somerdale factory at Keynsham. manufacturing and supply chain improvements. A P Cost reduction programmes. but this was well short of the 38% premium that Ryanair offered. Cost analysis and control 135 . A company spokesman commented that this amount of change was not unusual when two companies merged. reflecting market doubts about the offer. 3. E Programmes should be integrated into the overall company strategy. whilst tempting in order to get ahead of competitors. Directors should not C automatically assume that the most obvious cuts are the right ones. a detailed understanding of how company expenses can affect not just the bottom line but the overall quality of the product or service and a vision of where the company is heading. Any improvements in revenue will further enhance profits. thought and participation by directors. A few years previously it had had to withdraw an advert of a model dressed as a schoolgirl with the headline 'hottest back to school fares'. Effective cost reduction programmes should result from thorough management planning. also Cadbury's Marketing Director and Chief Strategy Officer. 3.4 Implementing cost reduction programmes As with choosing techniques. These savings would be generated by changes to IT and back office operations. As soon as shareholders' wealth starts to suffer the programme should be halted. there is a right way and a wrong way to implement cost reduction programmes. as mentioned above. and process. stance and gaze. cost reduction is seen by outsiders as not only reducing expenditure but reducing quality and service as well. including Cadbury's Chairman. R Case example: Kraft and Cadbury 3 Kraft took over Cadbury in February 2010 and by July 2010 more than 100 senior Cadbury staff had left. reduce motivation and have a detrimental effect on company harmony. Also in 2012 Ryanair attempted again to purchase its principal rival. which had been planned before the acquisition. together with the wording of the advert. Companies whose marketing strategies are based on low costs will probably get away with cost cutting for longer but if you work in an organisation that has always promoted high quality goods and services. management and employees. Critics pointed out that none of the top jobs subsequent to the acquisition had gone to Cadbury staff. again on the grounds that it might not be allowed by the competition authorities.4%. taking the process too far can have adverse effects. A previous bid in 2006 had been disallowed by the European Commission. Managers have to think about the extent to which cost reduction can be sustained before the business starts to suffer in other ways. Cost reduction is not about reporting smaller numbers in the income statement – it should be the culmination of extensive planning. shares in Aer Lingus rose 15.5 Potential problems with cost reduction programmes While companies seek to reduce costs to remain competitive. A good cost reduction programme is as much about damage limitation as cutting costs. Cost reduction is inevitably a sensitive area and the wrong approach can alienate staff. Regardless of how it is marketed. Chief Executive and Chief Finance Officer.

Svenska Handelsbanken's. (e) Internet technology is used to reduce costs. companies should pay close attention to how far they can take their cost reduction programmes before performance – both financial and operational – is adversely affected. Techniques that have been suggested as particularly relevant for the public sector include the application of lean manufacturing principles to ensure that expenditure that does not add value is not undertaken. squeezing central costs. A story in the Daily Telegraph in July 2010 claimed that public sector bodies could recruit up to 200 cost-cutting consultants on wages of up to £1. (d) Central services and costs are negotiated rather than allocated. One area in which public sector expenditure may increase is on cost-cutting consultants. as will using other countries' performance as 'competitive' benchmarks. help stimulate performance. (c) Lower credit losses because front line staff feel more concerned to make sure that the information on which they base lending decisions is correct. Improvements in the transparency and quality of publicly available information will. Despite this. claimed that: 'Experienced efficiency experts do not come cheap. Innovation is often the key to successful cost reduction programmes – management should not automatically assume that the most obvious areas for cost reduction are always going to be the right ones. Case example: Svenska Handelsbanken Swedish bank.6 Summary of cost reduction Cost reduction should not be a one-off exercise. however. A poorly executed cost-cutting programme can leave staff demoralised and undermine productivity. which has produced an attitude keen to weed out unwarranted expenses. service and quality could be maintained while reducing costs. given that the public sector is a huge buyer of products and services. low costs are the product of several factors: (a) Small head office staff. Case example: Public sector cost cutting How to cut public sector expenditure has been the subject of considerable debate in the UK. it's claimed. and a flat.000 a day. 136 Business Analysis . (b) People in regions and branches are self sufficient and well-trained and are measured by competitive results. The European Vice President of Svenska Handelsbanken believes that 'devolving responsibility for results. and quality management techniques such as Six sigma that aim to eliminate errors in service delivery. Improving procurement skills has been identified as another priority area. Doug Baird.' 3. with the benefit accruing to the customer's own branch. There should be focus not only on the costs themselves but also on in-house procedures and processes. using technology and … eradicating the budgeting "cost entitlement" mentality are just some of the actions we have taken to place costs under constant pressure'. due to the perceived need to reduce the public sector deficit. simple hierarchy. but they can deliver a huge return on investment and improve service delivery. turning cost centres into profit centres. Companies should continually review their costs to determine whether the same level of operations. Managing Director of consultants Interim Partners.

for example user-manuals which are specific to the market (ie user manuals in French would be added at the French distribution centre). 4. for the sake of focus. such as those with customers and suppliers.  Price and inventory co-ordination. A firm selling 'cheap and cheerful' goods will want suppliers who are able to supply 'cheap and cheerful' subcomponents. It involves the following.  A firm should choose suppliers with a distinctive competence similar to its own. 4 The supply chain Section overview  Whatever the exact nature of supplier bargaining power.  Reduction in the number of suppliers. 3  Reduction in customers served. T E Supply chain management (SCM) is a means by which the firm aims to manage the chain from input R resources to the consumer. This has had major consequences on the distribution methods of companies in these supply chains.  Logistics design.  Supply chain management is about optimising the activities of companies working together to produce goods and services.  Early supplier involvement in product development and component design.  Linked computer systems – electronic data interchange saves on paperwork and warehousing expense. however. Firms co-ordinate their price and inventory policies to avoid problems and bottlenecks caused by short-term surges in demand. The chain should be considered as a network rather than a pipeline – a network of vendors support a network of customers. arms length relationship with a supplier has been replaced by one which is characterised by closer co-operation. in some cases. from raw material suppliers to end customers. what might be the underlying strategic concerns?  Close partnerships are needed with suppliers whose components are essential for the business unit. with third parties such as transport firms helping to link the companies.  Joint problem solving.1 Introduction Market and competitive demands are. Supply chain relationships are becoming increasingly more co- operative rather than adversarial. delivering to their customers on a just in time (JIT) basis. Hewlett-Packard restructured its distribution system by enabling certain product components to be added at the distribution warehouse rather than at the central factory. Cost analysis and control 137 . As well as tactical issues. C 4. The adversarial.2 Supply chain management H A Supply chain management is about optimising the activities of companies working together to produce P goods and services.  Supplier representative on site. and concentration of the company's resources on customers of high potential value. such as promotions.  A firm can make strategic gains from managing stakeholder relationships. holding costs and excess capacity. Point to note: The aim is to co-ordinate the whole chain. Linkages between businesses in the supply chain must therefore become much tighter. compressing lead times and businesses are reducing inventories. many firms aim to build closer relationships for the sake of efficiency.

not just marginal. service and speed. Management Accounting. A process is a collection of activities that takes one or more kinds of input and creates an output. from which the following definition is taken. 5.  Fundamental and radical indicate that BPR is somewhat akin to zero base budgeting: it starts by asking basic questions such as 'why do we do what we do'.  Process. but under BPR the aim of manufacturing is not merely to make the goods. BPR is simply a synonym for squeezing costs (usually through redundancies). BPR recognises that there is a need to change functional hierarchies: 'existing hierarchies have evolved into functional departments that encourage functional excellence but which do not work well together in meeting customers' requirements' (Rupert Booth.  At best it may bring about new insights into the objectives of the organisation and how best to achieve them. Properly implemented BPR may help an organisation to reduce costs. Part of this process is the manufacture of the goods. 1994). The main writing on the subject is Hammer and Champy's Reengineering the Corporation (1993). Manufacturing should aim to deliver the goods that 138 Business Analysis . without making any assumptions or looking back to what has always been done in the past.  This section examines the business process re-engineering concept in detail. order fulfilment is a process that takes an order as its input and results in the delivery of the ordered goods.1 General overview Business process re-engineering (BPR) involves focusing attention inwards to consider how business processes can be redesigned or re-engineered to improve efficiency. such as cost. Definition Business process re-engineering (BPR) is the fundamental rethinking and radical redesign of business processes to achieve dramatic improvements in critical contemporary measures of performance. dramatic and process. Many organisations have taken it too far and become so 'lean' that they cannot respond when demand begins to rise. incremental improvements. cut down on the complexity of the business and improve internal communication. It can lead to fundamental changes in the way an organisation functions. Problems with the partnership approach to supply chain management are these. improve customer services. quality. For example. including looking at the types of organisations that might employ this process to improve efficiency and reduce costs. radical.  Each partner needs to remain competitive in the long term  There is a possible loss of flexibility  The relative bargaining power may make partnership unnecessary  Arguments about sharing profits 5 Business process re-engineering Section overview  Business process re-engineering involves focusing attention inwards to consider how business processes can be redesigned or re-engineered to improve efficiency.  At worst. The key words here are fundamental.  Dramatic means that BPR should achieve 'quantum leaps in performance'.

In his desperation. It's as simple as that.2 Examples of business process re-engineering R Some organisations have redesigned their structures on the lines of business processes. and any aspect of the manufacturing process that hinders this aim should be re- engineered. 3  A move from a traditional functional plant layout to a JIT cellular product layout is a simple example. Until recently it has been successful.  Elimination of non-value-adding activities. Consider a materials handling process. A company employs 25 staff to perform the standard accounting task of matching goods received notes with orders and then with invoices. but imports of higher quality pumps at lower prices are now rapidly eroding its market share. One way of improving the situation would have been to computerise the existing process to facilitate matching. processing purchase orders. About 80% of their time is spent trying to find out why 20% of the set of three documents do not agree. and is now being widely adopted by European companies. storing materials. 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. and quality 'built-in'  One manager provides a single point of contact  The advantages of centralised and decentralised operations are combined Case example: Car manufacturer Based on a problem at a major car manufacturer. Be prepared to apply your knowledge of BPR to a particular scenario or to examples that you are aware of from your reading or own experience. adopting BPR to avoid all the co-ordination problems caused by reciprocal interdependence. the remainder Cost analysis and control 139 . The first question to ask might be 'Do they need to be manufactured at all?' A re-engineered process has certain characteristics. Goods that are not agreed are sent back to the C supplier. This would have helped. The managing director feels helpless in the face of this onslaught from international competitors and is frantically searching for a solution to the problem. inspecting materials and paying suppliers. There are no files of unmatched items and time is not wasted trying to sort out these files. Goods that agree to an order are accepted and paid for. were ordered. H A P T E 5.  Often several jobs are combined into one  Workers often make decisions  The steps in the process are performed in a logical order  Work is performed where it makes most sense  Checks and controls may be reduced. the use of BPR has already transformed the performance of a significant number of companies in the USA which were mentioned in the article. Such re-engineering should result in the elimination or permanent reduction of the non-value- added activities of storing. Unfortunately. which incorporates scheduling production. The examiner has stated that good answers often draw on the candidate's own experience in the context of the question set. This process could be re-engineered by sending the production schedule direct to nominated suppliers with whom contracts are set up to ensure that materials are delivered in accordance with the production schedule and that their quality is guaranteed (by supplier inspection before delivery). 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. purchasing and inspection. but BPR went further: why accept any incorrect orders at all? What if all the orders are entered onto a computerised database? When goods arrive at the goods inwards department they either agree to goods that have been ordered or they don't.

it can be difficult to identify with clarity just what are an organisation's core competences and it is not too difficult to imagine an organisation whose core competence was.3 Implications of BPR for accounting systems Issue Implication Performance Performance measures must be built around processes not departments: this may measurement affect the design of responsibility centres. thus freeing more time to concentrate on core competences. See Answer at the end of this chapter. outsourcing is appropriate for peripheral activities: to attempt to outsource core competences would be to invite the collapse of the organisation. Certainly. the motor manufacturing industry seems to be moving in this direction. Arguably the reports should be designed round the process teams. In addition the supplier of the outsourced service can provide specialist expertise which is not available in-house or it would not be worth maintaining in-house. (b) Describe the major pitfalls for managers attempting to re-engineer their organisations. 6 Outsourcing Section overview  Often money and other resources are wasted trying to perform operations in which the organisation in question has little or no expertise. in fact. 140 Business Analysis .  One particular example is the outsourcing of IT services which will be considered in this section. Activity ABC might be used to model the business processes. components or services. Variances New variances may have to be developed. A further advantage of outsourcing is that external suppliers may capture economies of scale and experience effects that mean that costs may be reduced by using their services rather than in-house provision. Generally speaking. particularly for smaller organisations.  Outsourcing may be the answer to this problem – organisations are increasingly turning to external experts to perform such functions. Outsourcing should have also the major advantage of reducing the workload or the organisation's managers. Use of outsourcing has been driven often by it being the most cost-effective way of providing a service. Structure The complexity of the reporting system will depend on the organisational structure. However. Requirements (a) Explain the nature of BPR and describe how it might be applied to a manufacturing company like AB Ltd. outsourcing. 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.1 The use of outsourcing in business Outsourcing can be defined as the use of external suppliers as a source of finished products. 6. Getting the best out of outsourcing depends on successful relationship management rather than through the use of formal control systems. if there are independent process teams. Reporting There is a need to identify where value is being added. 5.

By utilising such standards. will provide chocolate eggs containing mini Mars products. After all. this has led to staff unrest due to the loss of UK jobs and there have been an increasing number of customer complaints about the level of service from the call centres. Cadbury has focused on marketing and sales activities to develop the Cadbury's Crème Egg into a product that is sold all year round.  It can save on costs by making use of supplier economies of scale.  The ability to measure what is actually supplied and thus establish the degree of conformity with specification. some organisations are wary of delegating control of business functions to outsiders because of the difficulty of assessing the cost-effectiveness of what is purchased: cost should be fairly clear.  It means giving up an area of threshold competence that may be difficult to reacquire.  The ability to specify with precision what is to be supplied: this involves both educating suppliers about the strategic significance of their role and motivating them to high standards of performance. After the acquisition Kraft went ahead with the controversial plan to close Cadbury's Keynsham plant. However.' The extract above was written before Kraft's acquisition of Cadbury in 2010. Bonanza currently operates in more than 100 countries and offers a telephone customer service facility. but the quality of what is purchased is extremely difficult to assess in advance. Interactive question 6: Outsourcing [Difficulty level: Intermediate] Bonanza plc is a financial services company that offers a credit card service on a global scale. Bonanza has set up a call centre facility to handle customer queries. businesses will have more confidence in the quality of the service being provided and suppliers will know what is expected of them. particularly over quality.  It can increase effectiveness where the supplier deploys higher levels of expertise.6.  It can lead to loss of control. for instance. The adoption of quality standards may help to overcome this problem. C H Case example: Mars and Cadbury's A P '… chocolate confectionery companies in the UK will sell Easter eggs promoting their brands and T products every spring. Due to changes in technology and pressure from competitors' activities. However. Bonanza is in a dilemma and is wondering if the customer service function should have been retained in-house. but pledged there would be no further closures of manufacturing sites in the UK. Cost analysis and control 141 . or E in packaging highlighting Mars products around the egg. The reason that you might be tempted to buy R one of these eggs is because it has Mars products associated with it. and is increasingly outsourcing this facility to locations offering lower labour costs. Mars therefore doesn't have to produce the egg itself – that activity can be outsourced. Outsourcing of non-core activities is widely acknowledged as having the potential to achieve important cost savings. thereby making the operation viable. There are also practical considerations relating to outsourcing. 3 On the other hand. and no further compulsory redundancies in manufacturing in the UK in the next two years. The decision whether or not to outsource can often be bound strongly to an organisation's competitive strategy and focuses on how strategic the activity is to the organisation. Mars. owing mainly to a lack of helpfulness and general language difficulties.2 Successful outsourcing Successful outsourcing depends on three things. it would be expensive to maintain production facilities for chocolate eggs for only a couple of months a year.  The ability to make adjustments elsewhere if specification is not achieved.

 Functions with only limited interfaces are most easily outsourced. 6.4. choosing a supplier and the supplier relationship. There is clear link here with the idea of core competences: a core competence will enable the company to create value in a way that its competitors cannot imitate.1 How to determine what will be outsourced?  What is the system's strategic importance? A third party IT specialist cannot be expected to possess specific business knowledge.  Do we know enough about the system to manage the arrangement?  Are our requirements likely to change? The arrangement is incorporated in a contract sometimes referred to as the Service Level Contract (SLC) or Service Level Agreement (SLA). The processing system function. Requirement What are the advantages and disadvantages of outsourcing the customer enquiry function? See Answer at the end of this chapter. activities from which the organisation does not derive significant value may be outsourced. management can focus on core business activities Managing such arrangements involves deciding what will be outsourced. The arrangement varies according to the circumstances of both organisations. eg client retains equipment but all on a time-used payroll services provided by FM company basis Management Mostly retained Some retained Very little retained responsibility Focus Operational A function Strategic Timescale Short-term Medium-term Long-term Justification Cost savings More efficient Access to expertise. There is a strong case for examining the possibilities of outsourcing non-core activities so that management can concentrate on what the company does best. eg payroll. These value activities are the basis of the company's unique offering.4 Outsourcing IT/IS services This section looks at a specific example of outsourcing – namely IT/IS services – and the advantages and disadvantages of outsourcing such a key business function. It is unlikely that any business has more than a handful of activities in which it outperforms its competitors. 6.3 The value chain. The purpose of value chain analysis is to understand how the company creates value. 6. core competences and outsourcing Core competences are the basis for the creation of value. better service. 142 Business Analysis . Outsourcing arrangement Feature Timeshare Service Facilities Management (FM) What is it? Access to an Focus on An outside agency manages the external specific organisation's IS/IT facilities.

such as India and South Africa. the level of service quality agreed should group these services together. many organisations are now outsourcing activities both near shore (such as Eastern Europe) and offshore (such as the Far East and India). With pressure to provide adequate customer service at low cost.5 Current trends in outsourcing In an effort to cut costs. infrastructure. for example. Case example: Barclays In January 2010 Barclays decided to bring IT application development back in-house after deciding not C to renew a £400m outsourcing agreement with Accenture after 6 years. 3 6. It might have reached the point where it had become more cost-effective to take the work back in-house. many organisations are closing call centres in parts of Western Europe and relocating to low- cost countries and regions. transfer to another supplier or move back in-house. language barriers. Timescale When does the contract expire? Is the timescale suitable for the organisation's needs or should it be renegotiated? Software ownership This covers software licensing. (a) Environmental (location. security and copyright (if new software is to be developed). time differences) (b) Labour (experience in relevant fields. cultural compatibility. risk. Cost analysis and control 143 . Before taking the decision to outsource overseas. Improvements in technology and telecommunications and more willingness for managers to manage people they can't see have fuelled this trend. P T The decision to return application development in-house resulted from a strategic review and a desire to E have the most efficient model that supported its business. Around the same time Barclays A also decided to bring the management of its desktop facilities back in-house. a number of points should be considered. hardware and software being used. 230 staff that had moved to H Accenture at the start of the agreement were to move back to Barclays. Employment issues If the organisation's IT staff are to move to the third party. Dependencies If related services are outsourced. Element Comment Service level Minimum levels of service with penalties for example:  Response time to requests for assistance/information  System 'uptime' percentage  Deadlines for performing relevant tasks Exit route Arrangements for an exit route. It is claimed that savings on call centre costs range from 35% to 55% for near shore outsourcing and 50% to 75% for offshore outsourcing. Commentators suggested that Barclays had R faced a situation where the costs of outsourcing had significantly increased because of the extra expensive services added on to the original outsourcing contract. size of labour market) (c) Management (remote management) (d) Bad press associated with the perception of jobs leaving the home country Case example: Call centres The inside of a call centre will look virtually the same wherever it is in the world. similar headsets. employer responsibilities must be specified clearly.

The main reason for this decision was increased salaries and property and accommodation costs in India. New Call Telecom. Case example: DHL In September 2003. for example. There are problems associated with outsourcing to Eastern Europe. along with improved telecomms capabilities. One third of college graduates speak more than two languages fluently and of the two million graduates per annum. many of which have been re-equipped. it is highly skilled.5. However in 2011 a trend appeared to be developing for call centre jobs to be moved back to the UK. 144 Business Analysis . the logistics firm.1 Outsourcing to Eastern Europe The newly-enlarged EU is providing organisations in Western Europe with a range of outsourcing opportunities.2 Outsourcing to India Moving back-office functions 'offshore' began in earnest in the early 1990s when organisations such as American Express. At the moment. These language skills. The vast manufacturing facilities that were used to produce for the massive Soviet market. labour is relatively cheap in Eastern Europe. Accenture and IBM have all set up call centres in India. 6. Reports suggested that Santander had had one of the worse complaints records in the banking industry in 2011. explained that India offered all of the economic advantages that companies were looking for. the legacy of an education system and somewhere where there is relatively good English. provide the opportunity for manufacturing to be outsourced. Operations in many countries are bound by an excess of red tape. however. announced that it was moving one of its call centres from India back to the UK. But not only is it cheap. The fact that English is widely taught and the existence of a Western culture are added attractions. Santander's chief executive commented that customers had said that this issue was the most important factor in terms of their satisfaction with the bank. Also in July 2011 the bank Santander announced it was moving its call centres back to the UK in an effort to please customers. General Electric and Swissair set up their own 'captive' outsourcing operations in India.5. 80% speak English. make it an ideal choice for call centres. 6. The vast majority of service jobs being outsourced offshore are paper-based back office ones that can be digitalised and telecommunicated anywhere around the world. In July 2011 telecommunications company. and it is closer than the Far East – an important consideration in today's rapidly-moving environment. Phil Morris. India has one of the most developed education systems in the world. and current political and market uncertainty in Russia could constrain growth there for some time. DHL. British Airways. GE. managing director of EquaTerra for Europe (an advisory company). The low labour cost in India has always made the outsourcing option attractive. Case example: UK companies outsourcing to India The number of UK companies outsourcing to near shore or offshore destinations rose from 47% to 57% in 2007 – with all of them using India at least once as the offshore destination of choice. and routine telephone enquiries that can be bundled together into call centres. announced it was shifting its data centre in Britain and parts of its IT operations in Switzerland to a state-of-the-art services centre in Prague that will oversee all of the organisation's European IT operations.

Cost analysis and control 145 . how these functions can be redesigned to improve efficiency. help increase business efficiency. new face of the ever-changing techniques have evolved to business environment. C H A P T E R 3 Business process Outsourcing may be re-engineering focuses employed by organisations attention on the internal to avoid wasting resources functions of the on functions that can be organisation to determine better provided by experts.Summary and Self-test Summary Traditional management As more and more accounting techniques have organisations strive to numerous limitations in the reduce costs.

The company has grown over the past 10 years and now has 30 employees. With the growth in home ownership and an increase in leisure time this sector of the economy has seemed recession-proof. Conrad is becoming concerned about its cost levels and the increasing popularity of cheaper furniture. 4 Coming up Roses Maggie Flowers is the owner of Coming up Roses. several glasshouses and a turnover of almost £5 million. Conrad's management is considering an intensive cost reduction programme to keep Conrad competitive in the furniture market. When inventory items reach their re-order level in a supermarket the in-store computerised inventory system informs the inventory clerk. she wonders? She is now contemplating re-focusing her activities on selling plants and not producing them. Maggie is annoyed when she sees garden centres putting large margins on her products for re-sale. Following the initial investigation the consultant reported. it raises a purchase order to one of its suppliers. all generating a huge demand for horticultural products. It has been suggested that she turns her growing areas into a garden centre. The furniture is manufactured to a high standard and appeals to customers looking for excellent quality but without the 'frills' expected of a bespoke manufacturer. The company is located on one site near to a rapidly expanding urban area. As a result. The clerk then raises a request daily to the ABC central warehouse for replenishment of inventories via fax or e- mail. Conrad's main expenses are materials for the furniture. 146 Business Analysis . Why can't Coming up Roses take advantage of these profits. With a recent downturn in the furniture market. If the company is to increase its profits as a garden nursery it must either acquire additional land for growing plants or it must direct more of its sales to the ultimate user (the general public) and move away from sales to other intermediaries (the garden centres) and so obtain higher margins. The site is relatively large but there is no room for expansion. If the local warehouse cannot replenish the inventory from its inventory holding. If the local warehouse has available inventory. ABC recently contracted an IT consultant to analyse and make recommendations concerning their current supply chain briefly described above. buying in from other specialist nurseries and transforming her glasshouse space into selling areas. with several new housing developments. Competitors appear to be moving their retail outlets away from the high street to out of town malls in a bid to reduce rental costs. The ABC area warehouse staff conduct all business communication with suppliers. There is a large market nearby. 'To enable an established traditional company like ABC to develop a virtual supply chain system it may be necessary to employ a business process re-engineering (BPR) approach. 2 ABC ABC has a chain of 20 supermarkets. The supplier delivers the inventory to the warehouse and the warehouse then delivers the required inventory to the supermarkets within the area. direct labour and rental costs for the retail stores. Requirement Advise Conrad's management team on the issues they should consider when devising the cost reduction programme. 3 Controlling outsourcing costs Explain how control can be exercised over the cost of outsourced services. it is forwarded to the supermarket within 24 hours of receiving the request. describe what is meant by a business process re-engineering approach. a company specialising in growing plants for sale to garden centres and to specialist garden designers.' Requirement With reference to the above scenario. It holds very little inventory and has been advertising heavily in good quality home magazines. Self-test 1 Conrad Furniture Conrad Furniture Company produces good quality furniture in a central workshop and sells it through its 10 retail stores across the UK.

