2023 ADVANCED LEVEL

Progress test

(3 ½ hours)

STRATEGIC BUSINESS MANAGEMENT

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 STRATEGIC BUSINESS MANAGEMENT EXAM

(2 questions)

1. Answer both questions.

2. Submit all workings.

3. Unless otherwise stated make all calculations to the nearest month and to the nearest
£.
Q1 Zappo plc
You are Tish Hope, a newly qualified accountant at a medium-sized firm, which has just
been engaged as adviser to Zappo plc, a small listed company which runs a chain of retail
stores that sell games software for computers and consoles. Zappo has a year end of 31
December. You have just been emailed by Ab Potts, the managing partner of your office, to
brief you about a meeting he has just had with Fran Simmons, the Finance Director of
Zappo.

To: Tish Hope

From: Ab Potts
Date: 4 May 20X5
Subject: Zappo

Tish
I had a very useful meeting with Fran Simmons yesterday, at which we discussed Zappo's
current situation. Zappo's board believes that it needs to take drastic action if it is to reverse
a recent decline in its business, and therefore requires our advice. The board is most
concerned with the number of people entering its stores ('footfall'); they regard this as the
most important factor in the industry and the board believes it needs to update its image to
improve this. I am seeing Fran again next week just before Zappo's next board meeting, and
I need you to prepare briefing notes for my meeting with Fran.

I attach notes from the last board meeting (Exhibit 1) – please note that these are
confidential.

I gather that the Zappo board thought that the acquisition of GameStar could be a very good
idea. At the next board meeting the directors will discuss how much they would be prepared
to pay for GameStar.

Fran Simmons also gave me a copy of a memo she prepared for the Zappo board (Exhibit
2). I understand that the board members have all received a copy. The memo indicates to
me that there are a number of operational issues that Zappo need to address in connection
with their proposed purchase of GameStar. I have my doubts about the wisdom of circulating
it in advance of their board meeting.

So here's what I would like you to do.

(1) I would like you to look at the proposals under consideration by the Zappo board and let
me know what you consider to be the strategic advantages and disadvantages of
acquiring GameStar and developing LeagueStar.
(2) I need you to calculate a valuation for GameStar using the data in Exhibit 3. As well as
carrying out the calculation, I need you to explain the limitations of the method you've
used and give an overview of the issues