Identify the main management problems such a policy might generate. Requirements (a) Examine the arguments that may be used to support or reject such a 'buy instead of grow' strategy for Coming up Roses. but is not fully convinced of the wisdom of such a move.Maggie has read that the further one moves downstream in the business chain – into dealing directly with the consumer – the greater is the profit margin. She is very tempted by this strategy. C H A P T E R 3 Cost analysis and control 147 . (b) Outsourcing has become a popular strategy for many companies in attempting to reduce their commitment to non-core activities.

This is essentially different from procedures such as automation where existing processes are simply computerised. Conrad should think about whether using cheaper materials will affect the quality of its furniture. A move to an entirely different type of location may affect Conrad's marketing strategy. gas and telephone charges? Just focusing on certain costs means there is a danger of these costs cut to the extent that the business cannot operate properly. as there does not appear to be any great expectations from customers. Would it adversely affect its reputation as being a provider of good quality and service? Retail parks may not be prestigious enough for some customers. Is one of its marketing ploys the fact that the stores are easily accessible. which could lead to more custom. such as cost. the processes are essentially the same. The most obvious costs are not always the ones that should be cut – in Conrad's case the materials. It is neither appealing to the top quality bespoke market nor to the customers looking for low prices. In other words. However. Conrad has identified its other main costs as being materials and labour. it should guard against cutting costs too much. it should think about the effects of cutting certain costs on its strategy. Conrad should also consider how its customers would view a move to a retail park or mall. Conrad might want to consider whether its current sources of materials are offering the best deals in terms of price but should think carefully before deciding whether cheaper materials could be used. Are there too many layers of management? Is there potential for savings in electricity. For a company whose reputation is based on quality. BPR involves significant change in the business rather than minimal or incremental changes to processes. Likewise. While these are obvious targets for a cost reduction programme. in town centre locations? If so – and if this is the reason the stores attract a lot of trade – relocation may not be such a good idea. If it still wants to be seen as offering 'middle of the road' quality it should be able to get away with a certain amount of cost reduction. as there comes a point when customers will start to notice differences in the furniture and in the levels of service. which may be quicker than email. This may seem like a good idea but Conrad should determine whether they are actually in direct competition with these retailers. labour and rent. this could be disastrous. Are they offering similar quality of products and similar levels of service? Would Conrad's customers be prepared to switch to these retailers on the basis of cost alone? Remaining in the high street may be more expensive but might give Conrad an advantage over these other retailers by being easily accessible. However. service and speed. Conrad has noticed that competitors are moving their retail outlets away from the high street to save rental costs. if the manufacture of furniture relies on specialist labour. this may again harm its reputation. Advertising in expensive magazines may be something to consider. the process of sending the order and receiving the goods to the warehouse is the same. if it does not want to compromise its quality reputation. Does this advertising generate large amounts of revenue? Are expensive magazines reaching the type of customer that Conrad attracts or is the company being too ambitious? There may be better ways of reaching potential customers. Conrad should guard against panicking about costs and take an organised approach to the programme. While it is correct to be concerned about its cost levels. 148 Business Analysis . quality. Answers to Self-test 1 Conrad Furniture The first thing Conrad has to consider is its future positioning in the market. the local warehouse could use EDI to send an order to the supplier. For example. Although some improvements in speed may be obtained. 2 ABC Business Process Re-engineering (BPR) is the fundamental rethinking and radical design of business processes to achieve dramatic improvements in critical contemporary measures of performance. although this should not be too much of a problem given that most of Conrad's customers are looking for excellent quality but 'without the frills'. Conrad should look at all costs to determine where the savings could best be made. it may be difficult to get people of such calibre at a cheaper price. although Conrad should guard against opting for the cheapest option simply on the grounds of cost. If it starts advertising in what might be seen as lower quality magazines.

due to inflation or variations in the quantity of throughput subject to outsourcing) (v) Reducing prices if the level of service is lower than anticipated 4 Coming up Roses (a) Coming up Roses is currently profitable and growing. In the example. C H  On-going control involves ensuring that the service delivered is actually of the contracted A level and quality (for example. Maggie could reverse her current position. For example. the supplier is aware of this and can send goods directly to the store. Maggie could escape this price pressure.  The organisation must confirm a price for the service with the successful bidder. At the same time. and where necessary replaced with more efficient processes. rather than inventory being ordered from the store via the central warehouse. the opportunities for additional growth are limited on the current site. A documented policy as to the tendering process is required and should cover factors such as the number of bids required. New hardware and software will also certainly be required. the supplier could monitor inventories in each store using an extranet. Cost analysis and control 149 . The options are either to acquire new land or to switch from the current strategy of growing in order to sell to distributors to one of buying plants from other suppliers to sell direct to the public. it is also more cost effective for the supplier as the central warehouse effectively becomes redundant. These could be lower than her own current production costs. to ensure that they are accepted. P T  The organisation must also give consideration to drawing up policies to deal with problems E which could arise in the following areas. She would be buying from a number of specialist nurseries and could seek the best terms available. ABC may have to clearly explain the benefits to staff from the new systems.  External organisations should then be invited to tender for providing the service. a service level agreement). squeezing Maggie's margins against her production costs. ABC may also need to obtain additional skills in terms of IT and ability to implement and use those systems. Arguments for buying instead of growing Probably the main argument for the proposed switch in strategy would be the higher profit margins that would be available. When goods reach re-order level. R (i) Judging the quality of service provided (ii) Approving any costs in excess of those agreed 3 (iii) Including a get-out clause in the contract (to be used if the contractor becomes complacent following a desire by the organisation to build up a long-term relationship) (iv) Including a price increase clause in the contract (for example. However. Key features of BPR involve the willingness of the organisation to accept change and the ability to use new technologies to achieve those changes. whether the bids should be sealed and so on. The aim of BPR is to provide radical improvements in efficiency and cost savings of up to 90%.  The organisation should document details of the level and quality of the service it requires from the external organisation. especially where large suppliers are achieving greater economies of scale than she can in her existing scale of operations. Amending the supply chain as noted above will help to achieve these benefits. Using BPR. Maggie is unable to obtain good margins on her output because she is selling to commercial purchasers who will inevitably seek the best value for money they can achieve. since garden centre products are 'lifestyle' rather than essential purchases and many customers are not particularly price-sensitive when making such purchases. At the moment. 3 Controlling outsourcing costs The most significant controls will need to be implemented at the planning stage of the process of outsourcing a service. By moving down the value chain. Not only does this provide inventory replenishment much more quickly. the actual reasons for the business processes being used can be queried. There are arguments both for and against this proposed new strategy.

however. this will reflect on Coming up Roses rather than on the original supplier. If there are problems. There might also be the fear that if Coming up Roses is not successful in this new retail operation it may not be able to re-enter the production market. She would be able to make use of her suppliers' expertise in cultivating delicate or exotic plants in that they would both produce saleable specimens for her and provide advice on how best to keep and display them. At the moment. Coming up Roses risks losing a degree of control over the quality of the products that it sells. One of the main problems is that of lack of direct control. A further major hurdle is that Maggie would have to finance considerable capital investment in order to convert the glasshouses into a suitable garden centre. If poor quality products are sold to the public. Despite the popularity of this strategy. this surrender of competence prevents further improvement in the outsourced function. A further problem is the loss of internal competences that accompanies outsourcing. Finally. Maggie would have access to a wider range of products from general and specialist suppliers. this is probably not a major problem. Staff may leave or be transferred. However as the expertise. The danger is that this may result in a poor quality of service. which may require expense and time to remedy. there are a number of problems that management may face when outsourcing. as the intention is to buy from a number of suppliers. However. By buying plants from other suppliers rather than growing them. There must also be a system set up for dealing with disputes over quality or service. If an activity is dealt with in-house. it should not be too difficult a task to re-enter the production market if required. technology and capital cost requirements of production are fairly low. its management loses direct managerial control over it. This would enhance the attractiveness of her garden centre at little cost. and those who remain will lose their skills. if the activity is outsourced it may be harder to determine who is responsible in the outsourcing agency and therefore disputes may be harder to settle. However. Not only would working practices have to change. they are not used to the processes involved either in buying plants from other suppliers or in selling to the general public. then management must negotiate carefully and set up systems for review and monitoring of the contract and the services provided under it. If outsourcing is to be used successfully. 150 Business Analysis . but there may also be a requirement for new staff with selling rather than horticultural skills. Arguments against buying instead of growing Perhaps the most persuasive argument against this strategy is that of core competences. the individual responsible is clearly identifiable. It could be argued that Coming up Roses risks disruption to its supplies if it moves away from growing its own plants. A further potential problem related to lack of direct control is that of responsibility. Maggie and the Coming up Roses staff have expertise in growing plants. At the same time. (b) Outsourcing Outsourcing enables organisations to concentrate resources on their value-adding core activities. Plant and equipment also will be sold or transferred. If a function of a business is outsourced. then there will be an individual who is directly responsible for that activity who will report to management on it.

000 R Less: closing inventory (60.000 2.000 90.000 P Cost of sales: T Opening inventory Nil 60.000 240.000 3 (Under-)/over-absorption (10.000) 25.200 = £50 per unit Therefore full cost (absorption cost) per unit = £50 + 70 = £120 (2) Under-/over-absorption of overheads July August Actual production 2.000 Income statements – absorption costing July August C H £ £ £ £ A Sales (£150 per unit) 225.000 130.000) 15.000 Production 140.Answers to Interactive questions Answer to Interactive question 1 WORKINGS Budgeted fixed production cos ts (1) Fixed production costs absorbed per unit = Budgeted production 110.000) (210.000) Net profit 10.000 = 2. Cost analysis and control 151 .000 35.000) Contribution 120.000 105.000 E Production 240.000 Income statements – marginal costing July August £ ££ £ £ Sales 225.000 Less closing inventory (35.000 175.200 (Under-)/over-production (200) 300 Fixed costs per unit £50 £50 (Under-)/over-absorption (£10.000 300.000 (Increase)/decrease in inventory and fixed costs charged against sales (25.000 450.000) Gross profit 45.000 (500  £50) Marginal cost profit 10.000 130.000) (110.000) (360.000 105.000) Nil (105.000) Nil (180.000) £15.500 Expected production 2.000 Less fixed costs (110.000 Difference in profits July August £ £ £ £ Absorption cost profit 35.000 450.000 Profits are different under each method due to the fixed costs that are included in closing inventory with absorption costing.000 Cost of sales Opening inventory Nil 35.200 2.

00/unit 500 [(15 / 100)  25.000] Alpha = = £27.75/unit 400 [(35 / 100)  25.00/unit Echo = £20.000] Echo = = £18.75/unit Oscar = £56.000] Bravo = = £12.00/unit Echo = £18.50/unit 500 Bravo = £50.000] Alpha = = £11.60/unit 500 Bravo = £61.000] Oscar = = £43.000] Alpha = = £10.00/unit Oscar = £62.000] Alpha = =£22.50/unit 300 [(30 / 100)  25.00/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)  32.25/unit 152 Business Analysis .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 [(3 / 15)  69. Answer to Interactive question 2 (a) Overhead cost Cost driver Set up costs Number of set ups Materials handling costs Number of times materials handled Ordering costs Number of orders Engineering costs Number of spare parts required (b) Set-up costs per unit = (Number of setups per product / Total number of setups)  Total set up cos ts  Number of units produced [(20 / 100)  25.50/unit Engineering costs/unit = (No of spare parts per product / total spare parts)  Total engineering cos ts Number of units produced [(15 / 60)  45.33/unit Echo = £23.00/unit 500 Bravo = £20.

000 120.000 Total contribution (£) 144.900 Break even point in batches = = 1.000: = A Contribution ratio P T where: E Contribution per unit R Contribution ratio = Selling price per unit (65  25) 3 = 65 40 = 65 465.000 4.75 43.00 18.000 132.75 Material handling costs 27.50 Engineering costs 22.00 20.00 62.00 80.00 Other costs: Set-up costs 10.50 18.000 6.000 Contribution per unit £18 £22 £30 The lowest common denominator for the sales mix is 4:3:2.00 20.00 50.00 20.00 42.00 12.00 35.000  25.50 50.60 61.167 pairs of roller skates Contribution / unit (55  25) (b) Margin of safety = Current sales units – Break even sales units = 20.50 450.000 Required sales revenue = (40 / 65) = £796.167 = 5. Assume that sale of racquets in the next period will be in this mix. 306.833 pairs of roller skates (29%) C Total fixed cos ts  Re quired profit H (c) Required sales revenue to ensure a profit of £25.10 205. Answer to Interactive question 3 Total fixed cos ts 425.25 163.00 100.550 batches 198 Cost analysis and control 153 .250 Answer to Interactive question 4 The first step is to calculate contribution per unit: McEnrova Grafassi Federdal Total sales units 8.00 138.50 Note: Remember to include the direct costs that were given in the question when calculating the total cost per unit. Total cost per unit Alpha Bravo Echo Oscar £ £ £ £ Direct costs: Material 60. This is a common mistake in exam situations.000 (a) Break even point = = =14.00 Labour 32.83 195.00 Ordering costs 11.33 23. Total contribution for the standard batch is £198 (4  £18 + 3  £22 + 2  £30).000 – 14.75 56.

000 306.550  4 = 6. (ii) Ignore the current way of doing business. (viii) Information provision should be included in the work that produces it. All aspects of the process. must be considered.900 Profit/(loss) NIL 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'. AB Ltd may be divided into departments. (ix) The customer should have a single point of contact in the organisation.000 (£100  3. This might affect where sales order processing and credit controls are carried out.550  3 = 4.300 93. and so is relevant to AB Ltd.100 The break even point in terms of sales revenue is: £ McEnrova 248.200 4.000 (£40  6.650) Federdal 310. (vii) Those who perform the process should manage it. Arguably.200) Grafassi 279. in some cases. The distinction between managers and workers should be eroded.100 Contribution per unit £18 £22 £30 Total Contribution (£) 111. AB Ltd does not need to manufacture.100) 837.200 Grafassi: 1. enlarged jobs are more efficient if they lead to fewer people being involved in the process. (iii) Carefully determine how to use technology. Key features of BPR (i) Focus on the outcome.650 Federdal: 1. Scientific management split jobs into their smallest components.550  2 = 3.600 102. This means that AB Ltd must have an information strategy for the company as a whole. For example. as it is split between several different responsibilities. what would we do?' 154 Business Analysis . BPR suggests that. from ordering to delivery. In effect. it involves the ordering and delivery of goods to the customer. a process is more than just manufacturing. Indeed having a large number of departments may make the process harder to manage. IT has often been used to automate existing processes rather than redesign new ones.900 Total Fixed Costs (£) 306. (iv) Review job design.000 Check: McEnrova Grafassi Federdal Total Sales units 6. (vi) Work must be done in logical sequence. Part of this process is manufacture of goods. not the task. The number of units of each model that has to be sold in order to break even is: McEnrova: 1. The same customer's order may be passed from department to department. However. (v) Do the work where it makes most sense.650 3. This can affect factory layout but also the sequence of clerical activities.000 (£60  4. BPR requires the asking of the fundamental question: 'If we were starting from scratch. The current organisation structure is not relevant to the process. decision aids such as expert systems should be provided.

so the potential for improved efficiency has not yet been achieved. when customers find a reason to be sympathetic to the unions' stand. they will have their own priorities that affect their stance. such as India. Managing this opposition would be difficult enough. Gate Gourmet had. Cost reductions become T E possible for two main reasons. There is also a loss of managerial expertise relating to the outsourced function or activity. This may illustrate an important disadvantage of outsourcing. when a dispute arose at Gate Gourmet. The customer dissatisfaction and staff union resistance illustrate a further disadvantage to outsourcing. rather than the view of the business as a whole. there have been complaints from customers about poor service. (iii) Implementation is difficult. a focus strategy or a differentiation strategy. First. many of whom were related to Gate Gourmet staff. It is the natural way to fit a business into the upstream supply chain. A further potential advantage is the increased effectiveness that can arise from greater specialisation. It will be necessary to consult with the service providers concerned and. as organisations fail to think through what they are trying to achieve. it has long been used by businesses too small to be able to establish in-house sources of C highly specialised or expensive goods and services such as legal services and safety equipment. This means that when changes occur in the market or the environment. It is now quite common for call centre work to be outsourced to countries with lower labour costs. Managers are thus left with a BPR formula that they may not fully understand and have to implement it in a hostile work environment. outsourcing has P become popular largely because it holds out the promise of reduced costs. It is natural enough that staff union organisers should be opposed to anything that threatens their members' livelihood and their own status. 'Make or buy' is a classic cost accounting problem. However. especially when casual. Managers will fight very hard to avoid any threats to their position. in fact. (vi) Management consultants responsible for the ideas often fail to come up with realistic strategies for implementation. but because BA's baggage handlers. been spun off from BA some years previously. Bonanza seems to be in the middle of outsourcing its call-centre operation and is wondering how far to take it. its Heathrow in-flight catering supplier. It could certainly expect to achieve the cost reductions mentioned above. whose executives are liberated from the management of peripheral activities. which is the potential for loss of control of the work involved. The dispute caused extensive delays to BA flights out of Heathrow. naturally enough. part-time or 3 temporary work patterns predominate. Second. outsourcing. a major employer is better placed to exert downward pressure on wage rates than are a large number of businesses employing a few staff each. such as improving quality. sales director and finance director may well conflict. for both goods and services. requiring major expenditure on consultancy. in an increasingly competitive and globalised business environment. and the process becomes captured by departmental interest groups. There may be other competitive responses more appropriate than BPR. Answer to Interactive question 6 Outsourcing has always been a feature of business life. and by the purchaser. In AB Ltd. the provider may be able to achieve economies of scale by R concentrating some aspect of the production or service process. investment in IT systems and disruption. (v) BPR becomes associated only with across the board cost cutting rather than a fundamental re- evaluation of the business. It is thus expensive and risky. (iv) Managers take a departmental view. It is not worth doing unless there is a good reason. who concentrates on a particular type of work.(b) Pitfalls (i) BPR is an all or nothing proposition. particularly in work employing low-skilled labour. not merely because of disruption to catering supplies. stopped work in sympathy. Bonanza is likely to find itself having to adjust its policy. (ii) AB Ltd is concerned about overseas competition. Stakeholder concern about outsourcing was of particular importance to British Airways in 2005. it may be much more difficult to plan a suitable response. Also. This can be achieved both by the supplier. The customer may deal with all three of them. which is its potential for generating stakeholder concern. Cost analysis and control 155 . H A More recently. the production director. The significance of this loss extends beyond concerns about quality.

156 Business Analysis .

CHAPTER 4

Investment appraisal

Introduction
Topic List
1 Overview of investment appraisal techniques
2 Adjusted present value
3 Modified internal rate of return
4 Real options
5 Firms with product options
6 Investment appraisal and risk
7 International investment appraisal
Summary and Self-test
Answers to Self-test
Answers to Interactive questions

157

Introduction

Learning objectives Tick off

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

158 Business Analysis

1 Overview of investment appraisal techniques

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

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

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

1.1.3 Accounting rate of return (ARR)
This can be calculated in two ways:
Average annual profit from investment
ARR =  100
Initial investment

Average annual profit from investment
Or  100
Average investment

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

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

Investment appraisal 159

1.2 Other issues – inflation and taxation
1.2.1 Inflation
The relationship between money rate of return, real rate of return and inflation rate is as follows.
(1 + m) = (1 + r) (1 + i)
Where: m is the money rate of return
r is the real rate of return
i is the inflation rate
If cash flows are stated in money terms, they should be discounted at the money rate; if cash flows are
stated in real terms, they should be discounted at the real rate.

1.2.2 Taxation
Tax writing-down allowances (WDA) are available on non-current assets which allows a company's tax
bill to be reduced. Unless told otherwise, WDA will be 20% reducing balance and tax is paid on profits
in the same year.

Interactive question 1: Investment appraisal techniques [Difficulty level: Easy]
Robbie plc is considering investing in a new piece of machinery which will cost £500,000. The
company has already spent £15,000 on exploratory work on the new machine.
Net cash inflows from the machine are expected to be £200,000 per annum. The machine has a useful
life of four years after which it will be sold for £50,000. Depreciation is charged on the straight-line
basis and Robbie plc's cost of capital is 10%.
Requirement
Calculate the following.
(i) Payback period
(ii) Accounting Rate of Return
(iii) Net Present Value
(iv) Internal Rate of Return
See Answer at the end of this chapter.

Interactive question 2: NPV with inflation and taxation [Difficulty level: Intermediate]
Bazza plc is considering the purchase of some new equipment on 31 December 20X0 which will cost
£350,000. The equipment has a useful life of five years and a scrap value on 31 December 20X5 of
£60,000.
Annual cash inflows generated from the equipment are expected to be £110,000, with operating cash
outflows of £15,000 per annum.
Inflation is running at 4% per annum over the life of the project and tax allowances are available on a
20% reducing balance basis. Tax is paid in the same year as the profits on which the tax is charged.
Corporation tax rate is 23% per annum and there is no writing-down allowance in the year of sale.
Bazza's cost of capital is 12%.
Requirement
Calculate the NPV of the project based on the above information and advise Bazza plc on whether the
project should be undertaken.
See Answer at the end of this chapter.

160 Business Analysis

2 Adjusted present value

Section overview
 Adjusted Present Value (APV) combines the ungeared value of a cash flow stream with the tax
effect of any borrowings as a separate element of value.

The adjusted present value (APV) calculation starts with the valuation of a company without debt then,
as debt is added to the firm, considers the net effect on firm value by looking at the benefits and costs
of borrowing. The primary benefit of borrowing is assumed to be the tax benefit (interest is tax
deductible) whilst the main cost of borrowing is the added risk of bankruptcy.
The decision rule is to accept the project as long as its total worth is greater than the outlay required.

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

Worked example: APV valuation
A company has a current annual cash flow to the firm of £10m which is expected to grow at 3% in
perpetuity.
The equity beta of the company is 1.2; market debt to equity ratio is 80%; and the tax rate is 23%.
The company has £120 million debt. The risk premium for the market portfolio is 8% and the risk-free
interest rate is 6%. What is the value of the firm using the APV method?

Solution
(i) Calculate the ungeared beta using the following formula:
D(1  T)
βe = βa (1 + )
E C
H
Where: A
P
βe = beta of equity in the geared firm
T
βa = ungeared (asset) beta E
R
D = market value of debt
E = market value of equity
4
T = corporate tax rate
1.2 = a [1 + (0.8) (1 – 0.23)]
1.2 = 1.616a
a = 0.74
(ii) Estimate ungeared cost of equity using CAPM:
Ungeared cost of equity = 6% + 0.74(8%) = 11.92%, say 12%
(iii) Calculate value of ungeared firm:
FCFF0 (1  g) (1 T)NOI(1  g)
VU  
k e,u g k e,u g

Investment appraisal 161

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

Interactive question 3: APV valuation [Difficulty level: Intermediate]
Mega Millions Inc is considering investing in a project with annual after-tax cash flows of £2.5 million
per annum for five years. Initial investment cost is £8 million.
The debt capacity of the company will increase by £10 million over the life of the project, with issue
costs of debt of £300,000. Interest rates are expected to remain at 8% for the duration of the project.
The existing cost of equity for the company is 14% and the current ratio of market value of debt: market
value of equity is 1:3. Corporation tax is 23% and the company's current equity beta is 1.178. The risk
free rate of interest is 7% and the market risk premium is 6%.
Requirement
Calculate the APV of the project and recommend whether Mega Millions should undertake the
investment with the proposed method of financing.
See Answer at the end of this chapter.

3 Modified internal rate of return

Section overview
 The modified internal rate of return (MIRR) is the IRR that would result without the assumption
that project proceeds are reinvested at the IRR rate.

In comparing the IRR to the NPV criterion in Section 1 above, we identified the assumption of
reinvestment rate as one of the problems with the IRR. A way to resolve this problem is to allow the
specification of the reinvestment rate. This modification is known as the modified internal rate of return
(MIRR).

162 Business Analysis

3.1 Calculating the MIRR

Worked example: Modified IRR
Consider a project requiring an initial investment of $24,500, with cash inflows of $15,000 in years 1
and 2 and cash inflows of $3,000 in years 3 and 4. The cost of capital is 10%.

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

Alternatively, instead of using discount tables, we can calculate the MIRR as follows.
44,415
Total return = = 1.813
24,500

4
MIRR = 1.813 – 1
= 1.16 – 1
= 16%
In theory the MIRR of 16% will be a better measure than the IRR of 24.7% (see below).

Investment appraisal 163

3.2 Decision criterion
The decision criterion of the MIRR is the same as the IRR – that is:
 If MIRR is larger than the required rate of return: ACCEPT
 If MIRR is lower than the required rate of return: REJECT

Interactive question 4: Modified IRR [Difficulty level: Easy]
The following cash flows are relevant for a project:
Year 0 Year 1 Year 2 Year 3
Cash outflows (£) –10,000 0 0 0
Cash inflows (£) 0 3,000 5,000 7,000
If the discount rate is 10% what is the modified internal rate of return?
See Answer at the end of this chapter.

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

3.4 Disadvantages of modified internal rate of return
However, MIRR, like all rate of return methods, suffers from the problem that it may lead an investor to
reject a project which has a lower rate of return but, because of its size, generates a larger increase in
wealth.
In the same way, a high-return project with a short life may be preferred over a lower-return project
with a longer life.

4 Real options

Section overview
 Real options give the right to the management of a company to make decisions when it is
profitable for the company. Real options were covered at the Professional stage. However, the
topic is taken further at the Advanced stage by providing greater detail of the types of options
available and also considering the process of how to value such options.
 Real options are not derivative instruments in the way that traded options such as those for
interest rate and foreign currency hedging are. Real options are very useful in the context of
selecting strategies.

A real option is the right, but not the obligation, to undertake a business decision, such as capital
investment – for example, the option to open a new branch is a real option. Unlike financial options,
real options are not tradable – for example, the company cannot sell the right to open another branch
to a third party. While the term 'real option' is relatively new, businesses have been making such
decisions for a long time.

164 Business Analysis

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

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

C
H
A
P
T
E
R

4

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

Investment appraisal 165

If PV  I . 4. They are also important for projects involving new products where their acceptance in the market is uncertain and companies would like to switch to more profitable alternative uses. the expansion will not take place. When the present value of the remaining cash flows (PV) falls below the liquidation value (L) . call it I . the asset may be sold. These options are particularly important for large capital intensive projects such as nuclear plants. Expansion will normally require an additional investment. are like American put options. Abandonment options. 166 Business Analysis . ie when PV > I .3 Option to abandon Whereas traditional capital budgeting analysis assumes that a project will operate in each year of its lifetime. airlines. and railroads. The extra investment will be undertaken only if the present value from the expansion will be higher than the additional investment. Abandonment is effectively the exercising of a put option. the firm may have the option to cease a project during its life. which are the right to sell the cash flows over the remainder of the project's life for some salvage value. This option is known as an abandonment option. Thus the option to expand is again a call option of the present value of the firm with an exercise price equal to the value of the additional investment.

there is a risk that a H discounted cash flow approach to valuation will not fully reflect the full value of the option.4 Option to redeploy The option to redeploy exists when the company can use its assets for activities other than the original one. An electric utility. Investment appraisal 167 . 5 Firms with product options Section overview  A product option is where the firm has the ability to sell a product in the future but does not have the obligation to do so. These options are also valuable in the utility industry. Naïve implementation of discounted cash flow analysis might suggest that the coal-fired plant be constructed since it is considerably cheaper. but are not generating any cash flows. The option to abandon is a special case of an option to redeploy. 4. P T E 5. the DCF approach is not fully appropriate.  Use a traditional DCF framework and factor in a higher growth rate than would be justified given the existing assets of the firm.  Value the option on the open market.  The option-based approach to valuation may be more suitable.1 Problems with traditional DCF techniques R In the context of a product option. The switch from one activity to another will happen if the PV of cash flows from the new activity exceeds the costs of switching. This is only possible if there is a traded market in such options. for the following reasons.5 Valuation of real options The valuation of options will be dealt with in Chapter 7 Financial Engineering. it provides greater flexibility. These options are particularly important in agricultural settings. Firms that have product options are often research and technology-based. a beef producer will value the option to switch between various feed sources.  The options represent a current asset of the business.2 Possible solutions to the valuation problem There are three possible methods of valuing product options. In addition.  Use an option-based approach to valuation. and firms owning natural resources. this approach is probably not feasible. for example. 5. For example. Whereas the dual plant costs more. The value of this operating option should be taken into account. Examples of product options are patents and copyrights. C When a firm has a product option that is not currently generating cash flow. it expresses contingent cash flows as expected cash flows. In particular.  Traditional valuation techniques may not be suitable for such organisations. Management has the ability to select which fuel to use and can switch back and forth depending on energy conditions and the relative prices of coal and gas. may have the option to switch between various fuel sources to produce electricity.4. 4  Any cash flows expected to be generated by the product could be outside of the detailed forecasting period. This is considered below. If there is no active market or if the option is difficult to separate from the other operations of the firm. consider an electric utility that has the choice of building a coal-fired plant or a plant that burns either coal or gas. This is A because a DCF approach may not incorporate all the possible future cash flows of the company. The problem with this is that any growth rate used will be subjective. preferring to use the cheapest acceptable alternative.

The following approach could be adopted. be possible to use techniques such as scenario analysis. This will be based on the expected cash flows that the asset can generate.3 Use of option pricing models The principles of option pricing are discussed in detail in Chapter 7 Financial Engineering. 5.  Identify the cost of delay. Where a company is investing in research and development. the underlying asset in the context of product options will not be traded.3. changes in technology and so on. the same approach will apply. such as natural resources. If the product is not implemented immediately.  Identify the value of the underlying asset. are as follows. 168 Business Analysis . It is typically assumed that this remains constant in present value terms. which means that the underlying asset must be easy to buy and sell. however. Given the uncertain nature of the cash flows and the distant time periods in which they may arise. This will reduce the present value of the asset. The higher the standard deviation. It would.  Identify the expiry date of the option. but the value of the option is clearly even more uncertain due to the greater uncertainty of the inputs.2 Using option pricing models to value product patents When valuing product patents as options. the expected volatility of the underlying asset price and the time to expiry.  They assume that the price of the underlying asset follows a continuous pattern. the key inputs for an option pricing will need to be identified.1 Problems with using option pricing models to value product options The problems of using option pricing models. if a firm has the right to mine natural resources. with any uncertainty being reflected in the cash flows of the asset. it will take time to extract the resources. owing to changes in the potential market for the product. Any cash flows after this date are expected to have an NPV of zero. Again this will be difficult to identify. it is not appropriate for long-term product options. being the underlying asset price.  Identify the exercise price of the option. the strike price. such as Black-Scholes. The impact of this is that the model will undervalue deeply out- of-the-money options.  Identify the standard deviation of the cash flows above.3. This is not a problem when valuing options on quoted shares. 5. it clearly will be difficult to value the underlying asset precisely.  They need the underlying asset to be traded.  They assume that exercise occurs at a precise point in time. While this may be a reasonable assumption in the context of short-dated equity options. this will reduce the value of the cash flows from the project as competing products will enter the market in future years. This is because the model is based on the principle of arbitrage. A similar approach could be adapted to valuing other product options. However. the more valuable the asset. since there will be generic competition after patent protection ends. it is clearly inappropriate in the context of product options. In the case of product options. meaning that arbitrage is not possible. This is the cost of investing in the resources needed to produce the asset. 5. While this may be a reasonable approximation most of the time for quoted shares. since it will underestimate the probability of a sudden large increase in the value of the underlying asset.  They assume that the standard deviation of price of the underlying asset is known and does not vary over the life of the option. exercise may occur over a long period of time. This is when the patent expires. but has no patents developed. For example.

thus difficult to assign probabilities to outcomes A risky situation is one where we can say that there is a 70% probability that returns from a project will be in excess of £100. which may be more E uncertain than operating decisions which are part of an ongoing strategy. assign probabilities to outcomes Uncertainty  Future possible outcomes  Little past experience. The NPV could depend on a number of uncertain independent variables. One particular approach to sensitivity analysis – the certainty-equivalent approach – involves the conversion of the expected cash flows of the project to riskless equivalent amounts. The greater the variability is. probabilities can be assigned to the various outcomes that could prevail. and hence the project returns. The basic approach of sensitivity analysis in the context of an investment decision is to calculate the project's NPV under alternative assumptions to determine how sensitive it is to changing conditions. Risk  Several possible outcomes  On basis of past relevant experience. This section examines the use of sensitivity analysis and expected values as ways of incorporating risk.  Estimates of benefits will be for several years ahead sometimes 10. In general. we are faced with an uncertain situation. or new venture. 15 or 20 years ahead or even C longer. 6 Investment appraisal and risk Section overview  Risk was covered in detail in Chapter 2 and was also dealt with in the Professional stage Financial Management paper.  Risk can be applied to a situation where there are several possible outcomes and. Actual costs may escalate well above budget as the work progresses. This section deals with risk from the viewpoint of how it affects investment appraisal. no information can be provided on the returns from the project.000 but a 30% probability that returns will be less than £100.1 Sensitivity analysis 4 Sensitivity analysis assesses how responsive the project's NPV is to changes in the variables used to calculate the NPV.  Estimates of capital expenditure might be for several years ahead. such as for major construction projects. are likely to be variable.000. If however.  There is a wide range of techniques for incorporating risk into project appraisal. P T  A major investment may be part of a new business strategy. on the basis of past relevant experience.  Selling price  Sales volume  Cost of capital  Initial cost  Operating costs Investment appraisal 169 . An indication is thus provided of those variables to which the NPV is most sensitive and the extent to which those variables would need to change before the investment results in a negative NPV. R 6. A distinction should be made between the terms risk and uncertainty. the greater the risk. and such long-term estimates can at best be approximations. H A  An investment decision may be significant in scale compared to most operating decisions.  Uncertainty can be applied to a situation where there are several possible outcomes but there is little past relevant experience to enable the probability of the possible outcomes to be predicted. risky projects are those whose future cash flows. The problem of risk may be more acute with capital investment decisions than other decisions for the following reasons.

the more sensitive is NPV to that project variable as the variable would need to change by a smaller amount to make the project non-viable. Year Initial investment Variable costs Cash inflows Net cash flows £'000 £'000 £'000 £'000 0 7.566 (c) Selling price 1.857 (1. NPV Sensitivity = % Pr esent value of project var iable The lower the percentage.8% 11.714) 5.590 3.000) (3.926 (1.000) 1 0. (a) Initial investment 1.500 4.024 Sensitivity =  100 = 14. once the decision has been taken to accept the investment.  Benefits  Cost savings  Residual value Sensitivity analysis therefore provides an indication of why a project might fail.500 4.6% 7. Kenney Co has a cost of capital of 8%.571 3.019 4.000 (b) Sales volume 1. The sensitivity of each project variable is as follows.024 The project has a positive NPV and would appear to be worthwhile.000 (7.852) 6. Management should review critical variables to assess whether or not there is a strong possibility of events occurring which will lead to a negative NPV.024 Sensitivity =  100 = 8. Management should also pay particular attention to controlling those variables to which the NPV is particularly sensitive. Discount PV of initial PV of variable PV of cash PV of net Year factor 8% investment costs inflows cash flow £'000 £'000 £'000 £'000 0 1. Solution The PVs of the cash flow are as follows. Worked example: Sensitivity analysis Kenney Co is considering a project with the folowing cash flows.000) 6.024 Sensitivity =  100 = 12.000) (7.000 1 (2.590 1.590 170 Business Analysis .500 2 (2.000) 6.167 2 0. A simple approach to deciding which variables the NPV is particularly sensitive to is to calculate the sensitivity of each variable.500 Cash flows arise from selling 650.8% 11.857 (7.566) 11.000 units at £10 per unit. Requirement Measure the sensitivity of the project to change in variables.

749 2 4.56%  317  128  The cost of capital can therefore increase by 132% before the NPV becomes negative. (d) Variable costs 1.694 3. management is more interested in the combination of the effects of changes in two or more key variables. The elements to which the NPV appears to be most sensitive are the selling price followed by the sales volume.000 2 2. C  Critical factors may be those over which managers have no control.500 0. T E R Interactive question 5: Sensitivity analysis [Difficulty level: Easy] Nevers Ure Co has a cost of capital of 8% and is considering a project with the following 'most-likely' 4 cash flows.15 +   (0. Parameters defining acceptability must be laid down by P the managers.000 Requirement Measure the sensitivity (in percentages) of the project to changes in the levels of expected costs and savings.1 Weakness of this approach to sensitivity analysis These are as follows:  The method requires that changes in each key variable are isolated.024 Sensitivity =  100 = 28.  Sensitivity analysis does not examine the probability that any particular variation in costs or revenues might occur.000) 1 (7.15)  = 18.402 0.500 7. Let us try discount rates of 15% and 20%. 6. Investment appraisal 171 .566 (e) Cost of capital.000) 1 (7. H A  In itself it does not provide a decision rule.756 3.  Looking at factors in isolation is unrealistic since they are often interdependent.7% 3. Year Purchase of plant Running costs Cost savings £ £ £ 0 (7.500 0.20 0.000) 1 4. We need to calculate the IRR of the project.123 NPV 317 NPV (128)  317 _  IRR = 0.1.000 6.833 3.870 3. However. Net cash Discount Discount Year flow factor PV factor PV 15% 20% £'000 £'000 £'000 0 (7.000) 1 2. Management should thus pay particular attention to these factors so that they can be carefully monitored.915 0. See Answer at the end of this chapter.

6. Assume that the risk free rate is 5%. for example in the following ways  By calculating the worst possible outcome and its probability  By calculating the probability that the project will fail to achieve a positive NPV 172 Business Analysis . Year Cash flow Discount factor Present value 5% $ $ 0 (9.000 0.000 (9.000) 1 4. Year Cash flow Discount factor Present value 10% $ $ 0 (9. A probability distribution of 'expected cash flows' can often be estimated.826 4.3 Probability analysis A probability analysis of expected cash flows can often be estimated and used both to calculate expected NPV and to measure risk. Solution The risk-adjusted NPV of the project is as follows. The standard deviation of the NPV can be calculated to assess risk when the construction of probability distributions is complex.000 0.) These 'certainty-equivalents' should then be discounted at a risk free rate.751 3.500 0.000) 1. This may be used to do the following.000 (9. is considering a project with the following expected cash flows. Step 1 Calculate an expected value of NPV Step 2 Measure risk. not just one.130 3 5.2 The certainty-equivalent approach Worked example: Certainty-equivalent approach Dark Ages Co.000 0.755 NPV + 5.000) 1.667 2 3.248 The project seems to be clearly worthwhile.363 2 5.000) 1 7. 2 and 3 cash flows respectively.864 2. (Note that this method of risk adjustment allows for different risk factors in each year of the project. However.826 2. because of the uncertainty about the future cash receipts.909 6.160 NPV 548 The project appears to be worthwhile after adjusting for uncertainty and should be accepted. 6. whose cost of capital is 10%. assess whether the project is worthwhile.900 0.952 4. the management decides to reduce them to 'certainty-equivalents' by taking only 70%.000 0.721 3 2. recognising there are several possible outcomes. Requirement On the basis of the information set out above. 60% and 50% of the Years 1.

We begin by calculating C the present values of the cash flows.000 1.000 0.2 2 300 0.000 0.25 350.9 1 200 0.Worked example: Probability estimates of cash flows A company is considering a project involving the outlay of £300.00 200.000 0.8 1 300 0.826 82.000 0.826 165.1 Investment appraisal 173 .909 90.000 0.50 300. Year 1 Cash flows Probability £ 100.25 200.826 247.909 181.826 289. we need to draw up a probability distribution of the expected cash flows.50 300. Requirement Calculate the expected value (EV) of the project's NPV and the probability that the NPV will be negative.50 200.909 272.000 0.7 4 2 100 0.00 Year 2 If cash flow in Year 1 is: there is a probability of: that the cash flow in Year 2 will be: £ £ 100.6 2 200 0.000 0.000 1.25 200.000 0. H A Year Cash Discount Present P flow factor value T 10% E £'000 £'000 R 1 100 0.50 100.25 Nil 0.000 which it estimates will generate cash flows over its two year life at the probabilities shown in the following table.25 100. Solution Step 1 Calculate expected value of the NPV First.000 0.8 2 350 0.000 0.000 1.25 300.25 1.25 200.000 0.00 The company's cost of capital is 10%.00 300.

 Expected values do not evaluate the range of possible NPV outcomes.0625 437. and 'expected' NPV may never actually occur. With international investment appraisal.7 0.750 181.6 53.5 65.700 272.50 0. For example.0625 + 0.8 0.25 289.0625 90.  Investment appraisal techniques for multinational companies must therefore incorporate these additional complexities into the decision-making process.25 0.1250 173.8 35.688 90.1 16. the project should go ahead unless the risk is unacceptably high.681 90. all of which will be considered in this section.8 0.4 33.50 82.9 27.8 0.2500 347.3.1 0.0 86.2 0.50 0.25 0.375 or 37. multinational companies must take into account factors that affect the behaviour of the economies of those countries which have an impact on their projects.9 0.8 0.25 0.125 = 0. 7 International investment appraisal Section overview International investment appraisal was covered briefly at the Professional stage but is analysed in more depth here.5%.25 165. a company may be making assumptions about the number of tourists from abroad who may be visiting. there would be an increase in the number of UK visitors to the USA if the pound strengthened significantly against the US dollar.25 0.9 0.1250 429.0625 256.1250 520.050 181.2 0.0625 + 0.25 82. political.369 272.50 247.420 Step 2 Measure risk Since the EV of the NPV is positive.50 0.420 £ EV of PV of cash inflows 344. This might be considered an unacceptably high risk. in appraising a tourist development. Companies that undertake overseas projects are exposed to such risks as exchange rate movements. 174 Business Analysis .1 Problems with expected values There are the following problems with using expected values in making investment decisions.9 0. Year 1 PV of Probability Year 2 PV of Probability Joint Total PV of EV of PV of cash flow cash flow probability cash inflows cash inflows £'000 £'000 £'000 £'000 (a) (b) (c) (d) (b)  (d) (a) + (c) 90.0 0. From the column headed 'Total PV of cash inflows' we can establish that this probability is 0. tax rates and inflation in the countries from which tourists may visit.1250 264.063 272.6 0.006 181.50 165.  Many of the projects that companies appraise may have an international dimension.113 3 344.9 5.0625 561.125 + 0.7 0.25 0. 6. cultural. This will be affected by such factors as interest rates.000.25 0.5 21.25 165. Exchange rates will also have an impact on the number of foreign visitors – for example.25 0.8 0.6 0. potential tourists will have less money to spend and spending on such luxuries as foreign holidays may decline.  An investment may be one-off.  Assigning probabilities to events is highly subjective.25 247. The probability that the project will have a negative NPV is the probability that the total PV of cash inflows is less than £300.000 EV of NPV 44.2 0. litigation and taxation risks. If interest and tax rates rise.7 0.420 Less: project cost 300.

6. Investment appraisal 175 . 7. is considering undertaking a new project in Portugal. and then convert the resulting NPV at the spot exchange rate. The current €/£ spot rate is 1. P T Company tax will be charged in Portugal at a rate of 40%. Pre-tax net cash inflows of €800m are A expected to be generated each year from the project. a UK company. There is a double taxation agreement between the UK and Portugal. and political risk that affect the present value of the project. The initial capital will therefore be €1. C There will also be an initial working capital requirement of €500m. An appraisal of an international project requires estimates of the exchange rate. Worked example: Overseas investment appraisal Bromwich plc.1. which means that no UK tax will be 4 payable on the project profits. (b) Discount the cash flows in the host country's currency from the project at an adjusted discount rate for that currency. Portuguese tax is paid at the end of the year following R that in which the taxable profits arise. which will be recovered at the end of H the project. with depreciation on a straight-line basis E being an allowable deduction for tax purposes.750m.250m. This will require initial capital expenditure of €1. 7. Requirement Calculate the present value of the project. and the euro is expected to appreciate against the £ by 5% per year. we can: (a) Convert the project cash flows into sterling and then discount at a sterling discount rate to calculate the NPV in sterling terms. double taxation agreements. For a UK company investing overseas.1 Calculating NPV for international projects There are two alternative methods for calculating the NPV from an overseas project. In a domestic project the NPV was calculated using the formula: n NCF TV NPV =  t + n -I t 0 t = 1  1+ WACC  1+ WACC n where: NCF is net cash flow WACC is the weighted average cost of capital TV is the terminal value I is the initial investment When a project in a foreign country is assessed we must take into account some specific considerations such as local taxes. with no scrap value envisaged at the end of the five-year lifespan. A project of similar risk recently undertaken by Bromwich plc in the UK had a required post-tax rate of return of 10%.1 Effects of exchange rate assumptions on project values Changes in exchange rates are as important as the underlying profitability in selecting an overseas project. that is the risk that arises from the fact that the cash flows are denominated in a foreign currency. The main consideration of course in an international project is the exchange rate risk.

payable one year in arrears.75 526.683 0.66 422.32 401. The subsidiary would produce a product which would achieve annual sales of $1. is considering whether to establish a subsidiary in Ruritania (where the currency is the $).826 0.60 1. at a cost of $2.95 317.400.000 at the end of four years. Tax allowable depreciation is at a rate of 20% on a straight line basis on all non-current assets.000.98 541.65 –105. It expects also to be able to sell the rights to make the product for $500. 176 Business Analysis .909 0. It is the company's policy to remit the maximum funds possible to the parent company at the end of each year.000 a year.05 Discount factor 1.000 and incur cash expenditures of $1.751 0.37 * using unrounded discount rates Interactive question 6: International investment appraisal [Difficulty level: Intermediate] Donegal.600.05 872.000 per annum will be incurred each year in the UK over the expected life of the project.52 1. The UK taxation rate on UK income and expenditure is 23%.000 and working capital of $400.000. The company's cost of capital for the project is 10%. Solution Method 1 – conversion of flows into sterling and discounting at the sterling discount rate 0 1 2 3 4 5 6 Euro flows (€m) Capital –1750 500 Net cash flows 800 800 800 800 800 Depreciation 250 250 250 250 250 Tax 220 220 220 220 220 –1750 800 580 580 580 1080 –220 Exchange rate 1.000 0.75 478.621 0.66 303. As this is an application of the international Fisher effect which is covered in Chapter 7 – Financial Engineering. The company has a planning horizon of four years.30 1.000.34 –187. The Ruritanian $:£ exchange rate is 5:1. we will demonstrate the calculations for this method in that chapter. Method 2 – discounting foreign cash flows at an adjusted discount rate When we use the second method we need to find the cost of capital for the project in the host country. Assume there is full double taxation relief in operation between the UK and Ruritania. a UK company.000. Administration costs of £100.47 331.18 €/£ Cash flows in sterling –1093. If we are to keep the cash flows in euros. Requirement Calculate the NPV of the project. See Answer at the end of this chapter.000.59 NPV in sterling 774.564 PV* –1093. at the end of which it expects the realisable value of the subsidiary's non-current assets to be $800. This would be represented by non-current assets of $2.24 1.80 445. and they need to be discounted at a rate that takes account of both the UK discount rate (10%) and the rate at which the exchange rate is expected to decrease (5%).44 1. Tax is payable at the rate of 35% in Ruritania and is payable one year in arrears.37 1.

1. Solution The NPV under the three scenarios is given in the table below.38 320.75 –1093.05 –102.2 The effect of exchange rates on NPV Now that we have created a framework for the analysis of the effects of exchange rate changes on the net present value from an overseas project we can calculate the impact of exchange rate changes on the sterling denominated NPV of a project. The opposite happens when the domestic currency appreciates. The NPV of the project should take explicit account of this potential loss by deducting the loss of export earnings from the relevant net cash flows.32 sterling 7.7.80 313. Investment appraisal 177 . the relevant cash flows for the evaluation of the project should take into account the loss of export earnings in the particular country.2. (a) The exchange rate remains constant at €1.34 528.2 Forecasting cash flows from overseas projects 7.19 R 2 580 362.83 774. Cash flows in £m Constant C H Cash flows exchange Sterling depreciates 5% Sterling appreciates 5% A Period in €m rate per year per year P 0 –1750 –1093. in which it already exports.05 298.23 4 5 1080 675 872.1 Effect on exports When a multinational company sets up a subsidiary in another country.5 –187.88 6 –220 –137. the sterling value of the cash flows increases and the NPV increases.80 3 580 362.60 for the duration of the project (b) Sterling appreciates 5 per cent every year (c) Sterling depreciates 5 per cent every year.75 –1093.14 4 580 362.66 328. The relationship between NPV in sterling and the exchange rate is shown in the diagram below (where 'e' is the exchange rate): NPV£ 0 e Worked example: Effect of changes in the exchange rate Calculate the NPV for the Portugal project of Bromwich plc (see previous worked example on overseas investment appraisal for details) under three different scenarios.5 422.5 401. In this case the sterling value of the cash flows declines and the NPV of the project in sterling declines.75 T 1 E 800 500 526. When there is a devaluation of sterling relative to a foreign currency.32 476.5 445.60 Present value in 521.

3. In general.000. The international aspects of the effects of taxes on investment appraisal are covered fully in the Advanced stage Tax Study Manual.2. suppose that the tax rate on profits in the Federal West Asian Republic is 20% and the UK corporation tax is 23%.3 Transaction. only the proportion of cash flows that are expected to be repatriated should be included in the calculation of the NPV.3 Subsidies Many countries offer concessionary loans to multinational companies in order to entice them to invest in the country. This gives rise to a foreign exchange exposure. The benefit from such concessionary loans should be included in the NPV calculation. 7. When the profits are remitted to the UK.1 Transaction exposure Transaction exposure occurs when a company has a future transaction that will be settled in a foreign currency. or the home currency value of foreign revenues could depreciate as a result of a stronger home currency.2. as exchange rates change. 7. The benefit of a concessionary loan is the difference between the repayment when borrowing under market conditions and the repayment under the concessionary loan. (a) Tax on foreign investment or sales income earned by resident companies.4 Exchange restrictions In calculating the NPV of an overseas project. (b) There should be a stable government and a stable currency. For example.2. and therefore pays £200. 7. translation and economic exposure 7.000 in tax on profits. and there is a double taxation agreement between the two countries. The main aspects of taxation in an international context are:  Corporate taxes in the host country  Investment allowances in the host country  Withholding taxes in the host country  Double taxation relief in the home country  Foreign tax credits in the home country The importance of taxation in corporate decision-making is demonstrated by the use of tax havens by some multinationals as a means of deferring tax on funds prior to their repatriation or reinvestment. 7. A subsidiary of a UK firm operating in the Federal West Asian Republic earns the equivalent of £1 million in profit.2 Translation exposure Translation exposure occurs in multinational corporations that have foreign subsidiaries with assets and liabilities denominated in foreign currency.3. Translation exposure occurs because the value of these amounts is eventually stated as per IAS 21 in the presentation currency (normally the domestic currency of the parent) in the company's financial statements.5 Impact of transaction costs on NPV for international projects Transaction costs are incurred when companies invest abroad due to currency conversion or other administrative expenses. should be low. These should also be taken into account. The cost of foreign obligations could rise as a result of the home currency weakening.000 against the full UK tax charge of £230. the home currency value of the foreign subsidiaries' assets and liabilities will change. and withholding tax on dividends paid to the parent. and hence will only pay £30. the UK parent can claim a credit of £200. (c) There should be adequate financial services support facilities.2. A tax haven is likely to have the following characteristics. Such changes can result in 178 Business Analysis .000.2 Taxes Taxes play an important role in the investment appraisal as they can affect the viability of a project. 7. 7.

The extent to which it constitutes a risk depends on the significance placed on the published accounting numbers. level of import restrictions and economic stability in the country in which it proposes to invest. translation losses or gains. 7. which can affect the efficient and effective operation of the multinational's activities. However. 7.3. It could be argued that translation exposure does not constitute a risk to an organisation as it is simply an accounting problem and does not affect the inflow or outflow of cash. Whenever a business operates in a foreign country. which will be recognised in financial statements. Any other behaviour is considered to be rude and may get business relationships off on the wrong footing. A devaluation of the yen relative to the US dollar will make Japanese imports cheaper in the US. tariffs or legal safety and quality E standards. 4 7. for example. Businesses should take cultural risks into account when deciding where to sell abroad and the extent to which activities should be centralised. Revenue and profits will therefore fall. thus reducing demand for UK goods. Definition Political risk is the possibility that political actions in another country will affect the investing company's value and position. customs and laws. a UK manufacturer producing a product for the UK market only. in an attempt to protect domestic industries or to protect T their countries from exploitation. potentially leading to UK consumers preferring the products of overseas competitors. R Multinationals can assess the extent of political risk by considering such factors as government stability.5 Cultural risk Cultural risk was considered briefly at the Professional stage but is examined in more detail here. In Asian countries for example. It does not use any imported materials and does not export to other countries. Cultural risk affects the products and services produced and the way in which organisations are managed and staffed.4 Political risk Political risk was covered at the Professional stage. Consider a UK manufacturer that exports to the US and whose main competitor is a Japanese firm. it is exposing itself to P political risk. Investment appraisal 179 . it exposes itself to the additional uncertainty of dealing with unfamiliar languages.3 Economic exposure Economic exposure is the degree to which the present value of a firm's future cash flows is affected by fluctuations in exchange rates. Communications between parties may be difficult and business opportunities jeopardised through ignorance of how transactions should be conducted. It differs from transaction exposure in that exchange rate changes may affect the value of the firm even though the firm is not involved in foreign currency transactions. The manufacturer does not have transaction exposure but does have economic exposure as an appreciation of the pound in relation to other currencies may make imports cheaper. but the UK manufacturer is still experiencing economic exposure. C H A As soon as a multinational company decides to operate in another country. exporting firms still face economic exposure. The nature and structure of the subsidiaries' assets and liabilities determine the extent of translation exposure to the parent company. a business card must be presented with both hands and the recipient should study it briefly rather than just putting it into a briefcase or pocket. The dollar/sterling exchange rate has not moved. Consider. may impose such measures as quotas. it is useful to remind ourselves of its meaning and how it may affect a company's position. Even when the exchange rate of the home currency remains constant. Host countries' governments.

with the possible loss of central control?  Is there such a thing as the global manager. Some products are extremely sensitive to the environmental differences. Important areas may include:  Export and import controls for political.6 Litigation risk Litigation risks can be reduced by keeping abreast of changes. acting as a good corporate citizen and lobbying. which has to think globally as well as act locally. EU membership.1 Deciding which markets to enter Making the right choices about which markets to enter is a key element in dealing with cultural risk. 180 Business Analysis . Not all countries recognise such international conventions.  The availability of technical skills such as financial management  The need for control  The importance of product and company experience  The need to provide promotion opportunities  Costs associated with expatriates such as travel and higher salaries  Cultural factors For an international company. equally at home in different cultures? 7. copyright and patent conventions.  Acceptance of international trademark. Such controls may not be overt but instead take the form of bureaucratic procedures designed to discourage international trade or protect home producers. There are a number of influences. in which case standardisation is possible. environmental or health and safety reasons.5.1 Legal impacts Companies may face government legislation or action in any jurisdiction that extend over the whole range of activities.  Favourable trade status for particular countries – for example.6. Failure to do so may result in infringements of local laws and policies. potentially leading to costly lawsuits. there are a number of problems. Environmentally sensitive Environmentally insensitive Adaptation necessary Standardisation possible  Fashion clothes  Industrial and agricultural products (commodity type products)  Convenience foods  World market products. Businesses should familiarise themselves with:  Cultures and practices of customers and consumers in different markets  Media and distribution systems in host countries  Different ways of doing business overseas  The degree to which national cultural differences matter for the product concerned  The degree to which a firm can use its own national culture as a selling point 7.  Do you employ mainly expatriate staff to control local operations?  Do you employ local managers.2 Management of human resources The balance between local and expatriate staff must be managed.5. others are not at all sensitive to these differences. eg jeans 7. methods and media. which bring about the need for adaptation. 7.  Restrictions on promotional messages.

Davidoff. Companies that meet a strict set of standards in one country may be accused of hypocrisy if their practices are laxer elsewhere. despite the fact that policies in many areas may be slow to change in reality.  Keep up to date with likely changes in policy. The problem was not with the law. stole the trademark of Imperial Tobacco's premium cigarette brand.  Ensure that the company keeps abreast of changes in the law and that staff are kept fully informed. C H A P T E R 4 Investment appraisal 181 . but its enforcement. and it took a ruling by the Indonesian Supreme Court to enforce Imperial Tobacco's rights.  Good citizenship – compliance with best practice and being responsive to ethical concerns can help to minimise the risk of government intervention. Sumatra. Issues of legal standards and costs have significant implications for companies that trade internationally. Businesses that fail to comply with the law run the risk of legal penalties and bad publicity.6. The British company had major problems enforcing its rights in Indonesia where a local company. Today's best practice often becomes tomorrow's legislation.2 Dealing with legal risks  Consequences of non-compliance. 7. High costs of compliance may ultimately lead to enforced relocation. One example of the problems of enforcing intellectual property legislation in certain markets is the case of Imperial Tobacco.

Summary and Self-test Summary 182 Business Analysis .

They have no use other than the manufacture of the new product.000 a year. The necessary machinery will be rented.000 0 0 0 0 Net cash inflows 0 19. Costs associated with the product are expected to be as follows. This rent (for the factory space) is not subject to any uncertainty.000 32.000 What is the modified internal rate of return if the project's cost of capital is 8%? Based on this information. 2 PG plc PG plc is considering investing in a new project in Canada which will have a life of four years. whose current annual salary is £30.Self-test 1 A project has the following estimated cash flows: Year 0 Year 1 Year 2 Year 3 Year 4 Initial investment -75. 3 Muggins plc Muggins plc is evaluating a project to produce a new product. 60. Investment appraisal 183 .000.000 of which £60.20 per unit Other variable costs £4. It will be installed in the company's factory. net of tax. Their disposal value is £50.64 per kg 3 units of component Y at £4. The company evaluates UK projects of similar risk at 14%.000 H A Apportionment of general building occupancy £168. Variable costs per unit Labour: £30 Materials: 6kg of material X at £1. The terminal value of the project is estimated at C$50. Requirement Calculate the NPV of the Canadian project. will be 4 transferred from another department. as a binding four-year lease would be created. should the company invest in the project? Give reasons for your answer.000. This will take up space that would otherwise be rented to another local company for £135.000 25. The product has an expected life of four years.000 30.000 per annum for Years 1. Economic forecasters expect sterling to strengthen against the Canadian dollar by 5% per annum over the next four years. 2 and 3 and C$45. The current spot rate of C$ against sterling is 1.000 represent additional cash expenditures (including rent E of machinery).000 and one assistant manager.400.000 P T Other overheads £80. at a purchase value of £98.000 kg of material X are already in inventory.40 Indirect costs each year C Apportionment of head office salaries £118.000 a year. where he will be replaced by a new appointee at a cost of £27. including working capital.000.7000.000. R To manufacture the product a production manager will have to be recruited at an annual gross cost of £34. The net after-tax cash flows which the project will generate are C$60. The initial investment is C$150.000 in Year 4.

In the first year of operation letters will cost $0. The new service would be financed half with internally generated funds and half by borrowing on the capital market at an interest rate of 12% a year. Market research undertaken at a cost of $50.000 a truck. Tax is payable one year in arrears. 184 Business Analysis .000. wishes to introduce a new service. This service would offer same-day delivery of letters and parcels posted before 10am within a distance of 150km. and 20.3 0. 4 Zedland Postal Services The general manager of the nationalised postal service of a small country.000 a van and $1. 180 new workers would be employed at an average annual wage of $13. Depreciation is tax allowable and the vehicles will have negligible scrap value at the end of five years.000 and 40% for the balance in excess of $500. Corporate taxes in Zedland.6 Requirement Assess on financial grounds whether the project is acceptable.000 forecasts that demand will average 15. Annual running and maintenance costs on new vans and trucks will increase by 25% a year. The service would require 100 new vans costing $8. Zedland.000 and year two $263. All the above data are based on price levels in the first year and exclude any inflation effects. Two postal rates are proposed.1 0. Existing premises will be used for the new service but additional costs of $150.7 4 1.000. at least zero net present value on their investments.25. where they would not be replaced. are as follows.000 3 18.000 each. to which the postal service is subject.000 would be moved from their existing duties. on average.000 4 19. Staff and premises costs are expected to rise because of inflation by approximately 5% a year during the five year planning horizon of the postal service. Nationalised industries are normally required by the government to earn at least an annual after tax return of 5% on average investment and to achieve. There will be no advertising after year two. The company requires that certainty-equivalent cash flows have a positive NPV at a discount rate of 14%. are at the rate of 30% for annual profits of up to $500. Expected sales volumes of the product.000 and five managers at average annual salaries of $20.9 2 1. at the proposed selling price of £125 a unit.8 3 1.000 a year will be incurred in year 1.5 0.000 All sales and costs will be on a cash basis and should be assumed to occur at the end of the year. Annual running and maintenance costs on similar new vans and trucks are estimated in the first year of operation to be $2. Advertising in year one will cost $1.300.000 each and 20 trucks costing $18.525 and parcels $5. Year Expected sales Units 1 10.000. The opportunity cost of capital for the postal service is estimated to be 14% a year.4 0. The government of Zedland will not allow the prices charged by nationalised industries to increase by more than 5%. All transactions may be assumed to be on a cash basis and to occur at the end of the year with the exception of the initial investment which would be required almost immediately. Year Costs Benefits 1 1. Ignore taxation. There is a five day working week and a 52 week year.000 2 18.000 a year. Vehicles are depreciated over a five year period on a straight line basis. Adjustment factors to arrive at certainty-equivalent amounts are as follows.000 letters a day and 750 parcels a day thereafter.000 letters each working day and 500 parcels each working day during the first year. The postal service's taxable profits from existing activities exceed $10.

C H A P T E R 4 Investment appraisal 185 . Include in your report a discussion of other factors that might need to be taken into account before a final decision is made on the introduction of the new postal service.Requirements Acting as an independent consultant prepare a report advising whether the new postal service should be introduced. State clearly any assumptions that you make.

575 1.0664 Net cash £'000 (88.125 1.000 = 117.592 Present value 254 137 (109) (303) The net present value is -£21.340 Management salaries (W4) 67 79 85 92 Rental: opportunity cost 135 135 135 135 Other overheads 66 78 84 90 835 1.769 0.000.000  £125  0.877 0.675 0.40 = £47 Year 1 10.800 1.736 1.5 186 Business Analysis .01 30.24) 29.65 3 Muggins plc Certainty-equivalent cash flows Year 1 Year 2 Year 3 Year 4 £'000 £'000 £'000 £'000 Sales (W1) 1.000 3 2 TV = 19.4 Year 4 19. the company should accept the project.000  As MIRR > required rate of return (8%).20) + £4.000 x 1.61 32.62 20.425 Material X (W2) 50 230 248 280 Other variable costs (W3) 517 1.769 0.21 NPV in £'000 13.000  £125  0. WORKINGS Year 1 10.6 (2) Material X Year 1 £50.58 27.000  £47  1.7 Year 4 19. 2 PG plc Year 0 Year 1 Year 2 Year 3 Year 4 Investment C$'000 (150) 50 After tax cash flows C$'000 60 60 60 45 Net cash C$'000 (150) 60 60 60 95 Exchange rate 1.000  6  £1.1188 or 11.184 1.3 Year 3 18.675 0.08 + 32.000  6  £1.8743 1.000  £47  1.88%  75.000  6  £1.000  £47  1.5 (3) Other variable costs Per unit: £30 + 3 + (3  £4.64  1.64  1.000 0.08 + 30.000  1.8 Year 3 18.000  £125  0.592 PV in £'000 (88.000 x 1.24) 33.08 + 25.495  117.000  £47  1.937 Sales less cash costs 290 178 (161) (512) Discount factor at 14% 0.25 MIRR     1  0. so the project is not acceptable.3 Year 3 18.000  £125  0.7000 1.7850 1.64  1.48 24.100 1.495  0.9 (1) Sales Year 2 18.877 0.000 opportunity cost Year 2 18. Answers to Self-test 1 PVOUTFLOWS = I0 = 75.4 Year 4 19.49 45.97 14% discount factors 1.1 Year 2 18.9680 2.622 1.

010 3. but it has a negative net present value ($24. Because projects must meet both targets to be acceptable.730 3. to give an acceptable overall result. It also considers other factors which may be relevant.321 3.457 2. this is subject to the further factors considered below.545 3.000 + £27. However.000  1.345 4.300 263 Depreciation 232 232 232 232 232 4.000  1. Before any final decision is taken.048 2. Non-financial factors The proposed service might well be of great value to the public. tantamount to cross-subsidisation.185 1.512) 557 818 800 767 Taxation (40%) 605 (223) (327) (320) (307) Profit after tax (907) 334 491 480 460 Investment appraisal 187 .795 Revenue less expenses (1.000 = £61.385 3.709 2. (4) Management salaries Year 1 £34. of course.942 4. Calculations are set out in the Appendix.844 Premises 150 158 165 174 182 Vehicle maintenance Vans 200 250 313 391 488 Trucks 20 25 31 39 49 Advertising 1.318 Parcels 682 1.075 1. Recommendation The proposed new service has an annual average return on average investment of 30%. It should perhaps be provided on that ground.139 4. It may be that charges could be increased and/or costs reduced.4 Year 4 £61. so that the net present value could become positive.340 2.160 3. it is recommended that the service is not provided. APPENDIX C H 1 Return on average investment A P Year 1 2 3 4 5 T $'000 $'000 $'000 $'000 $'000 E R Revenue Letters 2. This is.000  1. If the postal service's other projects have large positive net present values. the reliability of all forecasts should be reviewed. it might be possible to net them off against the negative net present value here.5 4 Zedland Postal Services From: A N Accountant To: The Board of directors Date: 1 April 20X9 Subject: Proposed new same day service Introduction This report considers whether the proposed new service will meet the two targets of a return on investment of at least 5% and a non-negative net present value.3 Year 3 £61.242 3.867 3. and a sensitivity analysis should be carried out.000  1.000).580 2.129 1.562 Expenses Staff 2.244 4 2.1 Year 2 £61.

072 558 417 352 (140) Net present value = ($24.123) 1.280) 1. 188 Business Analysis .160) (1.769 0. Total profit after tax = $858. 3 Assumptions made (a) The inflation rate.160.877 0.512) 557 818 800 767 Add depreciation 232 232 232 232 232 Taxation 605 (223) (327) (320) (307) Initial investment (1. (d) Return on average investment is to be computed ignoring financing costs.394 827 705 679 (307) Discount factor (14%) 1 0.160) (1.600 Average annual after tax return on investment =  100% = 30% $580.000).600 Average investment =$1.519 0. (c) If the five managers were not needed for this new service.000 Average profit after tax = $858.160) Cash flow (1. as it has already been incurred.592 0.000 2 Net present value Year 0 1 2 3 4 5 6 $'000 $'000 $'000 $'000 $'000 $'000 $'000 Revenue less expenses (1.000/2 = $580. (b) The cost of preliminary research is to be ignored. for both revenue per unit and costs (excluding depreciation) will be 5%.000 $171.675 0.456 Present value (1.000/5 = $171. they would remain in their present posts rather than being made redundant.

000 Resale proceeds – – – 50.000 250.826 0.000 0.500 = £87.000 3 200.000 600.800 165.000 2 200.683 Discounted cash flow (500.000 200.000/200.200 150.500 ARR  = 31.000) = 2. we generally find one discount rate with a positive NPV and another discount rate that results in NPV being negative.000) 181.000 50.000 200. This is generally carried out using trial and error.000 200.000 200.000 Discount factor (10%) 1.000 per annum R 2 87.000 Payback is therefore 2 years + (100.000 = 4 = £112.000 E = = £275.200 170.000 400. Investment appraisal 189 .750 NPV = £167.950 (iv) Internal rate of return (IRR) To calculate IRR.909 0.000 is a sunk cost and is therefore not relevant when appraising the project.000 200.000) 200.000 200.000 Net cash flow (500.000 4 (iii) Net present value Year 0 Year 1 Year 2 Year 3 Year 4 £ £ £ £ £ Initial investment (500. the payback period will be the amount of time it will take Robbie plc to earn £500.000 112. Cumulative Year Cash flow cash flow £ £ 1 200.5 years (ii) Accounting rate of return (ARR) Average Accounting Pr ofit ARR  Average Investment Accounting Profit = Cash flow Depreciation Cost Re sale value Depreciation  Useful life 500.000) Cash flow 200.Answers to Interactive questions Answer to Interactive question 1 Note: The exploratory work of £15.500 C H Cost  Re sale value A Average Investment = 2 P T 500. (i) Payback period In this case.000.500pa Average profit per annum = £200.751 0.000  50.8% 275.

factor 1.578) (25.879 158.5% Answer to Interactive question 2 WORKINGS (all figures in £) (1) Tax writing-down allowances (WDA) Year WDA/Written-down value Tax saved at 23% 20X0 350.030 86.845 62.000) Investment Cash (net) 95.567 DCF (333.688 12.300) IRR = 25.950  49.688 Proceeds (60.153 Dis.000) 12. 190 Business Analysis .202 56.578 Sale 60.000 98.000 98.000 WDA (20%) (70.136 Tax (23%) (21.893 0.362 88.304 8.862 111.200 WDA (35.950 IRR = 10 +  (30 – 10) (167.673 NPV = £20. When trial and error is applied.672) 6.300).304 20X3 179. we find that NPV at a 30% discount rate is £ (49.712 0.752 106.172 As NPV is positive.561) WDA/Bal all 16.850 22.636 0.100 12.633) (24.595 12.136 (3) Tax computations 20X1 20X2 20X3 20X4 20X5 Tax at 23% of net cash inflows 21.578 25.800 102.561 NPV calculation 20X0 20X1 20X2 20X3 20X4 20X5 Initial (350.900) 76.633 24.900) 86.000 WDA (56.000 0.000) Balancing all 54.724) (23.360 WDA (28.880 10.840) 8.000) 16. We already have a positive NPV when the discount rate is 10%.797 0.000 (333.595 20X5 114.800) 10.243 6. the project is feasible and should be undertaken.243 20X4 143. 167.880 20X2 224.862 111.380 87.850) (22.578 (2) Inflation computations 20X1 20X2 20X3 20X4 20X5 Net cash inflows 95.527 89.800 102.100 20X1 280.752 106.724 23.000 WDA (44.825 68.

1 5.000 4 Value of inflows if reinvested at the 10% cost of capital Interest rate Amount when Year Cash inflows multiplier reinvested £ £ 1 3.94 Ungeared cost of equity (using CAPM) = Rf + ßa × market premium = 7 + 0.517 × £2.517 NPV = £(8m) + 3.23m H A As APV is positive. T E R Answer to Interactive question 4 PVOUTFLOWS = £10.000 1.] Investment appraisal 191 .5 Annuity factor (13% for 5 years) = 3.28% [The IRR for the project is 20.79m – £0. Interest payable = £10m × 8% = £0.000 APV = £0.5 2.94 × 6 = 12.13% rather than 10% which we have used.13%.5 2.184m Discount at cost of debt (8%) over 5 years = £0.735m Step 3 Issue costs = £300.993 = £0.184  3.3m + £0.5 2.5m = £0.74m C = £1.178 = ßa (1 + (1 × (1 – 0.000 1.630 2 5.21 3.130/10.000) – 1 = 17.000 16.79m Step 2 Calculate the present value of the tax shield from debt financing.000 1.5 2. Ungeared beta D(1  T) ße = ßa (1 + ) E 1.8 × 23% = £0.500 3 7. the project should be undertaken with the proposed method of P financing.Answer to Interactive question 3 Step 1 Calculate NPV of the project with the original cost of equity with no gearing.0 7.23/3))) ßa = 0.130 3 MIRR = (16.8m Tax saved = £0.6% (say 13%) Discounted cash flow using 13% as the discount rate Year 0 12345 £m £m £m £m £m £m Initial investment (8) – – – –– Annual cash flow – 2. The reason it is higher is because the IRR assumes a reinvestment rate of 20.

230 (385) Exchange rates 5:1 5:1 5:1 5:1 5:1 £'000 cash flows From/(to) Ruritania (480) 120 106 106 446 (77) Additional UK expenses/income (100) (100) (100) (100) UK tax effect of UK expenses/income 23 23 23 23 Net sterling cash flows (480) 20 29 29 369 (54) UK discount factors 1 0.852) 5.826 0.000) (7.555 Answer to Interactive question 6 Time 0 1 2 3 4 5 $'000 cash flows Sales receipts 1.600 1.500).600 1.555 560 The project has a positive NPV and would appear to be worthwhile.000) Tax allowable depreciation (brought in to calculate taxable profit) (400) (400) (400) (400) $ taxable profit 200 200 200 200 Taxation (70) (70) (70) (70) Add back tax allowable depreciation (as not a cash flow) 400 400 400 400 Capital expenditure (2.000) Scrap value 800 Tax on scrap value (W1) (140) Terminal value 500 Tax on terminal value (175) Working capital (400) 400 (2.600 Costs (1.000) 1 0.857 (2.995 560 (c) Savings sensitivity =  100  4.621 Present values (480) 18.400) 600 530 530 2.683 0.000) (1.143) 5. therefore the company should not proceed.909 0. Year Discount factor PV of plant PV of running PV of savings PV of net cash 8% cost costs flow £ £ £ £ 0 1.000 – (4  $400. Answer to Interactive question 5 The PVs of the cash flows are as follows.000) (1.000) (3.8% 11.000.0 21.000 as tax written down value = $2.856 (7.000) = $400.2 24.704 2 0.000 560 (b) Running costs sensitivity =  100  14% 3.751 0.556 3.000) (1.000 192 Business Analysis .600 1.995) 11. 560 (a) Plant costs sensitivity =  100  8% 7. WORKINGS (1) Tax is payable on $400.000 (7.926 (1.5) NPV = £ (197.0 (33.8 252.999 3. Sensitivity of the project to changes in the levels of expected costs and savings is as follows.

CHAPTER 5 Business and securities valuation Introduction Topic List 1 Valuation techniques 2 Company valuation: general principles 3 Valuing acquisitions 4 Valuing debt 5 Unquoted companies and start-ups Summary and Self-test Answers to Self-test Answers to Interactive questions 193 .

Introduction Learning objectives Tick off  Demonstrate a detailed understanding and application of different methods of business and securities valuation. income-based and cash-based methods  Demonstrate a detailed knowledge and understanding of when the use of each valuation technique is most appropriate  Apply appropriate techniques to the valuation of acquisitions and mergers and demonstrate ability to perform relevant calculations to value such activities  Demonstrate a detailed understanding and application of methods of valuing debt 194 Business Analysis . including asset-based.

1 Valuation techniques Section overview  This section looks at the valuation techniques you may be required to use in an exam situation.1. It is a way of assessing the impact of different sets of mutually consistent assumptions on the value of a company or its business units.3 Shareholder value analysis (SVA) SVA is the process of analysing how certain decisions affect the net present value of cash to shareholders. 1. So VBM is an approach to management that aligns the strategic. operational and management processes to focus management decision-making on what activities create value. At the corporate level it provides a framework for evaluating options for improving shareholder value by determining the trade-offs between reinvesting cash in the company.1. It has been suggested that a good way of relating a range of value drivers is to use scenario analysis (covered in Chapter 2). VBM extends this philosophy by focusing on how companies use the idea of value creation to make both major strategic and everyday operating decisions. They should be ranked in terms of their impact on value and responsibility assigned to individuals who can help the organisation meet its targets.4 Economic Value Added (EVA®) EVA® = Net Operating Profit after Tax (NOPAT) – WACC  Capital Employed C H OR A EVA® = (ROIC – WACC)  Capital Employed (where ROIC = Return on invested capital) P T E R 5 Business and securities valuation 195 .1.1 Shareholder value 1.  You should be familiar with the Shareholder value analysis (SVA) technique that was covered in the Professional stage Financial Management paper.1 Value-based management (VBM) VBM starts with the philosophy that the value of a company is measured by its discounted future cash flows. SVA consists of three primary analyses:  Determining the present value of the costs of all investments using the appropriate cost of capital  Estimating the economic value of the business by discounting its expected cash flows to find their present values  Determining the economic value of the business by finding the difference between the above elements 1. Value drivers can be difficult to identify as it requires an organisation to think about its processes in a different way and existing reporting systems are often not equipped to supply the necessary information. 1. 1.2 Value drivers A value driver is any variable that affects the value of the company. distributing cash to shareholders and investing in new businesses.1. Value is created only when companies invest capital at returns that exceed the cost of that capital.

R & D expenditure.300 Net property. The NOPAT figure should not be that taken directly from the financial statements. plant and equipment 2. 196 Business Analysis .500 Accumulated depreciation 1.72% EVA 393 Essentially EVA® is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return for shareholders or lenders at similar risk.200 Invested capital 2.000 Expenses other than interest 800 Depreciation 300 Earnings before interest and taxes (EBIT) 900 Taxes on EBIT @ 23% 207 Earnings before interest and after taxes (NOPAT) 693 Current assets less excess cash and securities 400 380 Non-interest bearing current liabilities 100 120 Adjusted net working capital 300 260 Gross property.000 1.72% Based on previous year's invested capital The calculation of EVA takes place as follows. unusual items) to make the figure more meaningful in the context of a valuation.200 3.200 2. but will contain numerous adjustments (eg current values rather than historic costs. ® The use of EVA to value a company will be discussed in Section 3. It can be used at divisional as well as corporate level and is based on the idea that a business must cover both its operating costs and its capital costs. EVA calculation: Method 1 Invested capital 2. performance measurement and corporate valuation. Year 20X5 20X6 Sales 2.500 2.72% Invested capital 2. Case example: EVA The derivation of EVA can be illustrated using an example.500 Times cost of capital 12% Capital charge 300 NOPAT 693 Less capital charge (300) EVA 393 EVA calculation: Method 2 ROIC 27. plant and equipment 3.500 Times: excess return 15.4 of this chapter.72% Less: cost of capital –12% Excess return 15.460 Return on invested capital (NOPAT/invested capital) 27. It can be used for such purposes as capital budgeting.

R Constant annual dividends: D0 D0 D0 D 5 P0 =    .. then the MVA simply measures the difference between the market value of common stock and the equity capital of the firm.7 Total shareholder return This technique measures the change in capital value of a listed company over a period (typically at least one year) plus cash payouts to shareholders expressed as a percentage of the initial share price at the start of the period.share price at beginning)  Cash paid to shareholders TSR = Share price at beginning The cash payouts to shareholders will include regular and special dividends. It represents the discount rate at which the discounted future annual cash flows expected to be generated over the useful life of a firm's assets are equal to the current cash value of the firm's net operating assets. nor does it account for intermediate cash returns to shareholders.1. 1.6 Market value added (MVA) The MVA of a company is defined as: MVA = Market value of debt + Market value of equity – Book value of equity The MVA shows how much the management of a company has added to the value of the capital contributed by the capital providers.1.1. it excludes inflation) that identifies the relationship between the cash generated by a business relative to the cash invested in it.1.  0 (1 k e ) (1 k )2 (1 k e )3 ke e where P0 = Ex dividend market value of the shares Business and securities valuation 197 . If the market value and the book value of debt is the same. A firm's equity MVA is sometimes expressed as a market to book ratio: MVA book value The higher the MVA the better for the company as a high MVA indicates that the company has created wealth for its shareholders. The formula is: (Share price at end . Its very nature prevents TSR being used for organisations that are not listed.5 Cash flow return on investment (CFROI) This technique is an Economic Profit (Cash Flow) based valuation framework.2.. It can be easily compared across companies of different sizes and benchmarked against industry or market returns without the complication of size bias.2 Valuation techniques C H 1. The MVA is related to EVA because MVA is simply the present value of the future EVAs of the company. CFROI is a real rate of return measure (that is. 1.. The main problem with MVA is that it does not take opportunity cost of capital into account. share buy-backs and any other cash payments.1 Dividend valuation model A This model states that a company's value is the present value of all the future cash flows to investors P T discounted at the investors' required rate of return for that company. There are two types of model – E the constant annual dividends model and the constant growth model. CFROI can be used at divisional level and can also be applied to privately held firms. 1.

. although it is expected that an additional risk premium of 2% will be applicable to Target. Dividend yield is also covered in Chapter 16 Financial statement analysis of the Advanced level Corporate Reporting text.000.2. See Answer at the end of this chapter. D0 = Constant annual dividend ke = Shareholders' required rate of return Constant growth model D0 (1 g) D (1 g)2 D (1 g) D1 P0 =  0  . It is an important ratio as it relates two key considerations for investors – the market price of a share and its earnings capacity. The P/E ratio is calculated as: Market price of share Total market value of equity which is the same as EPS Total earnings The value of the P/E ratio reflects the market's appraisal of the share's future prospects. However. This can also impact on periodic P/E ratios. 1.. How shareholders view this movement will depend on their preference between short-term and long-term returns.3 Income – P/E ratio The P/E ratio is the most important yardstick for assessing the relative worth of a share. An EPS ratio that changes substantially and frequently may indicate an earnings volatility issue that could increase the perceived risk of the company.. IAS 33 Earnings Per Share prescribes principles for the determination and presentation of EPS. The current return to shareholders of companies in the same industry as Target is 12%. if: (a) The current level of dividend is expected to continue into the foreseeable future. If additional debt finance is expected to be used to generate good returns in the long-term. The main issue with using ratios for valuation purposes is that they can be manipulated by company management. This Standard is covered in the Advanced Stage Corporate Reporting manual.2. Compute the expected valuation of Target. it is possible that the dividend yield might fall significantly in the short-term because of a fall in short-term dividends. 1.2 Income – dividend yield The dividend yield is calculated as follows: Dividend per share Dividend yield   100 Market price per share With dividend yield we are looking at the effect of gearing on the market price of shares.  0 = (1 k e ) (1 k e ) 2 (k e g) k e g where D0 = Current year's dividend g = Growth rate in earnings and dividends D0 (1 + g) = Expected dividend in one year's time (D1) ke = Shareholders' required rate of return P0 = Market value excluding any dividend currently payable Interactive question 1: Dividend valuation models [Difficulty level: Easy] Target has just paid a dividend of £250. the market price may rise to reflect expectations of enhanced long-term returns. being a smaller and unquoted company. or (b) The dividend is expected to grow at a rate of 4% pa into the foreseeable future. either directly 198 Business Analysis .

Requirements What would be a suitable range of valuations for the shares of Mayfly? See Answer at the end of this chapter. Interactive question 3: Discounted cash flow basis of valuation [Difficulty level: Intermediate] Diversification plc wishes to make a bid for Tadpole Ltd. The earnings of Mayfly over the past five years have been as follows.000 20X1 £72.000 20X4 £75.2.000 a year. the calculations of which are covered in the Financial Statement Analysis chapter of the Advanced level Corporate Reporting manual.000 4 150.000 The after-tax cost of capital of Diversification is 15% and the company expects all its investments to pay back.000) 1 (80.000 3 100. Mayfly. but is a company with very good growth prospects. Quoted companies which are similar in many respects to Mayfly are: (a) Bumblebee.000) 2 60. (b) Wasp. Interactive question 2: Valuations [Difficulty level: Easy] Flycatcher wishes to make a takeover bid for the shares of an unquoted company. What is the maximum price that the company should be willing to pay for the shares of Tadpole? C See Answer at the end of this chapter.000 5 150. and has a P/E ratio of seven. in discounted terms. or indirectly.000 20X2 £68.000 The average P/E ratio of quoted companies in the industry in which Mayfly operates is 10. which has had a poor profit record for several years.000 20X3 £71. Before the EPS can be considered to be useful by analysts trying to value the company. the after-tax cash flows (ignoring the purchase consideration) could be as follows. within five years. Tadpole makes after-tax profits of £40. which has a P/E ratio of 15. Year Cash flow (net of tax) £ 0 (100. 1. You should also refer to this chapter to familiarise yourself with the limitations of the use of financial ratios for analysis purposes. This method of valuation may be appropriate when one company intends to buy the assets of another company and to make further investments in order to improve cash flows in the future. H A P T E R 5 Business and securities valuation 199 . 20X0 £50.4 Income – discounted cash flow The value of a company is basically the present value of all its future expected cash flows. Diversification believes that if further money is spent on additional investments. the earnings figure must be adjusted to reflect the sustainable earnings of the company. The result of this process is a 'normalised earnings' figure.

These are covered in detail in Chapter 16 Financial statement analysis of the Corporate Reporting text and may involve distortions in assets.2 Distortions in accounting figures Anyone undertaking a valuation using accounting figures will need to be aware of possible distortions in those figures.1 What affects the value of a company? Company value is not just affected by sales and profit forecasts.com is a web site that provides useful financial ratios and statistics for company valuation. The main difficulty in an asset valuation method is establishing the asset values to use. 200 Business Analysis . its value will increase. replacement basis and realisable basis. period figures may be distorted by the timing of receipts or payments or unusual items. Some rules of thumb for valuing companies in different industries are given by BizStats. 2. 1. If a company has a popular product or product range that the public will want to buy. The figure attached to an individual asset may vary considerably depending on whether it is valued on a going concern or a break-up basis. This figure excludes profits from discontinued operations. the value of a share in a particular class is equal to the net tangible assets attributable to that class divided by the number of shares in the class. 2 Company valuation: general principles Section overview  Accountants can be involved in the valuation of shares for numerous purposes.5 Asset-based measures If the net asset method of valuation is used. 2. The value of the company will change depending on the purpose for which it is valued. We covered valuation techniques in Section 1 above. Possibilities include the historic basis (although this is unlikely to be relevant).  The purpose for which a share is valued will determine the value that is placed on the share.2.1 So what is a company worth? There is no precise answer to this question. Companies could be worth:  The tangible assets  The assets plus goodwill  Whatever someone is prepared to pay for them BizStats. provided of course that the people who want to buy it can actually afford to do so. changes in estimates and fair values. equity or earnings. liabilities. Industry statistics can be used for benchmarking purposes when undertaking valuations. profits/losses from the sale of non-current assets and start-ups. If cash flows are used rather than earnings. Remember to exclude intangible assets (which include goodwill) unless they have a market value (such as patents and copyrights).com as follows: Type of business 'Rule of Thumb' valuation Accounting firms 100 – 125% of annual revenues Book stores 15% of annual sales + inventory Coffee shops 40 – 45% of annual sales + inventory Petrol stations 15 – 25% of annual sales + equipment/inventory 2. Values ought to be realistic. Value can be influenced by the type of industry the company operates in. the level of competition faced by the company and the customer base. to reflect the sustainable earnings of a company. restructuring and redundancy costs amongst other adjustments. it may be necessary to produce a normalised earnings figure.1. To combat problems with earnings.

000 R loan notes 60. C £ £ H A Total value of assets less current liabilities 340.9% preference shares of £1 50. the valuation would be as follows.000 Taxation 20.000 deferred taxation 10.000 P Less intangible asset (goodwill) 20. 3.5 above.000 Goodwill 20. Non-current assets £ £ £ Land and buildings 160.000 4. and how to value the combined company after the acquisition or merger takes place.000 220.000 Plant and machinery 80.1 Asset-based model The asset-based approach to valuation was reviewed in Section 1.000 270.000) Deferred taxation (10.000 T Total value of assets less current liabilities 320.000 Cash 5.000 E Less: preference shares 50. 3 Valuing acquisitions Section overview  This section looks at the various ways in which the target company in an acquisition or merger situation can be valued.000 (100.000 Ordinary shares of £1 80.000 12% loan notes (60.000 120.000) 270.000 5 Net asset value of equity 200.000 Current liabilities Payables 80. Worked example: Asset-based model The summary statement of financial position of Cactus is as follows.000 Current assets Inventory 80. These models use the statement of financial position as the starting point in the valuation process.50 Business and securities valuation 201 .000 340.000 Requirement What is the value of an ordinary share using the net assets basis of valuation? Solution If the figures given for asset values are not questioned.000 Reserves 140.000 160.000 Value per share £2.000 260.000 Motor vehicles 20.000 Receivables 60.2.000) 60.000 Number of ordinary shares 80.000 Short-term investments 15.

60 Worked example: Takeover offer price Spider plc is considering the takeover of an unquoted company. 3. Fly Ltd. A high P/E ratio may indicate: (a) Optimistic expectations Expectations that the EPS will grow rapidly in the years to come. Case example: P/E ratios Some sample P/E ratios taken from the Financial Times on 13 June 2013 Market indices FTSE 100 12.27 Mobile telecommunications 11.2 Market relative model (the P/E ratio) The P/E method of valuation was reviewed in Section 1.07 General retailers 15.29 FTSE AIM Negative Industry sector averages (main market) Chemicals 21. (b) Security of earnings A well-established low-risk company would be valued on a higher P/E ratio than a similar company whose earnings are subject to greater uncertainty. so that a high price is being paid for future profit prospects. Some stocks (for example. (c) Status If a quoted company (the predator) made a share-for-share takeover bid for an unquoted company (the target). Fly Ltd is a company with 100. on the strength of expected future earnings. The P/E ratio of an unquoted company's shares might be around 50% to 60% of the P/E ratio of a similar public company with a full Stock Exchange listing (and perhaps 70% of that of a company whose shares are traded on the AIM). but in addition. there is an advantage in having shares which are quoted on a stock market: the shares can be readily sold. those of some internet companies in the late 1990s) have reached high valuations before making any profits at all.3 above. 50p per share.2. it would normally expect its own shares to be valued on a higher P/E ratio than the target company's shares. The EPS could be a historical EPS or a prospective future EPS. the company's P/E ratio is 16. a higher P/E ratio will result in a higher price.000 shares and current earnings of £50. The P/E ratio produces an earnings- based valuation of shares. Many small but successful and fast-growing companies are valued on the stock market on a high P/E ratio. How might Spider plc decide on an offer price? 202 Business Analysis .58 FTSE all-small 54. Spider's shares are quoted on the Stock Exchange at a price of £3. For a given EPS figure.66 Pharmaceutical and Biotechnology 16.60 FTSE all-share 13. This is done by deciding a suitable P/E ratio and multiplying this by the EPS for the shares which are being valued. A quoted company ought to be a lower-risk company.59 Construction 38.38 Food producers 11.000.20 and since the most recent published EPS of the company is 20p.

25.000 Less: capital expenditure (9. The haggling will go on until the negotiations either break down or succeed in arriving at an agreed price. Spider's management might then come back with a revised offer.000 Remove taxes (1 – Tax rate.000) Free cash flow 65. at 9. because of its lower status as an unquoted company. (c) If the acquisition of Fly Ltd would contribute substantially to Spider's own profitability and growth. 12. the P/E ratio on which Spider bases its offer will probably be lower than the P/E ratio that Fly's shareholders think their shares ought to be valued on. then Spider should be willing to offer a higher P/E ratio valuation. (a) If Fly Ltd is in the same industry as Spider plc. its P/E ratio ought to be lower.25. say.000) Less: changes to working capital (1.80 each. 12.5  50p = £6. in order to secure acceptance of the offer by Fly's shareholders.3 Free cash flow model The free cash flow approach has been explained in detail in Chapter 4 in the context of project appraisal and is also briefly covered in Chapter 16 Financial statement analysis of the Advanced level Corporate Reporting text. Of course. the P/E ratio that should be used for the share valuation will be higher than if only small EPS growth is expected. 10. that is. T)  77% Operating income after taxes 61. say valuation on a P/E ratio of 10. The procedure for valuing a target company on the basis of its predicted cash flow is similar to that used for investment appraisal.6  50p = £4. Step 1 Calculate the free cash flow The free cash flow to the firm is defined as: FCF = EARNINGS BEFORE INTEREST AND TAXES (EBIT) Less: TAX ON EBIT Add back: NON CASH CHARGES Less: CAPITAL EXPENDITURE Less: NET WORKING CAPITAL INCREASES Plus: NET WORKING CAPITAL DECREASES C H Plus: SALVAGE VALUES RECEIVED A P Example T E £ R Earnings before interest and taxes (EBIT) 80. and suggest a valuation based on a P/E ratio of. Spider might decide that Fly's shares ought to be valued on a P/E ratio of 60%  16 = 9.6.5. Solution The decision about the offer price is likely to be preceded by the estimation of a 'reasonable' P/E ratio in the light of the particular circumstances. so that its EPS will rise rapidly in the years to come. Some haggling over the price might be necessary. that is. that is.5  50p = £5. (b) If Fly Ltd is thought to be growing fast.600 5 Depreciation (non cash item) 14.600 Business and securities valuation 203 . or to any other strategic objective that Spider has. Fly's shareholders might reject this offer.5. 3.

Marathon has 8. Requirement What is Marathon's value per share? 204 Business Analysis .000 million shares in issue.070 Marathon has non-operating assets with an estimated present value of £400 million.043.016 20Y3 2. Step 4 Discount free cash flow at WACC to obtain value of the firm. Based on the present value of future interest payments.2 20Y1 1. Step 5 Calculate equity value Equity value = Value of the firm – Value of debt Worked example: Calculating value per share You have completed the following forecast of free cash flows for an eight year period.000 million.917.2 20Y2 2.6 20X9 1. Year FCFF £m 20X7 1.987. Free cash flows are expected to grow at 3% beyond 20Y4. The WACC is assumed to be 12%.887.6 20Y4 2. The WACC is calculated using the cost of equity (ke) and cost of debt (kd). capturing the normal business cycle of Marathon plc. Step 2 Forecast FCF and terminal value For a time horizon of six years the following values need to be estimated: FCF1 FCF2 FCF3 FCF4 FCF5 FCF6 TERMINAL VALUE Step 3 Calculate the weighted average cost of capital (WACC). E D WACC = ke  + kd  ED ED where: D = the value of debt E = the value of equity (Note that kd is the cost of debt after tax).860 20X8 1.951. the present value of its outstanding debt is £3.6 20Y0 1.

365. considers making a bid for Tetrion plc a rival company.567 1.500 3.500 1.03)/(0.74 20Y2 2.500 1.404 836.680.000 Depreciation 250 Total expense 6.910 Total liabilities and owners' equity 10.Solution Present Year FCFF(£m) PV @ 12% value (£m) 20X7 1.11 20Y3 2.0 0.070.03)  0.550 Total assets 10.797 1.6 0.71 20Y4 2.404 9.712 1. The following information is used. plant & equipment 5.0 0.636 1.000 Inventory 2.951.560 1.450 6.950 Payables 3.040 Long-term debt 2.2 0.800 Accum depreciation 750 500 250 Net property.860.987.12 – 0.800 4.571 Value of non-operating assets 400 Total value of Marathon 19.6 0.000 T E Cost of sales 3.08 Interactive question 4: Valuing an acquisition using free cash flow model [Difficulty level: Intermediate] The management of Atrium plc.96 20Y1 1.600 2.500 3.600 1.850 1.240.98 20X8 1.200 Property.016.950 Income statement C H 20X4 A £ P Sales 12.660.000 – Equity 4.2 0. In order to convince its shareholders.651 Less: Value of debt (3.050 3.452 923.893 1.917.400 1.965 Business and securities valuation 205 .680 Terminal value = (£2.000 1.00 £m Total present value for forecast period (see above) 9. plant & equipment 5.000 Value per share £2.507 1.887. Statement of financial position 20X4 20X3 Change £ £ £ Cash 300 100 200 Receivables 2.940 2.504.000 2.185 Net income 3.126.000) Value of equity 16. a valuation of Tetrion is undertaken.150 Taxes (23%) 1. a company in the DIY industry.750 5 Interest 0.070  1.500 1.28 9.0 0.33 20Y0 1.043.6 0. The current market price of Tetrion is £29 per share and a 20 per cent premium will persuade Tetrion shareholders to sell.450 6.651 Shares outstanding 8.42 20X9 1.100 Income before tax 5.022.500 R Selling: General administrative 3.

594 10.160 Free cash flow 1.869 EBDIT 5.909 Less: Tax on EBIT @ 23% 1.360 Non-current assets 1.208 1.500) Taxes (1. To arrive at the value of the equity as in the case of the free cash flow valuation. It can be used as a performance evaluation tool (see Section 1.110 3.696 15.383 Total free cash flow 1.132 1.700 2.132 1. The value of the company is equal to the value of the invested capital plus the present value of the economic profits from operations.265) Total 4. Free cash flows 20X4 Cash flows – Operations £ Revenue 12.656 3.125 2. we need to subtract the value of debt from the value of the company.732 Less: Additions to working capital 1.438 29.360 1.12) 28.125 10.983 2.320 Free cash flow 1.983 2.428 Depreciation 250 300 360 432 519 EBIT 5.406/0. 206 Business Analysis . 3.4 above) and can also be relevant ® to valuing acquisitions.075 The following predictions are made by the management of Atrium for the next five years 20X5 20X6 20X7 20X8 20X9 £ £ £ £ £ Free cash flows Sales 12.406 Terminal value (3.605 3.500 6.000 Cash expenses (6.1.894 2.500 8.234 10.503 1.592 3.371 2.605 31.512 1.160 2.235 Cash flows – Investments Working capital 1.250 6.969 Plus depreciation 250 300 360 432 518 Less: Capital expenditure 1. The present value of the company using EVA is given by: EVA1 EVA 2 PV = C + + +… 1 WACC (1 WACC)2 where C is the invested capital.800 Total 3.800 2.156 12.000 18.742 13. An example of how to calculate the value of a company using EVA® is shown below.000 15.310 12.750 23.297 Operating costs excluding depreciation 6.4 EVA® approach ® EVA is an estimate of the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and debt holders could get by investing in other securities of comparable risk.875 8.789 Requirement If the WACC is 12% and there are 100 shares outstanding what is the value of each share of Tetrion plc? At the current market price of Tetrion of £29 per share should the shareholders of Atrium agree to the acquisition of Tetrion? See Answer at the end of this chapter.575 8.503 1.

000) 400 400 400 400 400 Free cash flow (2.091) (491) 80 452 NPV 452 Alternative approach ROIC (NOPAT/previous year's invested capital) 4.5 Adjusted present value approach Adjusted Present Value was covered in detail in Chapter 4 in the context of investment appraisal. C H A P T E R 5 Business and securities valuation 207 . By including a financing element. 3.4% 10% 33.1 Advantages of EVA The EVA approach focuses on long-term net present value. with the present value of the tax shield being added back.68 0.000) (1.3% 55% 50% EVA = (ROIC – WACC) x capital (112) – 280 360 160 PV factor 1 0. If APV is positive then the acquisition should be undertaken.556) (1.75 0. it brings home to managers the costs of capital used.75 0.4.62 PV of cash flow (2. thus emphasising the importance of careful investment and control of working capital.83 0.91 0.2 Disadvantages of EVA The EVA approach suffers from the usual problems of being based on historical accounting figures that can be distorted.000) 488 560 800 840 600 PV factor (WACC 10%) 1 0.68 0.91 0.4.83 0.000 1. 3.000) 444 465 600 571 372 Cumulative PV (2.62 PV of EVA – (102) – 210 245 99 Cumulative PV – (102) (102) 108 353 452 Total PV of EVA 452 3. Worked example: Valuation: EVA approach Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Invested capital 2.200 800 400 – NOPAT – 88 160 400 440 200 Less: Change in invested capital (2. Cash flows of the company are discounted using the ungeared cost of equity.600 1.

26) Gross profit 210.34) (45.30) (156.26) (599.64 157. an unquoted company.61 353.00 270.78) (199.00 300.00 512.88) (20.55 Non-current assets 400.26 399.22 907.52 998. PROFORMA INCOME STATEMENTS AND STATEMENTS OF FINANCIAL POSITION Current Years 20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 £m £m £m £m £m £m £m Sales 620.00 Total assets 500.00 478.27) – Earnings before tax 77.60 Current assets 100.62 153.94 – – Equity 100.00 100.78) EBIT 77.00 682.00) (144.37 384.00 454.00 238.00) (441.00 100.20 825. The analysis of the prospects of NERON by XERON is reflected in the following income statements and statements of financial position.48 199.60 94.64 152.53) (169.06 512.00 328.00) (26.00 750.35 146.69 122.78) (184.87 399.55 Assumptions: Growth rate for sales (until 20Y3) 10% Depreciation expense (20X7) £40m Accounting depreciation equals tax depreciation Interest rate on debt 8% Tax rate 23% All debt is interest bearing Capital expenditures/year £20m All available cash flow is applied to repaying debt until repaid in full Ungeared beta 1.00 478.26 Operating expenses (133.00 335.21) (36.00 96.90 404.70 91.95 252.63 15.61) (553.59) (45.09) (28.00 428.00 100.71 199.52 Less: Cost of goods sold (410.98 198.00 378.00 64.00 512.43 121.00 400. 208 Business Analysis .90 642.83 169.74 998.73) (1.82 70.88) Net income 59.55 Total assets 500.00 354.48 Less: Taxes (17.21 199.10 312. The owners of NERON want £500m for the business.00 142.00 241.70 118.0% Market risk premium 7.05 201.00 400.71) (14.88) (21.1 Terminal value reflects level perpetuity equal to 20Y3 cash flow Risk free rate 6.57 142.00 428.90 642.00 454.10) (512.00 275.90 642. Worked example: APV of acquisition Suppose that the management of XERON plc is considering the acquisition of NERON Ltd.5% Requirement Calculate the APV of NERON and determine on the basis of your answer whether XERON should proceed with the acquisition.55 Debt 400.29 49.00) (475.65 281.87) (599.00 100.00 242.48 Less: Interest expense – (32.16) (199.19) (11.

64m 20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 Total £m £m £m £m £m £m £m £m Firm free cash flows 96.62 Less: Debt value 400.60 Discount factor at 14.766 0.46m/ (1.98 158.46m The present value of the terminal value is: 6 £1.32 91.00 52.98 0.68 1. Solution Step 1 Calculation of firm free cash flow 20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 £m £m £m £m £m £m £m EBIT(1 – Tax rate) (£m) 59.68 183.926 0.29 74.00 50.46 91.5 = 14.25% The tax shield is discounted at the gross cost of debt (8%). H A quantification and announcement of these synergies are essential as shareholders of the companies P involved in the acquisition process may need persuasion to back the merger.857 0.46 115. 3. 302. T E The two examples below show how estimates of synergies may be announced.15 94.98 0.00 46.98 158.1  7.37 83.62 The APV is therefore.00) (20.60 Step 2 Calculation of APV The firm free cash flow is discounted at the ungeared cost of equity capital which is: keu = rf + ßa (rm – rf) = 6 + 1.20 – Step 3 Calculation of terminal value The terminal value under the no-growth assumption is: £185.68 183.00) (20.24 93.82 5. R 5 Business and securities valuation 209 .29 96.60 185.00) (20.875 0.– Discount factor at 8% – 0.00 Less: CAPEX (20.62 million The managers of XERON plc should proceed with the acquisition. APV = £738.60 185.00) (20.302.52 535.00 42.735 0.68 1. The identification.00) (20.60 Plus: Depreciation expense 40.514 0.64 Total firm value 1.68 153.00 PV of interest tax savings 6.450 PV of free cash flows 84.00) Firm free cash flow 79.00) (20.62 million – £500 million = £238.30 135.794 0.30 109.98 130.6 Synergy C The existence of synergies may increase shareholder value in an acquisition.587 0.30 3.82 5.1425) = £585.681 – Present value – 6.36 6.00 Equity value 738.70 0.29 .30 135.1425 = £1.60/0.18 4. 20X7 20X8 20X9 20Y0 20Y1 20Y2 20Y3 £m £m £m £m £m £m £m Interest tax savings (£m) -– 7.98 Terminal value 585.46 115.00 48.64 2.671 0.20 nil 17.00 44.138.30 3.40 88.60 153.25% 0.

massive customer defection is quite common). professional and commercial communities.  Enhanced revenue opportunities arising from new products and brand extensions across the enlarged group's markets. Case example: Merger of Informa and Taylor & Francis Proposed merger of Informa and Taylor & Francis Released: 2 March 2004 Proposed merger of Informa and Taylor & Francis to create a new force in specialist information. 210 Business Analysis .6 million by the beginning of 2005. customer and product presence and enhanced financial strength will enable it to drive both organic and acquisition-led growth. As a result. scientific. a new international force in the provision of specialist information through its combined publishing and events businesses.  Increased operational and financial scale and geographic reach. scientific and commercial customer communities. revenue synergies must be identified and delivered. higher return on equity or a longer period of growth. Nevertheless. The one-off cost of achieving these savings is estimated at £1.  The cross-over demand for information in the academic. The boards of Informa and Taylor & Francis announce a proposed merger to create T & F Informa.6. Customer Relationship Management and Product Technology Management are the two core business processes that will enable the delivery of revenue. Euronext says it is considering the 'progressive reduction' of trading fees on its equity markets by between 10 and 15% during that timeframe. The Exchange says these synergies should kick in over the first two or three years following the merger. Case example: Euronext Euronext says the $10 billion takeover proposal by NYSE would generate cost and revenue synergies of $375 million. Revenue synergies arise from (a) Increased market power (b) Marketing synergies (c) Strategic synergies Revenue synergies are more difficult to quantify relative to financial and cost synergies. When companies merge. The stock markets will be content with cost synergies for the first year after the deal. 3.1 Revenue synergy Revenue synergy exists when the acquisition of the target company will result in higher revenues for the acquiring company. T & F Informa will benefit from:  The existing strong momentum and prospects for both Informa and Taylor & Francis. expanded 'total systems capabilities.3 million in 2004.  Annual pre-tax cost savings of at least £4. Its geographic. of which $250 million will result from rationalising the combined group's IT platforms. It is hard to be sure how customers will react to the new situation (in financial services mergers. But revenue synergies are more difficult. cost synergies are relatively easy to assess pre-deal and to implement post-deal. whether customers will actually buy the new.  A well balanced and robust portfolio of assets combining operationally geared professional and commercial operations with resilient and stable academic publishing. T & F Informa will be a leading provider of high value specialist information to Informa and Taylor & Francis' overlapping academic. and how much of the company's declared cost savings they will demand in price concessions (this is common in automotive supplier M&A where the customers have huge purchasing power over the suppliers). but thereafter they will want to see growth.

 Debt capacity By combining two firms. If one of the firms has tax deductions that it cannot use because it is losing money. with great projects but insufficient capital. IBM has far more cash than promising projects.3 Financial synergy  Diversification Acquiring another firm as a way of reducing risk cannot create wealth for two publicly traded firms. In the case of private firms or closely held firms. The resulting costs from economies of scale are normally estimated to be substantial. and has accumulated $4 billion in cash that it is trying to invest. and may be able to borrow more (have a higher debt ratio) than the individual E firms. with a cumulative net present value of $100 million. with diversified stockholders. while the other firm has income on which it pays significant taxes.6. As the level of operation increases. It is under pressure to return the cash to the owners. a hypothetical company. the combined firm will have less T variable earnings. R 5 Business and securities valuation 211 . It has to be weighed against the H A immediate transfer of wealth that occurs to existing bondholders in both firms from the P stockholders. The assets of the firm being taken over can be written up to reflect new market value.3. in some forms of mergers. has a severe capital rationing problem. has no effect on the combined value of the two firms involved in the takeover. A takeover.6. there might be a potential value gain from diversification. motivated only by diversification considerations. but it could create wealth for private firms or closely held publicly traded firms. Managers may reject profitable investment opportunities if they have to raise new capital to finance them. Case example: Softscape Inc Assume that Softscape Inc. If IBM takes over Softscape Inc. It may therefore make sense for a company with excess cash and no investment opportunities to take over a cash-poor firm with good investment opportunities. or vice versa. where the owners may not be diversified personally. which results in approximately $500 million of investments. it is possible to create a firm that may have the capacity to borrow money and create value. Diversification will lead to an C increase in debt capacity and an increase in the value of the firm. When two firms in different businesses merge. 3. The additional value of combining these two firms lies in the present value of the projects that would not have been taken if they had stayed apart. the combining of the two firms can lead to tax benefits that can be shared by the two firms.  Cash slack When a firm with significant excess cash acquires a firm. being rejected. it can be argued that the value of the combined firm will increase by the synergy benefit of $100 million.  Tax benefits The tax paid by two firms combined together may be lower than the taxes paid by them as individual firms. The value of the combined firms will always be the sum of the values of the independent firms. The value of this synergy is the present value of the tax savings that accrue because of this merger. each of which has little or no capacity to carry debt. but can now be taken because of the availability of cash. leading to higher tax savings from depreciation in future years. which is the net present value of the projects possessed by the latter that can now be taken with the excess cash from the former. the marginal cost falls and this will be manifested in greater operating margins for the combined entity. the combination can create value.2 Cost synergy A cost synergy results primarily from the existence of economies of scale.

In 2010 BA agreed new plans with unions to increase pension contributions in order to reduce the deficit. They can either work to inflate or depress the share price. as the deficit in pension plans was difficult to determine. Optimistic accounting policies. There may be agency issues with both approaches. even though shareholders may lose out as a result. 3. A study by Cocco and Volpin published in April 2012 did not find clear evidence of whether or not markets were able to correctly price companies with defined benefit pension plans. The merger had however been delayed because of problems with BA's pension funds. It prevents the acquiring firm in a hostile takeover from using surplus cash in the pension fund to finance the takeover.1 Accounting policies Accounting policies can have a significant impact on the valuation of acquisitions. What was important was investor uncertainty about the value of liabilities. 3. The requirement for three yearly full valuations of pension schemes. after having had discussions for some time. On the other hand accelerating expenses or making very conservative estimates of future earnings may depress share prices. The aim normally used to be to clear the deficit within 10 years. There were a number of positive strategic reasons for the merger – spreading the cost base and competing more effectively with other European airlines. The arrangement ensures that the fund's assets remain the property of its participants. A pension parachute is a type of 'poison pill'. which closed in 2003.7 Accounting policies and pensions 3. company insiders had better information than external investors and managers might also manipulate the assumptions used for the valuation of scheme assets and liabilities. A large deficit in a defined benefit pension fund can also be a deterrent in a merger or acquisition. The schemes were a problem despite having been closed to new members for many years – one since 2003 and the other since 1984.7. can cause companies to reappraise their plans. taking into account new actuarial assumptions. The larger NAPS scheme. bringing forward revenue recognition and delaying provisions may inflate the company position and share price. Case example: British Airways British Airways (BA) and Spanish airline Iberia eventually agreed to merge in 2010. On the other hand directors who feel they can benefit if a takeover occurs may be tempted to depress a company's market valuation. employers operating schemes that have deficits have to agree with the scheme's trustees a plan to pay off the deficit. because they had few overlapping routes. Its two final salary schemes had a combined deficit of £3. but still had staff contributing to it as well as pensioners.2 Pensions Pension issues may also act as a deterrent to takeover. but poor investment returns and increases in pensioners' longevity outweighed the impact of the tougher conditions. valuing assets generously. 212 Business Analysis . had the bigger deficit of over £2bn. The two were also a good match. a deterrent to takeover. because of the risks involved.7.7 bn in 2010. and hence share prices to deter takeovers. Under UK pension regulations. Directors who wish to retain their own jobs may attempt to boost earnings. although the UK pensions regulator has indicated that more flexibility will be allowed during the current recession. generally by making extra payments. In 2007 the scheme became less generous to contributing staff.

It is not the same as the redemption yield on debt or the cost of debt. without ever having to redeem the loan. that is. (d) Sometimes people quote an interest yield. (b) Debt can be quoted in % or as a value. unless the debt is specifically described as cum interest. where P0 is the ex- interest value: i(1 T) P0 = kd where kd is the after tax cost to the company. where the company will go on paying interest every year in perpetuity. plus the discounted T present value of the redemption payment (ignoring tax). C 4. up to the year of redemption. Both mean that £100 nominal value of debt is worth £97 market value. defined as coupon/market price.3 Redeemable debt H The valuation of redeemable debt depends on future expected receipts.2 Irredeemable debt For irredeemable debentures or loan stock.000 blocks). The market value is the A P discounted present value of future interest receivable. 4.1 Notes on debt calculations (a) Debt is usually quoted in £100 nominal units. excluding any interest payment that might soon be due i = the annual interest payment on the stock rd = the return required by the loan stock investors Irredeemable (undated) debt. E R Value of debt = (Interest earnings  Annuity factor) + (Redemption value  Discounted cash flow factor) 5 Business and securities valuation 213 . 4 Valuing debt Section overview  The basic idea behind debt valuation is that the value is the present value of all future cash flows to the investor (that is. 4. (e) Always use ex-interest prices in any calculations.  Different types of debt (irredeemable. but this is only a crude approximation unless the debt is irredeemable and there is no tax effect. This is known as the coupon rate. interest plus capital redemption) discounted at the debt investor's required rate of return. or blocks (euro loans are usually quoted in €1. always use £100 nominal values as the basis to your calculations unless told otherwise. eg 97% or £97. (c) Interest on debt is stated as a percentage of nominal value. the valuation formula (ignoring taxation) is: i P0  rd where: P0 = the market price of the stock ex interest. redeemable and convertible) are valued in different ways. paying annual after tax interest i (1 – T) in perpetuity.

The redemption yield on the bonds is 8% annually and 2% quarterly. If the market value falls to this minimum. Requirement Calculate the market value of the debentures.4 Convertible debt When convertible loan notes are traded on a stock market. What will be the current market value of each £100 of debenture? See Answer at the end of this chapter.50 which is expected to grow by 4% per annum. Worked example: Market value of debentures Furry has in issue 12% debentures with par value £100.000.330 14 Redemption 110.000 and redemption value £110. n Conversion value = P0 (1 + g) R where: P0 is the current ex-dividend ordinary share price g is the expected annual growth of the ordinary share price n is the number of years to conversion R is the number of shares received on conversion The current market value of a convertible bond where conversion is expected is the sum of the present values of the future interest payments and the present value of the bond's conversion value. We are discounting over 14 periods using the quarterly discount rate (8%/4). The actual market price of convertible loan notes will depend on:  The price of straight debt  The current conversion value  The length of time before conversion may take place  The market's expectation as to future equity returns and the associated risk If the conversion value rises above the straight debt value then the price of convertible loan notes will normally reflect this increase.000 12. with interest payable quarterly.710. and remember to use an annuity factor for the interest. 4.11 36.758 83.000 0. which are redeemable at par in three years' time. Investors now require a redemption yield of 10%.710 Market value is £119. the minimum market price will be the price of straight loan notes with the same coupon rate of interest. it follows that the market attaches no value to the conversion rights. 214 Business Analysis .380 119. Solution You need to use the redemption yield cost of debt as the discount rate. Period Cash flow Discount factor Present value £ 2% £ 1–14 Interest 3. The debentures are redeemable on 30 June 20X4 and it is now 31 December 20X0. Interactive question 5: Value of redeemable debt [Difficulty level: Easy] A company has issued some 9% debentures. Worked example: Convertible debt What is the value of a 9% convertible bond if it can be converted in five years' time into 35 ordinary shares or redeemed at par on the same date? An investor's required return is 10% and the current market price of the underlying share is £2.

46 × 0. where we look at Bonds. Just as changing an accounting policy will T change your reported figures. for example:  To sell the company  As part of a divorce settlement  For taxation purposes  To raise capital from investors C H The important thing to note is that.  Share price volatilities also have to be determined before any share-based payments (such as share option schemes) can be valued. Business and securities valuation 215 . 5. convertible bonds and so on.1 Why value unquoted shares? Unquoted shares are valued for all sorts of purposes. there are many P sources of information on which share values can be based. When unquoted shares are being valued for tax purposes.  The size of the holding may affect the control of the company and this might have a significant effect on the valuation.04 × 35 = £106. you will A change the share price.46 Present value of £9 interest per annum for five years at 10% = 9 × 3. the estimated price that the shares would achieve if sold on the open market.621 = £66.50 × 1.11 Current market value of convertible bond = 34.  Start-ups can be valued using the models we have described previously although there may be problems related to the uncertainties surrounding forecast figures used. When trying to value a company's shares. unquoted companies are more difficult to value. Shares are valued on different bases for different purposes. therefore the companies themselves have to be valued before the share price can be determined. as soon as you change the purpose of the valuation. one of the most frequent errors is to assume that this exercise can be conducted without taking into account the value of the entire enterprise. which may be very different from the unquoted company whose value is trying to be ascertained.or over-valuation. 5 Unquoted companies and start-ups Section overview  While it is possible to value quoted companies given the availability of vast quantities of information.  Shares are not quoted on the Stock Exchange.23 Debt is covered in more detail in Chapter 6 Section 3.2 How do we value unquoted shares? 5 The valuation of unquoted shares is not an exact science and as mentioned above there may be a range of possible values.791 = £34. Sole reliance on such measures as the P/E ratio for comparable quoted companies can result in valuable information being omitted from the valuation process.11 = £100. with a few exceptions. The value of unquoted companies may be affected by the existence of certain rights and obligations attached to preference shares. P/E ratios of comparable quoted companies are directly affected by these companies' levels of gearing. leading to potential under.12 + 66. Solution n 5 Conversion value = P0 (1 + g) R = 2.12 Present value of the conversion value = 106. changing the valuation basis will affect the item you are trying to value. the valuation method used tends to be. E R 5.

When a majority shareholding is valued. Various Court decisions over the years have given us guidance as to how we can use an imaginary market sale to arrive at a value. 5. the following table gives you a starting point for consideration: Shareholding Discount on 100% Company value 75% + Nil to 5% > 50% but < 75% 10 – 15% 50% 20 – 30% (but a much greater discount if another party holds the other 50%) 5. there is a control premium attached to it.  Appropriate yields and price/earnings ratios. Unless there are exceptional circumstances.  Whether control is in excess of 75%.  The value of the company's assets. As a crude guidance. meaning that the articles of association can be changed by the holder. meaning that the overall value will be in excess of the pro rata value to the value of the company as a whole.  The size of the shareholding. to a small or non-existent influence over the company's affairs of a minority shareholding. and any other information normally available to its shareholders. For this purpose. 216 Business Analysis . for example. This depends very much on the nature of the unquoted company. A 75% holding also gives the holder the right to wind up the company.  Whether minority shareholders have contractual rights that would be expensive for majority shareholders to buy out. and the shareholders' rights. The extent of the premium depends on the answers to the above factors. you should consider the following:  The rights and prospects attached to the shareholding – for example. if the degree of control is less than complete.  Whether restrictions apply to.  Whether the minority shareholdings are concentrated on one individual or dispersed.  The company's dividend policy. the valuer should consider:  The sustainable future reported earnings after tax.3 Valuing majority shareholdings The valuation of a majority shareholding must reflect the extent to which a potential buyer of the shares can or cannot control – or influence – the company. There are many degrees of control which are usually determined by the voting power of a particular block of shares.  Any other relevant factors. the value of the shares will be less than a pro-rata proportion of the overall value of the company. In order to value a majority shareholding.4 Valuation of minority shareholdings Whilst there are few differences between the value of a majority holding in a private company and that of a quoted company.  The company's performance as shown in its financial statements.  The commercial and economic background at the valuation date. the right to appoint directors. there can be major differences between the values of minority holdings. These range from full control (including the power to liquidate the company). sale of shares or receipt of dividend.

These circumstances would need to be considered on a case by case basis. Identifying the drivers C Any market-based approach or discounted cash flow analysis depends on the reasonableness of financial H A projections. unknown implementation timing  High development or infrastructure costs  Inexperienced management 5. untested products  Unknown market acceptance.  Size – private companies are often much smaller than quoted companies. If there are little or no prospects of cash returns in the near future. 5. Although the growth prospects of an unquoted company may not be as attractive as those of a quoted company. resources of the business. financial characteristics of the guideline public companies. Projections must be analysed in light of the market potential. Similarly the question of which parties.  Expectations of cash returns – the marketability factor of unquoted companies is affected by the likelihood of minority shareholders receiving a future cash return. and how many parties. therefore the adjustment in valuation may be positive rather than negative.2. it is more appropriate to value minority shareholdings of unquoted companies using the present value of anticipated dividend streams (see Section 1.  Most start-ups typically have no track record  Ongoing losses  Few revenues.5 High growth start-ups The valuation of start-ups presents a number of challenges for the methods that we have considered so far due to their unique characteristics which are summarised below. T E R 5 Business and securities valuation 217 . either in the form of dividends or due to the flotation of the company. unknown product demand  Unknown competition (in infant industries)  Unknown cost structures. Consideration should also be given. the P management team. The following steps should be undertaken with respect to the valuation of a high-growth start up company.1 above). to any contractual protection or rights pertaining to minority shareholdings (eg through the Articles of Association or service contracts). there will be little or no value attached to minority shareholdings unless some significant influence can be exerted on the directors or other shareholders. smaller organisations operating in a niche market may be more dynamic.1 Projecting economic performance All valuation methods require reasonable projections to be made with regard to the key drivers of the business. Any size adjustment to valuations depends very much on specific circumstances. Rather than using DCF analysis and market comparability models for valuation purposes. An article in Finance Week on 27 March 2007 entitled 'Valuing your unquoted company's shares' identified several factors that should be considered when valuing minority shareholdings in an unquoted company.5. and other factors. hold the majority shares may be a key issue in valuing any tranche of minority shares.  Marketability – this may be the only difference between the quoted company being used for comparison purposes and the unquoted company. however. Quoted companies' shareholders are more likely to receive cash returns by way of dividends or share buybacks.

This means that long-term projections. usually sold through private transactions. Most of the investment of a start-up is in people. free cash flows are first projected and are then discounted to the present using a risk-adjusted cost of capital. or techniques. Complicating factors include comparability problems. Market-based methods The market approach to valuation also presents special problems for start-ups. Discounted cash flows Using the DCF methodology. expansion of distribution and manufacturing capacity. Forecasting growth For most high growth start-ups the proportion of profits retained will equal the return on invested capital as the company needs to achieve a high growth rate through investing in research and development. the value of company will be given by: R C V= r g Now assuming that the growth rate of revenues gR is different than the growth rate of costs gC: R C V= – r  gR r  gC 218 Business Analysis . rarely is the forecast period less than seven years. that are at a similar stage of development and that focus on existing or proposed products similar to those of the company being valued. products. human resource development (to attract new talent). Asset-based method The asset-based method is not appropriate because the value of capital in terms of tangible assets may not be high. need to be prepared. the next step is to consider which is the most appropriate of the valuation approaches we have considered so far: net assets. differences in fair market value from value paid by strategic acquirers. marketing and/or intellectual rights that are treated as expenses rather than as capital. Period of projection One characteristic of high growth start-ups is that in order to survive they need to grow very quickly. lack of disclosed information.5. 5.2 Valuation methods Once growth rates have been estimated. market or discounted cash flows. Start-ups that do grow quickly usually have operating expenses and investment needs in excess of their revenues in the first years and experience losses until the growth starts to slow down (and the resource needs begin to stabilise). and development of new markets. all the way out to the time when the business has sustainable positive operating margins and cash flows. and the fact that there are usually no earnings with which to calculate price-to-earnings ratios (in this case price-to-revenue ratios may be helpful). For example. However. one could use the constant growth model which specifies that: FCFF V= r g where: r = required rate of return g = growth rate of earnings Our discussion of the high growth start-up indicates that the growth rates of revenues and costs may vary. Since FCF = Revenue – Costs = R – C. This valuation process involves finding other companies. These projections will depend on the assumptions made about growth.

307 T Current assets E Inventory 250 R Receivables 125 Cash 8 383 5 Current liabilities Payables 180 Taxation 50 Business and securities valuation 219 . The value of the company now is: £100m £500m V= = £2. A very important problem with the discounted flow approach is the sensitivity of the valuation model to the underlying assumptions. and have begun a search for organisations interested in its purchase.22 0 that is. 5. or switch investments at various decision points. whose owners are also the directors. technology. and management of other causes can have a dramatic effect on the value of the start-up. technology. we assume a number of scenarios for the drivers of value and derive a value under each scenario. Worked example: Valuing a start-up QuickLeg is an internet legal services provider which next year expects revenue of £100m and costs of £500m. Changes in the growth rate induced by changes in demand.21 0. For example suppose that the growth rate of revenues falls from 21 per cent to 20 per cent.27 million 0.22  0 The above model seems to capture the phenomenon observed in many start-ups of high losses in the first year of operations with high values of the company.727. or product is to assign probabilities of success to each of the various possibilities. delay. What is the value of QuickLeg? Solution £100m £500m V= – = £7. The revenues of the firm are expected to rise by 21 per cent every year but costs will remain at the same level. the company has lost £5 billion. abandon.22 0.727. The best way of incorporating uncertainty into the discounted cash flow analysis for a new company. Interactive question 6: Valuation methods [Difficulty level: Intermediate] Black Raven Ltd is a prosperous private company. Another problem with the discounted cash flow is that it cannot reflect managerial flexibilities and the strategic options to expand. MOST RECENT STATEMENT OF FINANCIAL POSITION £'000 £'000 £'000 Non-current assets (carrying amounts) Land and buildings 800 Plant and equipment 450 C Motor vehicles 55 H Patents 2 A P 1.5. The next step is to assign probabilities to each scenario and arrive at a weighted average value. The required rate of return is assumed to 22 per cent. The directors have decided to sell their business. Relevant information is as follows. They have asked for your assessment of the price per ordinary share a purchaser might be expected to offer.22  0. The procedure to be followed is akin to the Monte Carlo methodology.27 million 0.20 0.3 Probabilistic valuation methods In a probabilistic cash flow model.

000 2 80. Albatross plc Bullfinch plc Crow plc Div. £ Land and buildings 1.000 Year 4 70. 220 Business Analysis .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.000 4 90.5 Three years ago 12 8.0 Previous year 12 8.0 Average 12 8.0 10. £'000 £'000 £'000 230 153 1.4 9.000 ordinary shares of £1) 300 Reserves 760 1. the directors of Black Raven Ltd have had the non- current assets revalued by an independent expert.000 for the last six years. with the following results.6 8. is as follows. yield P/E ratio Div.060 Share capital (300.075.0 10. Your assessment of the net cash flows after interest and tax which would accrue to a purchasing company.000 Requirement Use the information provided to suggest alternative valuations which prospective purchasers might make.33 10.0 9.3 8. allowing for the capital expenditure required after the acquisition to achieve the company's target five-year plan.5 12.000 Plant and equipment 480.000 The company's five-year plan forecasts an after-tax profit of £100. yield P/E ratio Div.000 Year 2 120.060 The profits after tax and interest but before dividends over the last five years have been as follows. See Answer at the end of this chapter.460 Long-term liability Loan secured on property 400 1.000 for the next 12 months.7 9.0 12. Year £ 1 90. as opposed to a rate of only 14% on the net tangible assets.000 Year 5 120.0 13.5 12.000 Year 3 140.000 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.5 9. with an increase of 4% a year over each of the next four years.000 3 105. The annual dividend has been £45.000 5 (most recent) 100. As part of their preparations to sell the company.3 8. £ Year 1 120. yield P/E ratio % % % Recent year 12 8.6 9.000 Motor vehicles 45.5 11.

Summary and Self-test Summary C H A P T E R 5 Business and securities valuation 221 .

although they also publish texts for external sale to universities. Profed City Tutors Issued shares (million) 4 10 Net asset values (£m) 7.000 below their cost. Study materials are written and word processed in-house. and now employs around 40 full-time lecturers. However:  A recent valuation of the buildings was £1.  Due to a dispute with one of their clients. STATEMENT OF CHANGES IN EQUITY FOR THE YEARS ENDED 31 DECEMBER 20X5 20X6 20X7 £'000 £'000 £'000 Profit after tax 280 260 410 Dividends (150) (160) (185) Retained profit 130 100 225 222 Business Analysis . 3 Profed uses a discount rate of 15% to appraise its investments.5% pa Notes: 1 The net assets of Profed are the net book values of tangible non-current assets plus net working capital. using the information available and stating any assumptions made. City Tutors' growth rates were gleaned from press reports. In order to arrive at an estimate of what they believe the business is worth. This includes courses of lectures provided on their own premises and provision of study material for home study.5m above book value. The shareholders of Profed mainly comprise the original founders of the business who would now like to realise their investment. Requirements (a) Compute a range of valuations for the business of Profed.2 15 Earnings per share (pence) 35 20 Dividend per share (pence) 20 18 Debt: equity ratio 1:7 1:65 Share price (pence) 362 Expected rate of growth in earnings/dividends 9% pa 7. and has done for many years. Freelance lecturers and authors are employed from time to time in times of peak demand. (b) Comment upon the strengths and weaknesses of the methods you used in (a) and their suitability for valuing Profed. Most of the lecturers are qualified professionals with many years' experience in both their profession and tuition. 2 Wilkinson plc Wilkinson plc has identified Chris Limited as a potential acquisition target. who have a similar business.  Inventory includes past editions of textbooks which have a realisable value of £100. Profed's earnings growth rate estimate was provided by the marketing manager. 10 authors and 20 support staff. they have identified a long-established quoted company. Self-test 1 Profed Profed provides a tuition service to professional students. 2 Growth rates should be assumed to be constant per annum. Summary financial statistics for the two companies for the most recent financial year are as follows. You have obtained the following information about Chris Limited. It has approached you as its financial adviser to ask for assistance in valuing the company. based on expected growth in sales adjusted by normal profit margins. colleges and so on. but sent out to an external printing company.000 could prudently be made. an additional allowance for bad debts of £750. City Tutors. The business was started fifteen years ago.

5 (d) The tax rate in 20X1 and 20X2 was 23%. E R (b) Interest expenses were £13 million in 20X1 and £18 million in 20X2.200 1. The P/E ratio for the quoted company sector in which Chris Limited's activities fall is around 15 times and the sector's gross dividend yield is around 11%.000. 3 Cub plc The following data relates to Cub plc Income statement and dividend data 20X1 20X2 £m £m Sales 995 1.180 Pre-tax accounting profit 201 255 Taxation 46 59 Profit after tax 155 196 Dividends 50 60 Retained earnings 105 136 Statement of financial position data 20X1 20X2 £m £m Non-current assets 370 480 Net current assets 400 500 770 980 Financed by: Shareholders' funds 595 720 Medium and long-term bank loans 175 260 770 980 Pre–tax accounting profit is taken after deducting the economic depreciation of the company's C non-current assets (also the depreciation used for tax purposes). Business and securities valuation 223 . The  of the sector is around 0.175 2. STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X5 20X6 20X7 £'000 £'000 £'000 Non-current assets 1.200 10% debentures 20Y2 1. using four different methods of valuation.175 2.405 1.365 1. These should be added back in the calculation. H Other relevant information A P T (a) Economic depreciation was £95 million in 20X1 and £105 million in 20X2. The debentures pay a semi-annual coupon and are redeemable at the end of 20Y2. The gross redemption yield on 20Y2 gilts paying a similar level of coupon is 11%. when it would be useful and why each method gives a different value.560 Working capital 810 870 940 2. (c) Other non-cash expenses (net of tax) were £32 million in 20X1 and £36 million in 20X2. (e) Cub had non-capitalised leases valued at £35 million in each year 20X0-20X2. Discuss the limitations of your analysis and what further information you would require to conduct a more informed valuation.200 1. Explain the rationale behind each valuation.8 and the return on the market is around 21%.200 2.500 The non-current assets include an unused property which has a market value of £100.500 Share capital 100 100 100 Retained earnings 875 975 1. Requirements Estimate the value of Chris Limited.275 2.275 2.

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

Dividend valuation model The dividend valuation method gives the share price as: Next year ' s dividend cos t of equity  growth rate which assumes dividends being paid into perpetuity. This will take account of factors such as marketability of shares.96 P/E ratio Profed City Tutors Issued shares (million) 4 10 Share price (pence) 362 Market value (£m) 36.18 × 1. R Next year's dividend Again.850 Value per share = £1.218 per share.075 For City Tutors. and growth at a constant rate. the P/E ratio for an unquoted company should be taken as between one half to two thirds of that of an equivalent quoted company.Answers to Self-test 1 Profed (a) The information provided allows us to value Profed on three bases: net assets. next year's dividend = £0. even though their validity may be questioned in part (b) of the answer. This will value Profed at 12  £0.2 Earnings per share (pence) 35 20 P/E ratio (share price  EPS) 18. cost of equity = + 0. possibly because it is a younger.200 Add: increased valuation of buildings 1. although the basis for the estimate may be questionable. P/E ratio and dividend valuation.500 Less: decreased value of inventory and receivables (850) Net asset value of equity 7.075 = 12. we might estimate an appropriate P/E ratio of around 12. We can instead P use the information for City Tutors to estimate a cost of equity for Profed. in view of the possible higher growth prospects of Profed. status of company. assuming Profed is to remain a private company. growth potential that will differ from those for Profed. Profed's growth rate has been estimated as higher than that of City Tutors.1. developing company. there appears to be no rational basis for this.20 per share. cost of equity = + Growth rate Market price 5 £0.62 Business and securities valuation 225 . All three will be computed.1 The P/E for a similar quoted company is 18.20  1. This is assuming the T E business risks are similar. C H While we are given a discount rate of 15% as being traditionally used by the directors of A Profed for investment appraisal. from the DVM.09 = £0. For Profed. and ignores the small difference in their gearing ratio.84% £3. Assets-based valuation £'000 Net assets at book value 7. Being generous.35 = £4. a total valuation of £16. All other things being equal.8m.

Shareholders will be reluctant to sell for less than the net asset value even if future prospects are poor.8 million.45 21. It is thus a method that reflects the earnings potential of a company from a market point of view. using it as a basis to value a smaller. Exceptions would include property investment companies and investment trusts. be important as a floor value for a company in financial difficulties or subject to a takeover bid. The latter would perhaps give a sounder basis from which to compute an applicable P/E ratio. The status and marketability of shares in a quoted company have tangible effects on value but these are difficult to measure. and renders this method quite inappropriate. The P/E ratio will also be affected by growth prospects – the higher the growth expected. unquoted company in the same industry can be problematic. Even if the P/E ratio of City Tutors can be taken to be indicative of its true worth.96 7. 13% as a cost of equity for Profed (it could be argued that this should be higher since Profed is unquoted so riskier than the quoted City Tutors): £0. however. the higher the ratio. The earnings yield method of valuation could however be useful here. customer/supplier relationships. as would be perceived by the market. expertise.09 valuing the whole of the share capital at £21. did not coincide with those of Profed management it is difficult to see how the P/E ratio should be adjusted for relative levels of growth. the market values of the assets of which will bear a close relationship to their earning capacities. This is not reflected in the net asset values. Knowledge of the net asset value (NAV) of a company will. a large part of whose value lies in the skill.13  0. say. A potential purchaser of Profed will generally value its intangible assets such as knowledge. The growth rate incorporated by the shareholders of City Tutors is probably based on a more rational approach than that used by Profed.45 0. Range for valuation The three methods used have thus come up with a range of value of Profed as follows. In the valuation in (a) a crude adjustment has been made to City Tutors' P/E ratio to arrive at a ratio to use to value Profed's earnings. If the growth prospects of Profed. and thus its prevailing P/E ratio.218 Share price = = £5. One of the first things to say is that the market price of a share at any point in time is determined by supply and demand forces prevalent during small transactions. Provided the marketing is efficient. It is not known whether the share price given for City Tutors was taken on one particular day. brands and so on more highly than those that can be measured in accounting terms. it is likely to give the most meaningful basis for valuation.8 (b) Asset-based valuation Valuing a company on the basis of its asset values alone is rarely appropriate if it is to be sold on a going concern basis.9 P/E ratio 4. P/E ratio valuation The P/E ratio measures the multiple of the current year's earnings that is reflected in the market price of a share.8 Dividend valuation 5.20 16. or was some sort of average over a period. economic and political changes can all affect the day-to-day price of a share. This can result in a very inaccurate result if account has not been taken of all the differences involved. A downturn in the market. 226 Business Analysis . and will be dependent upon a lot of factors in addition to a realistic appraisal of future prospects. Using. knowledge and reputation of its personnel. Value per share Total valuation £ £m Net assets 1. Profed is typical of a lot of service companies.

particularly in light of its apparently better growth prospects. where the total cash flows will be of greater relevance. Dividend-based valuation The dividend valuation model (DVM) is a cash flow-based approach. Research has indicated the acquisitions of private companies are typically priced at a discount of 30% to 40% to the quoted sector P/E. Determination of an appropriate cost of equity is particularly difficult for an unquoted company.150. 5 Business and securities valuation 227 .  The adjustment to get to an appropriate P/E ratio for Profed may have been too harsh. This discount probably reflects the lack of marketability of the private company shares compared to those of its quoted counterparts. the value C of Chris Limited would be: H A £6. Even accepting that the required 'perfect capital market' assumptions may be satisfied to some extent. 15  £410.790. reducing the valuation. and the results from the model are highly sensitive to changes in both these inputs. His required return may thus be higher than that envisaged in the dividend valuation model.000  60% = £3.000 = £6.000. unquoted company to carry greater personal risk. Although they both operate the same type of business. the formula used in (a) assumes constant growth rates and constant required rates of return in perpetuity. The dividend valuation model valuation provided in (a) results in a higher valuation than that under the P/E ratio approach. It is perhaps more appropriate for valuing a minority shareholding where the holder has no influence over the level of dividends to be paid than for valuing a whole company. Reasons for this may be:  The share price for City Tutors may be currently depressed below its normal level.150. it should be possible to sell the unused E property without affecting the earnings stream for around £100. The practical problems with the dividend valuation model lie mainly in its assumptions. and the use of an 'equivalent' quoted company's data carries the same drawbacks as discussed above. On top of this.000. the fact that City Tutors sells its material externally means it is perhaps less reliant on a fixed customer base. which values the dividends that the shareholders expect to receive from the company by discounting them at their required rate of return. in reality.690.  The cost of equity used in the dividend valuation model was that of City Tutors. giving a total valuation of R £3. Using a discount of 40%. It is also highly dependent upon the current year's dividend being a representative base from which to start. Similar problems arise in estimating future growth rates. 2 Wilkinson plc Earnings-based valuation P/E ratio The earnings-based valuation would be based on applying the P/E ratio for similar quoted companies to Chris Limited's earnings. resulting in an inappropriately low P/E ratio. The validity of this will largely depend upon the relative levels of risk of the two companies.  Even if business risks and gearing risk may be thought to be comparable a prospective buyer of Profed may consider investment in a younger.000 P T This is the value of the earnings stream.000 This value would be the approximate value of a quoted company in the sector.

000.640. This can be done with the capital asset pricing model.000  60% = £1.8(21 – 11) = 19% The market value (MV) of the company is given by the formula MV = D1/ (ke . then a different P/E ratio would be appropriate. ke is the cost of equity and g is the expected growth rate in dividends.567. The sector P/E reflects the expected growth in earnings in the sector. MV = 185  1. The assumption that past dividend growth of 11% will continue in the future may not be valid. When the calculation would be useful A minority investor who only receives dividends from the company will find this most useful and therefore it may be relevant if Wilkinson plc only intends to take a minority stake. ke = 11 + 0. use of the sector  implies that Chris Limited has comparable gearing and business risk to the sector average. £2. The sector P/E reflects the risk of the sector in general. Dividend-based valuation – Dividend valuation model In order to use the dividend valuation model. ke = rf + e (rm rf) where: ke = the company's cost of equity rf = the risk-free rate (estimated as the yield on gilts) and rm = the return on the market. this value should be discounted. It may be that Chris Limited's expected growth rate is better or worse than the sector average. When the calculation is useful Use of earnings to value a company implies that the investor has control of the earnings and can dictate dividend policy. 228 Business Analysis . including business and gearing risk. It would therefore be suitable if Wilkinson plc is aiming to get control of the company. the cost of equity of the company must first be estimated.11) = £2.g) where D1 is the prospective dividend (estimated as D0  {1 + g}).11/ (0. It may be better to identify specific companies in exactly the same class of business as Chris Limited.567. for example. If Chris Limited has a different level of gearing or is in a part of the sector where the business risk is slightly different.000 Since this valuation relies on the  of quoted companies and would give the value of a quoted company's dividend stream. The calculation has assumed that Wilkinson plc acquires a controlling interest and forces the sale of the unused property. It is not clear whether Chris Limited is an average company or whether it is in a more or less attractive part of the sector. meaning that a different P/E ratio would be more appropriate. Limitations of the calculation As with the earnings estimate.000. The value of g can be estimated from extrapolating the dividend growth of Chris Limited over the last few years and is 11% ({185/150} – 1).19 – 0. Adjusting for the value of the unused property.540. the value of the business would be around £1. It has been assumed the company will dispose of the unused property even if Wilkinson plc only obtains a minority holding. Limitations of the calculation The sector P/E is an average for the sector.

The resultant annual yield (11% + 3%=14%) needs to be altered to a semi-annual rate of return of 6.682 0.047.500.8% (1. Asset-based valuation Net realisable value of assets The net book value of the company's assets is £2. Note: The precise calculation here using the square root is probably over the top and gives a spurious level of accuracy.8% £ 1–10 60. non-current assets T may include intangibles which could not easily be sold at book value.500. costs of disposal. Cash flow Discount factor Present value Time £ at 6. The best indication of required returns is given by the details on gilts for the same maturity with the same coupon in the question.Dividend-based valuation – Dividend yield Dividend yield is: 1 185   1. A P The contents of each category of asset and liability are not known.000 = £1. It has been assumed that the company will dispose of the unused property.400 10 10 1. obsolescent inventories.000. say 3%. To establish the value available to equity investors. it assumes that Chris Limited is similar to the sector in terms of gearing and business risk.200.000. E R The value of intangibles such as brands and goodwill may not be included in the above valuation.14 . Limitations of the calculation C The only data available is net book value.109.939 The total value of the company's equity is therefore £2. When the calculation would be useful As with the dividend valuation model. A six-monthly factor of 7% would be just as good. 5 Business and securities valuation 229 .009.453. A risk premium must be added on to the yield on the gilts to compensate for the additional risk of Chris Limited.046. the market value of the loan stock must be deducted.539 1. which may not represent realisable value due to potential H revaluations. discounted at the investors' required rate of return.068 621.000.682  60% = 1. The required yield on the loan stock has been estimated and the 14% may not be appropriate. Limitations of the calculation As with the above methods.000 1/1. even if Wilkinson plc does not acquire a controlling shareholding. it is most useful for a minority investor who will only receive a dividend flow from the company.1) since the coupon is semi-annual. the valuation of Chris Limited would be £1.000 – £1. and so on. This will be the present value of the loan stock's future cash flows.09 425. For example.000 7.11 Discount for lack of marketability: 1.000 Including the proceeds from the assumed sale of the unused property.

if the earnings are going to grow from the current base. Alternatively. The very high earnings of £410. such as very high directors' remuneration  Details on growth prospects  More specific details on the company's business. then the dividends based methods are likely to give the most appropriate valuations. The dividend policy may give a clue as to the directors' expectations for future profitability and sustainable dividend growth. When the calculation would be useful Net realisable value assumes the company's assets can be sold off. The asset-based valuation is the lowest of the four figures. Additional information required  Market value of assets  Existence and value of intangibles  Analysis of profits between ordinary recurring items and exceptional one-off items.000 may not be representative and in subsequent years the earnings may fall back to a level similar to earlier years. this explains the much lower valuations using dividends based methods. This is probably because the company derives its value not from its assets base but from its earnings stream and cash flows. Since the dividends have grown at a much slower rate than earnings. then the earnings-based valuation is likely to be the most appropriate of all the above. Alternatively. to obtain a more fundamental cash-based valuation  Details of any comparable deals executed in the recent past 3 Cub plc Economic value added® Economic value added® = Net operating profit after tax (NOPAT) – (Capital employed  Cost of capital) 230 Business Analysis . Reasons for differences between the valuations The earnings-based valuation is based upon an earnings figure that has grown dramatically in the final year. by contrast. This will only be appropriate if Wilkinson plc acquires a 75% interest and can force a compulsory liquidation. the company must obtain at the very least 50% to be able to force the disposal of any surplus assets. If this is the case. have grown at a reasonably constant rate over the three-year period regardless of earnings performance. Replacement cost of assets may be appropriate to use for a purchaser who is considering starting up an equivalent business from scratch. The problem will be in identifying the cost of replacing intangible assets such as goodwill and brands. which may have distorted the profits in individual years  Details of costs or income that may be avoided or lost if the company is acquired. The dividends of Chris Limited. its business risk and gearing risk and similar information for closely comparable quoted companies  The shareholding Wilkinson plc intends to buy  The possibilities for synergies  Cash flow details.

0 – (0.135  805) = £137.9 – (0.5% Economic value added 20X1 EVA® = 197.23) 10.25  (7% (1 – 0.9 million ® 20X2 EVA = 245. 20X1 20X2 £m £m Profit after tax 155 196 Add: Non-cash expenses 32 36 Add: Interest after tax charge (1 – 0.23)) = 11.9 NOPAT 197.0 245.Net operating profit after tax Net operating profit after tax is arrived at after making a number of adjustments.25  (8% (1 – 0. the company has created significant value in both 20X1 and 20X2 and appears to be on a rising trend.0 13.8% 20X2 cost of capital = (0.118  730) = £110. C H A P T E R 5 Business and securities valuation 231 .2 million On this measure.9 Capital employed Capital employed is on start of year figures 20X1 Capital employed = Capital employed at end of 20X0 + Leases = 695 + 35 = £730 million 20X2 Capital employed = Book value of shareholders' funds + Bank loans + Leases = 595 + 175 + 35 = £805 million Weighted average cost of capital 20X1 cost of capital = (0.75  14%) + (0.75  16%) + (0.23)) = 13.

000 (100.000 or more. A P/E ratio of 15 (Bumblebee's) would be much too high for Mayfly.000 0. but estimates of future earnings are uncertain.550 Maximum purchase price 101.497 74.04 ke g 0. Mayfly's expectations of earnings are probably better than those of Wasp. and Mayfly is an unquoted company. Cash flows ignoring Discount Present Year purchase consideration factor (from tables) value £ 15% £ 0 (100. perhaps.000 0. but since Mayfly is an unquoted company and therefore more risky.500 = £357.000) 1 (80.360 3 100.500. and over the last four years £71.500.000.000 D0 £250.200.910 232 Business Analysis .000 g = 4% or 0. Answers to Interactive questions Answer to Interactive question 1 ke = 12% + 2% = 14% (0. or conceivably even as low as 50% of 10 = 5. because the growth of Mayfly's earnings is not as certain.000(1.658 65.000 0. Answer to Interactive question 3 The maximum price is one which would make the return from the total investment exactly 15% over five years.04) (b) P0 = = = £2. so that the NPV at 15% would be 0.756 45.000 0.000 as the high estimate.785. A high estimate of earnings might be £75.800 5 150.000 = £525. This solution will use the most recent earnings figure of £75. On the other hand.870 (69. There might appear to be some growth prospects.000 (a) P0 = = = £1.714 ke 0. (b) P/E ratio. a lower P/E ratio might be more appropriate: perhaps 60% to 70% of 10 = 6 or 7. A low estimate of earnings in 20X5 would be. A suitable P/E ratio might be based on the industry's average.572 85.000) 0.600.14) D0 = £250.04 Answer to Interactive question 2 (a) Earnings. and low P/E ratio and low earnings: 5 × £71. Average earnings over the last five years have been £67.000) 1.14 D0 (1  g) £250. The valuation of Mayfly's shares might therefore range between: high P/E ratio and high earnings: 7 × £75.500.14 0.600) 2 60.800 4 150. £71. 10.

Answer to Interactive question 4 First we calculate the PV of the free cash flows over the five year planning horizon.00 × 120%) £34. 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.797 0.636 0. which were: T E £465.37 3 Redemption value 100 0. 20X5 20X6 20X7 20X8 20X9 £ £ £ £ £ FCF 1.789 Discount factor at 12% 0. Answer to Interactive question 6 Tutorial note: This question provides comprehensive practice of valuation techniques.657 18.) Business and securities valuation 233 .983 2. You could for example have made adjustments to estimated earnings in (c) to allow for uncertainty. the most recent year's P/E ratios are considered to be the only figures which are appropriate.011 1.80 Discount of selling price from value 84% The shareholders of Atrium should buy Tetrion at the offered price.47.302 Less: Debt 2. 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. C (a) Earnings-basis valuations H A If the purchaser believes that earnings over the last five years are an appropriate measure for P valuation.412 1. Answer to Interactive question 5 Discount Present Year Cash flow factor value £ 10% £ 1–3 Interest 9 2.486 22.302 Shares outstanding 100 Intrinsic value per share £213.10 97.000 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.503 1. and even though average earnings have been taken.893 0.198 1.024 Total PV = £23.302 £ PV @ 12% (see above) 23.000 R  £93.00 Price at which Tetrion shareholders will sell (£29. or used a different figure to 17% in (d).02 Market share price £29.567 PV 1.000 Equity value 21.132 1.712 0. in (b) that the last five years are an appropriate indicator and so on). we could take average earnings in these years.751 75.47 Each £100 of debenture will have a market value of £97. (A trend towards an increase in the P/E ratio over three 5 years is assumed.605 31.

000) A share valuation on an expected earnings basis would be as follows.486 Year 5 116.326. P/E ratio Albatross plc 8. £ Expected earnings: Year 1 100.71 Because of the unquoted status of Black Raven Ltd.000 £1. it could be argued that a similar growth rate in dividends would be expected. is not much better than a guess. P/E ratio Earnings Valuation Number of shares Value per share £'000 £'000 (i) 9. in spite of the expected increase in future earnings. The only reliable dividend figure for Black Raven Ltd is £45.000 £2.84. rather more than the 12% for quoted companies because Black Raven Ltd is unquoted.5 £108.5 300. P/E ratio Average future earnings Valuation Value per share 5.25 should be considered too low. This is 12%.000 or £1.25 per share 12% A purchasing company would. Forecast earnings based on the company's five year plan will be used. with growth Since earnings are expected to increase by 4% a year.84 (ii) 5. On the other hand.000 or £1.98 It is not clear whether the purchasing company would accept Black Raven's own estimates of earnings.000 Year 2 104. A yield basis valuation would therefore be: £45.5 93 511.20 per share (k g) (0.17 0. in the absence of information about the expected growth of dividends in the quoted companies. (c) A dividend yield basis of valuation. purchasers would probably apply a lower P/E ratio. however. However.0 Average 9.000 £1.167 93 852.04) 234 Business Analysis .160 Year 4 112. a higher yield than 12% might be expected. and an offer of about £1.5 (ii) Share valuations on a past earnings basis are as follows.000  £375. An average yield for the recent year for the three quoted companies will be used.167 (i) Reduce by about 40% to allow for unquoted status 5. We shall assume that the required yield is 17%.000 £594. the choice of 12%.986 Average 108. and an offer price of £1. since Black Raven Ltd is an unquoted company.5 300.5 Bullfinch plc 9.000 a year gross. be more concerned with earnings than with dividends if it intended to buy the entire company.71 per share would be more likely than one of £2. 17% or whatever.000 Year 3 108. and it is reasonable to suppose that investors in Black Raven would require at least the same yield.000(1.0 Crow plc 10.4 (say £108. (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.04) P0    £360. D0 (1 g) 45. Future earnings might be used.

C H A P T E R 5 Business and securities valuation 235 .28 3 140 0. Although the loan of £400.28 395.877 105.519 62.50 4 70 0.44 5 120 0. but a figure of less than £2 per share would be offered on a DCF valuation basis.592 41. depending on the view taken of Black Raven Ltd's assets. In view of the high asset values of the company an asset stripping purchaser might come forward. It might be argued that cash flows beyond Year 5 should be considered and a higher valuation could be appropriate.(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%.769 92. The present value of the benefits from the investment would be as follows.675 94.74 A valuation per share of £1. (e) Summary Any of the preceding valuations might be made. 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. Year Cash flow Discount factor PV of cash flow £'000 14% £'000 1 120 0. but since share valuation is largely a subjective matter.000 is secured on some of the company's property. many other prices might be offered.32 might therefore be made.24 2 120 0. This basis of valuation is one which a purchasing company ought to consider.

236 Business Analysis .

CHAPTER 6 Cost of capital and financial structuring Introduction Topic List 1 Overview of sources of finance 2 Overview of cost of capital. portfolio theory and CAPM 3 Bonds and debt 4 Financial restructuring 5 Refinancing and securitisation 6 Small company finance 7 Working capital management Summary and Self-test Answers to Self-test Answers to Interactive questions 237 .

and medium-sized enterprises  Demonstrate and apply detailed knowledge of working capital management techniques 238 Business Analysis . securitisation  Demonstrate detailed knowledge and understanding of the small. including the flat and gross redemption yields  Demonstrate and apply detailed knowledge of yield curves. portfolio theory and the capital asset pricing model (CAPM)  Demonstrate and apply detailed knowledge and understanding of the use of bonds as a method of finance  Demonstrate and apply detailed knowledge of bond price.and medium-sized enterprise financing problem  Demonstrate detailed knowledge and understanding of the various methods of financing available to small. loan agreement conditions and raising finance  Demonstrate a detailed understanding and application of cost of capital issues. sensitivity to yield and components of the yield  Demonstrate detailed knowledge and understanding of duration  Demonstrate detailed knowledge and understanding of credit risk and credit spread  Demonstrate a detailed understanding of how financial reconstruction takes place  Demonstrate and apply detailed knowledge of how to carry out a financial reconstruction  Demonstrate and apply detailed knowledge and understanding of the different reasons for refinancing  Demonstrate and apply detailed knowledge of the workings of. Introduction Learning objectives Tick off  Demonstrate and apply detailed knowledge of sources of finance. and reasons for.

we review in detail the issues affecting small businesses as they seek finance. principally in Financial Management. and capital that is needed to finance growth. in Section 6. 1 Overview of sources of finance C H A Section overview P T  In this section we discuss the factors that determine the sources of finance that businesses choose. In this way.3. but it is worth stressing that debt financing will be more appropriate when:  The company is in a healthy competitive position  Cash flows and earnings are stable or rising  Profit margins are reasonable  The bulk of the company's assets are tangible  The liquidity and cash flow position is strong  The debt-equity ratio is low  Share prices are low (unless share prices are low because the company already has high gearing) 1.2 Matching assets with funds As a general rule. or dividends on its equity funding.1 Equity and debt You have already covered the different features of equity and debt in your earlier studies. 6 1. acceptability and feasibility framework you studied in the Business Strategy syllabus. 1. however.2 Capital structure Often the decision on the right capital structure will be a complex one. A company would not normally finance all of its short-term assets with short-term liabilities. The mix of finance a business should use can be assessed using the suitability.1 Stability of company One determinant of the suitability of the gearing mix is the stability of the company. It may seem obvious. the returns made by the asset should be sufficient to pay either the interest cost of the loans raised to buy it. but instead finance short-term assets partly with short-term funding and partly with long-term funding (see Section 7). 1. assets which yield profits over a long period of time should be financed by long-term funds.3.3. You may wish to refresh your memory by referring back to this study material. 1. E R  Later in this chapter. If. the company cannot be certain that when the loan becomes repayable. it will have enough cash (from profits) to repay it. a long-term asset is financed by short-term funds. They are also considering the mix of long-term and short-term debt. Remember businesses are not just deciding what the best mix of equity and debt should be. the attractiveness of different lenders and the security they wish to offer amongst other factors. Aims Main funding sources Maintenance of current level of operations Internal sources Growth External finance Cost of capital and financial structuring 239 .3 Long-term capital requirements for replacement and growth A distinction can be made between long-term capital that is needed to finance the replacement of worn-out assets.3 Suitability of capital structure 1.

plant etc) by a long-term loan in the foreign currency. Investors themselves adjust their level of personal gearing and thus the level of corporate gearing becomes irrelevant.4 Signalling Some investors may see the issue of debt capital as a sign that the directors are confident enough of the future cash flows of the business to be prepared to commit the company to making regular interest payments to lenders. Both inflation and uncertainty about future interest rate changes are reasons why companies are unwilling to borrow long-term at high rates of interest and investors are unwilling to lend long-term when they think that interest yields might go even higher. However if the asset ultimately generates home currency receipts.7 Cost and flexibility Interest rates on longer-term debt may be higher than interest rates on shorter-term debt. 1. the alternative view of Modigliani and Miller is that the firm's overall weighted average cost of capital is not influenced by changes in its capital structure.8 Optimal capital structure and the cost of capital When we consider the capital structure decision. the question arises of whether there is an optimal mix of equity and debt that minimises the cost of capital.3. As gearing rises. 240 Business Analysis . without needing to take the directors' views into account. 1. However issue costs or arrangement fees will be higher for shorter-term debt as it has to be renewed more frequently. At very high levels of gearing the holders of debt too will begin to require higher returns as they become exposed to risk of inadequate profits.3. In addition foreign loans may carry a lower interest rate. is minimised. Similarly it can try to match its foreign assets (property. One view (the traditional view) is that there is an optimal capital mix at which the average cost of capital.6 Domestic and international borrowing If the company is receiving income in a foreign currency or has a long-term investment overseas.5 Clientele effect When considering whether to change gearing significantly. will look to buy shares. Their argument is that the issue of debt causes the cost of equity to rise in such a way that the benefits of debt on returns are exactly offset. directors may take into account changes in the profile of shareholders. and which a company should therefore try to achieve. because of the tax relief that can be obtained on interest which causes the weighted average cost to fall as gearing increases. 1. These shareholders will look to sell their shares.3. Euromarket loans also generally require no security and it may be easier to raise large sums quickly on overseas markets. A further issue is tax exhaustion. whilst other investors. The argument would be that an efficient market would have sufficient information to be able to make its own mind up about the debt issue. 1. 1. As you may remember. A business may also find itself locked into longer-term debt.3. If gearing does change significantly. who are now attracted by the new gearing levels. It can take out a long-term loan and use the foreign currency receipts to repay the loan. However this depends on the view that market efficiency is not very high. there will be a long-term currency risk. with adverse interest rates and large penalties if it repays the debt early. then it is in the company's interests to use debt finance. so the return demanded by the ordinary shareholders begins to rise in order to compensate them for the risk resulting from a larger and larger share of profits going to the providers of debt. it can try to limit the risk of adverse exchange rate movements by matching. the company may adjust to a new risk- return trade-off that is unsuitable for many shareholders. companies will discover that they have no taxable income against which to offset interest charges. but the principle of interest rate parity suggests that the foreign currency will ultimately strengthen. weighted according to the different forms of capital employed. and they therefore lose the benefit of the tax relief on the interest. If tax is included in the model. and hence loan repayments will become more expensive.3. that at a certain level of gearing.

The collateral loan providers require may also be too much. It could for example E R adversely affect the company's reputation if it made a rights issue that was not fully subscribed. On the other hand the effective cost of debt might be cheaper than the cost of equity. but the attitudes that P directors and owners have towards the principal risks. 1. Companies with substantial non-current assets may be able to borrow more.5 Present sources of finance Perhaps it's easy to find reasons why new sources of finance may not be desirable.5.1 Lenders' attitudes Whether lenders are prepared to lend the company any money will depend on the company's circumstances. and also the risks of raising finance. 1.2 Loss of control The directors and shareholders may be unwilling to accept the conditions and the loss of control that obtaining extra finance will mean. of bankruptcy. (b) The price of additional debt finance may be security. To optimise capital structure. restricting disposal of the assets secured and covenants that limit the company's rights to dispose of assets in general or to pay dividends. Owners will be concerned about the combination of risk and return. but on the other 6 hand significant profit incentives in their remuneration packages may encourage them to take more risks than the owners deem desirable. Owner-director attitudes to risk may also differ.4. 1. increase. particularly if tax relief can be obtained.4. 1.4. 1.3 Costs The directors may consider that the extra interest costs the company is committed to are too high. which will cause the value of the company's securities to fall. As firms take on higher levels of gearing.4.1 Risk attitudes H A The choice of capital structure will not only depend on company circumstances. with a corresponding increase in its cost of funds. the company may not be able to obtain that finance. 1. more general economic risks. but equally they may be considered more acceptable than drawing on current sources.4 Commitments The interest and repayment schedules that the company is required to meet may be considered too tight. particularly as they affect the company's ability to generate cash and security for the loan. or fear. particularly if the directors are themselves required to provide personal guarantees.4 Acceptability of capital structure C 1. At very high levels of gearing.4. Control may be diminished whether equity or loan funding is sought: (a) Issuing shares to outsiders may dilute the control of the existing shareholders and directors. and the company will be subject to greater regulatory control if it obtains a stock market listing. financial managers must therefore not increase gearing beyond the point where the cost of investor worries over bankruptcy outweighs the benefits gained from the increased tax shield on debt. For example shareholders may be unwilling to contribute further funds in a rights issue. and hence liquidation ('bankruptcy'). Investors will be concerned over this and sell their holdings. the firm may face costs arising from the possibility. 1. The business may wish to improve its relations with its suppliers.5 Feasibility of capital structure Even if directors and shareholders are happy with the implications of obtaining significant extra finance. Directors may be concerned with the risk to their income and job security. Cost of capital and financial structuring 241 . and one condition may be lessening its reliance on trade credit. the chances of default on debt repayments. The differing costs of raising finance (zero for retained earnings. This will include the risks that are specific to the T business. much more expensive for equity issues) may also be important.

6. particularly debt with its guaranteed income and priority on liquidation. that businesses are confident of making sufficient profits to fulfil their obligations on debt and that they believe that the shares are undervalued. or may require that its gearing does not exceed specified limits. In the context where retained earnings are referred to as a source of finance it needs to be made clear that this refers to operating cash flows retained in the business rather than paid out as dividends.  Investors prefer safer securities. and the issue costs of debt are lower than those of equity.  By contrast the market will interpret equity issues as a measure of last resort. 1. 1. provided this does not mean excessive changes in dividend payout ratios.3 Future trends Likely future trends of fund availability will be significant if a business is likely to require a number of injections of funds over the next few years. However debt (particularly less risky. It contrasts with the view that businesses will seek an optimal capital structure that minimises their weighted average cost of capital.  Some managers believe that debt issues have a better signalling effect than equity issues because the market believes that managers are better informed about shares' true worth than the market itself is. The order of preference will be:  Retained earnings*  Straight debt  Convertible debt  Preference shares  Equity shares (rights then new issues) * Note: A common error in the exam is to refer to retained earnings as a source of finance when there may be no liquid resources in the business. 1.4 Restrictions in loan agreements Restrictions written into agreements on current loans may prohibit a business from taking out further loans. 1. it may be difficult to raise cash through share issues.5.5.2 Consequences of pecking order theory  Businesses will try to match investment opportunities with internal finance.6.6 Pecking order theory Pecking order describes the order in which businesses will use different sources of finance.5 Maturity dates If a business already has significant debt repayable in a few years' time.  There are no issue costs if retained earnings are used.5. so major amounts will have to be borrowed. 242 Business Analysis .2 Shareholder willingness to invest If the stock market is depressed. 1. that managers believe that equity is currently overvalued and hence are trying to achieve high proceeds whilst they can. because of cash flow restrictions it may not be able to take out further debt which is repayable around the same time. Their view is the market will interpret debt issues as a sign of confidence.5. 1.1 Reasons for following pecking order  It is easier to use retained earnings than go to the trouble of obtaining external finance and have to live up to the demands of external finance providers.  The main consequence in this situation will be reinforcing a preference for using retained earnings first. 1. secured debt) will be the next source as the market feels more confident about valuing it than more risky debt or equity.

rather than what they should do. 2 Overview of cost of capital. and external equity funds the last.3 Limitations of pecking order theory  It fails to take into account taxation. determining the type(s) of finance that companies should be using for investment purposes and so on. starting with straight debt. external finance will be issued in the C pecking order.  These techniques were covered extensively in the Financial Management paper at Professional stage. 1. since internal equity funds will be the P first source of finance that businesses choose.6. and choose the source of finance that experience suggests will cause them few or no problems. portfolio theory and the capital asset pricing model (CAPM) are reviewed here.  Benchmarking occurs where businesses identify a leader in their market and adopt a similar capital structure. agency costs or how the investment opportunities that are available may influence the choice of finance. H A  Establishing an ideal debt-equity mix will be problematic. surplus internal funds will be invested.  Knowledge of all of these topics is essential at the Advanced stage as you will be expected to use them when developing financial strategies or structures.  If it is not possible to match investment opportunities with internal finance. There will thus be limited opportunities to invest funds. 6  Pecking order theory is an explanation of what businesses actually do. then sub-optimal decisions will be made regarding the projects that are undertaken and the way in which capital is structured. Cost of capital and financial structuring 243 . financial distress. portfolio theory and CAPM Section overview  The important fundamentals of financial management – cost of capital. Studies suggest that the businesses that are most likely to follow pecking order theory are those that are operating profitably in markets where growth prospects are poor.1 Cost of capital The importance of cost of capital cannot be emphasised enough in the formulation of financial strategy. However the capital structure that is appropriate for the market leader with the investment opportunities that it faces may not be appropriate for the less successful businesses in that industry.  Past experience may be an important influence. The argument is that managers are aware of the advantages and disadvantages of both equity and debt. 2. It is used for discounting cash flows of potential projects. If the incorrect cost of capital is used. However there is evidence to suggest that companies that are significantly more highly geared than the industry average will have difficulty obtaining further debt finance. and these businesses will be content to rely on retained earnings for the limited resources that they need. Of course the average may hide wide variations that are acceptable to different companies. if there is a deficiency of internal funds.4 Behavioural theories A number of studies have suggested that businesses pursue rules of thumb or behaviour patterns. T E R 1.6. therefore you should review earlier study notes to ensure you are familiar with the detail.  The herd theory states that businesses will stick closely to the industry average capital structure.

What will be the expected rate of return from ordinary shares in Rigel. Interactive question 2: Cost of equity [Difficulty level: Easy] The following data relates to the ordinary shares of Stilton.1.1. Growth will come about from the retention and reinvestment of profits. 20X1 3 pence Expected growth rate in dividends and earnings 10% pa Average market return 8% Risk-free rate of return 5% Beta factor of Stilton equity shares 1. 2.2. The model is as follows: g = rb Where: g = growth in future dividends r = the current accounting rate of return b = the proportion of profits retained (ii) Capital Asset Pricing Model (CAPM) The CAPM is based on a comparison of the systematic risk of individual investments with the risks of all shares in the market and is calculated as follows: ke = rf + e (rm – rf) where: ke is the cost of equity capital rf is the risk-free rate of return rm is the return from the market as a whole e is the beta factor of the individual security Interactive question 1: CAPM [Difficulty level: Easy] Investors have an expected rate of return of 8% from ordinary shares in Algol.1 Pecking order theory Remember what we said in the last section about pecking order theory and the order of funds being:  Retained earnings  Debt  Equity shares 2.2 Cost of equity The cost of equity (ke) of a company is the same as the returns required by investors and can be calculated in several different ways: the dividend valuation model (covered in Chapter 5). which have a beta of 1. 31 December 20X1 250 pence Dividend per share. The expected returns to the market are 7%. which have a beta of 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? See Answer at the end of this chapter. and the Capital Asset Pricing Model (CAPM). 244 Business Analysis . Current market price. (i) Earnings retention model This model is based on the premise that retained profits are the only source of funds.8? See Answer at the end of this chapter. the Gordon growth model.

5. then the conversion value is ignored and the bond is treated as redeemable debt. when calculating the weighted average cost of capital. Conversion value is calculated as follows. and what do betas of 0. Interactive question 3: CAPM and beta factor [Difficulty level: Easy] C (a) What does beta measure. this is the (post-tax) interest as a percentage of the ex interest market value of the loan stock (or preference shares). the cost of preference shares is a separate component and should not be combined with the cost of debt or the cost of equity. T E R 2. (i) Irredeemable debt capital After-tax cost of irredeemable debt capital is: i(1 T) kd  P0 where: k d is the cost of debt capital after tax T is the rate of corporation tax (ii) Redeemable debt The procedure is to calculate an internal rate of return on the pre-tax cash flows (the gross redemption yield). For redeemable debt. n Conversion value = P0 (1 + g) R Cost of capital and financial structuring 245 .1. If conversion is expected. The post-tax cost of debt is then calculated by multiplying the gross redemption yield by (1 – T). (iv) Cost of convertible debt This calculation will depend on whether conversion is likely to happen or not. but the number of years to redemption is replaced by the number of years to conversion and the redemption value is replaced by the conversion value (that is. the IRR method for calculating the cost of redeemable debt is used. If conversion is not expected. 1 and 1. The first step is therefore to calculate the internal rate of return of the following cash flows: t0 = ex-interest market value t1 – tn = interest tn = redemption price (iii) Cost of preference shares As preference shares usually have a constant dividend the perpetuity valuation formula is used: D kp = P0 where: D = constant annual dividend P0 = ex-div market value Remember that.3 Cost of debt 6 The cost of debt is the return an enterprise must pay to its lenders.5 mean? H A (b) What factors determine the level of beta that a company may have? P See Answer at the end of this chapter. the market value of the shares into which the debt is to be converted). For irredeemable debt. the cost is given by the internal rate of return of the cash flows involved.

4 Weighted average cost of capital (WACC) WACC is calculated by weighting the costs of the individual sources of finance according to their relative importance as sources of finance. Two methods of weighting could be used: market value or book value. as the use of historical book values may result in WACC being understated. Ignoring taxation.1. The debt is due for redemption at par on 1 January 20X6. what do you estimate to be the current cost of debt? (b) If a new expectation emerged that the cost of debt would rise to 12% during 20X3 and 20X4 what effect might this have in theory on the market price at 28 December 20X2? (c) If the effective rate of tax was 23% what would be the after-tax cost of debt of the loan notes in (a) above? See Answer at the end of this chapter. The market price is £90 ex interest. WACC is calculated using the following formula:  E   D  WACC =  ke +  kd  E  D   E  D  Where: ke is the cost of equity kd is the cost of debt (net of tax) E is the market value of equity in the firm D is the market value of debt in the firm 246 Business Analysis . Calculate the cost of this capital if the debenture is: (a) Irredeemable (b) Redeemable at par after 10 years Ignore taxation. The general rule is that market value should always be used if data is available. The market price of the loan notes at 28 December 20X2 was £103 cum interest. 2.000 of 8% loan notes on which the interest is payable annually on 31 December. See Answer at the end of this chapter. where: P0 is the current ex-dividend ordinary share price g is the expected annual growth of the ordinary share price n is the number of years to conversion R is the number of shares received on conversion Interactive question 4: Cost of debt (no tax) [Difficulty level: Easy] Allot has in issue 10% loan notes of a nominal value of £100. Interactive question 5: Cost of debt (with tax) [Difficulty level: Intermediate] (a) A company has outstanding £660.

H £'000 A Ordinary shares of 50p 2. Cost When used Cost of equity  Discounting earnings after finance costs.5 Effective interest rates The effective interest rate is the rate on a loan that has been restated from the nominal interest rate to one with annual compound interest. It is used to make loans more comparable by converting individual loans' interest rates into equivalent annual rates.000 T E The ordinary shares are currently quoted at 130 pence each and the loan notes are trading at £72 per R £100 nominal. Corporation tax is currently 23%. taxation and preference dividends. It is calculated using the following formula: n r = (1 + i/n) – 1 where: r is the effective interest rate i is the nominal interest rate n is the number of compounding periods per year (eg 12 for monthly compounding) 2.1.  Calculating value of a share in a dividend valuation or earnings valuation model. 6 See Answer at the end of this chapter. Calculate the weighted average cost of capital for this entity. taxation and preference dividends. Weighted average cost of capital  Discounting earnings before finance costs.  Appraising investments where the mix of additional finance carries a significantly different level of risks to the existing finance mix. Interactive question 6: Weighted average cost of capital [Difficulty level: Easy] C An entity has the following information in its statement of financial position.6 Uses of different costs of capital It is important to use the appropriate cost of capital in the right calculation.500 P Debt (12% irredeemable. Marginal cost of capital  Appraising investments in circumstances where gearing levels or project risks fluctuate significantly. The ordinary dividend of 15p has just been paid with an expected growth rate of 10%. nominal value) 1. Cost of capital and financial structuring 247 .  Appraising investments where the source of finance is project-specific.1. 2.  Calculating the value of an enterprise (ie total of equity and debt) using an earnings valuation model.  Appraising investments with similar business risks where gearing does not change.

2.3 CAPM and cost of capital CAPM can be used to produce a cost of capital for an investment project. Interactive question 7: CAPM and cost of capital [Difficulty level: Easy] Panda plc is all-equity financed. It makes use of a beta value which measures a share's volatility in terms of market risk. Requirement Estimate the minimum return that Panda will require from the project and assess whether the project is worthwhile. By holding a portfolio of shares.1.2. It wishes to invest in a project with an estimated beta of 1.2. investors can reduce unsystematic risk (which applies to individual investments) through diversification.5. The project requires an outlay of £10.1. Rather than holding shares in just one company – and thus being exposed to the risks associated with that company in particular and its industry in general – investors should prefer to hold shares in a combination of different companies in various industries. rj = rf + w (rw – rf) where rw is the expected return from the world market portfolio and w is a measure of the world systematic risk.2 Portfolio theory and CAPM 2. For a portfolio of shares. based on the figures you are given.4 International CAPM The possibility of international portfolio diversification increases the opportunities available to investors. This analysis implies that investors can benefit from maximum diversification by investing in the world market portfolio consisting of all securities in the world economy. 2. New risk and return combinations may be available. the CAPM is used to calculate the required rate of return for any particular investment and is based on the assumption that investors require a return in excess of the risk-free rate to compensate them for systematic risk. which is due to variations in market activity such as macroeconomic factors. With regard to portfolio theory. risk will be reduced.2.000. if the investor has invested in companies whose shares move in different ways in response to economic factors. Investors cannot diversify away systematic risk.000 and will generate expected returns of £12.2. See Answer at the end of this chapter. The project has significantly different business risk characteristics from Panda's current operations. 2. then we have an international CAPM formula as follows. 2.1 Portfolio theory Modern portfolio theory is based around the premise that an investor will want to minimise risk and follows the 'do not put all your eggs in one basket' theory.2.2 CAPM We mentioned the CAPM in Section 2. 248 Business Analysis . based on the systematic risk of that investment. The CAPM formula is given in Section 2.2 in relation to calculating the cost of equity. the beta value will be the weighted average of the beta factors of all the securities in the portfolio. In this way. The market rate of return is 12% and the risk-free rate of return is 6%. If we assume that the international capital market is a fully integrated market like an enlarged domestic market.

. The actual return r on any security is shown as: 6 r = E(rj)+ 1F1 + 2F2 .. which analyses the returns on a share as a function of a single factor – the return on R the market portfolio. the Arbitrage Pricing Theory (APT) assumes that the return on each security is based on a number of independent factors... such as interest rates and industrial P production. T E Unlike the CAPM.. unlike CAPM. MCPM also adds the risk premium to the estimated yield of a company's debt to calculate its cost of equity... Cost of capital and financial structuring 249 . + e where E(rj) is the expected return on the security I is the sensitivity to changes in factor 1 FI is the difference between actual and expected values of factor 1 2 is the sensitivity to changes in factor 2 F2 is the difference between actual and expected values of factor 2 e is a random term Factor analysis is used to ascertain the factors to which security returns are sensitive.. where rf is the risk-free rate of return r1 is the expected return on a portfolio with unit sensitivity to factor 1 and no sensitivity to any other factor r2 is the expected return on a portfolio with unit sensitivity to factor 2 and no sensitivity to any other factor Such an approach generalises the CAPM and postulates the following model for the risk premium of a portfolio: E(rj)= rf + (E(rA) – rf)A + (E(rB) – rf)B + . +(E(rm) – rf)m + . the expected return E(rj) can be shown as: E(rj)= rf + 1(r1  rf) + 2(r2  rf) . (E(rB) – rf)B is the risk premium on factor B and so on The APT model calculates the risk premium by constructing a portfolio with a beta of 1 in relation to the factor under consideration (such as the interest rate) and a beta of zero in relation to all the other factors.. Subsequent empirical research has shown that there may be other factors in addition to A market risk premium that explain differences in asset returns. Four key factors identified by researchers have been:  Unanticipated inflation  Changes in the expected level of industrial production  Changes in the risk premium on bonds (debentures)  Unanticipated changes in the term structure of interest rates It has been demonstrated that when no further arbitrage opportunities exist.6 Market-derived capital pricing model This model uses option pricing model to calculate the equity risk premium from a share's volatility.5 Arbitrage pricing theory C The CAPM specifies that the only risk factor that should be taken into account is the market risk H premium.2.. 2. The risk premium of that specific portfolio is then used as a proxy for the risk premium for the factor under consideration...2.. Correlation is not a factor in the model......2. Where (E(rA) – rf)A is the risk premium on factor A..

 As interest rates rise.S SIZE + i.  The volatility of a bond is the sensitivity of the bond to movements in the yield/interest rate. that an increase in share prices should not of itself warrant further increases.1 Terminology This terminology should be familiar to you from your earlier studies but it is worthwhile to recap on it here.m is the stock's beta i. A bond – also known as loan stock or debenture – is debt capital issued by companies. the government and local authorities. issue specific risk and fiscal risk.  The yield curve is a graphical representation of the structure of interest rates.m (E(rm) – rf) + i.D DIST + i.m is the stock's beta with respect to momentum Momentum is the concept that a stock that has performed well recently will continue to perform well. the price of bonds falls. or on both. including credit and default risk.  Credit risk is the risk undertaken by the lender that the borrower will default either on interest payments or on the repayment of principal on the due date. whereas the distress factor is proxied by the difference in return between a portfolio of the highest book to market value stocks and portfolio of the lowest book to market value stocks. 250 Business Analysis .M MOM Where i.  Bonds can be priced at par. 3 Bonds and debt Section overview  Bonds are an important source of finance for companies.2. the weights being the present value of the benefits involved. The size factor is measured as the difference in return between a portfolio of the smallest stocks and a portfolio of the largest stocks.S is beta with respect to size i.  The yield on a bond is made up of a number of elements. momentum: E(rj) = rf + i.  Returns on bonds can be measured using the flat yield or gross redemption yield. at a premium or at a discount. where the yield offered by bonds is plotted against maturity.7 Three and four factor models Fama and French identified two factors in addition to the market portfolio that explain company returns namely size and distress. liquidity and marketability risk.  The credit spread is the premium required by an investor in a corporate bond to compensate for the credit risk of the bond. 2.  Duration is the weighted average length of time to the receipt of a bond's benefits (coupon and redemption value). a student of Fama. The Fama and French three factor model is as follows E(rj) = rf + i.m (E(rm) – rf) + i. 3. added a fourth factor to the model. The theory of momentum appears to be inconsistent with the efficient market hypothesis.D is the stock's beta with respect to distress Carhart. The existence of momentum has been explained by the irrationality of investors who under-react to new information.D DIST where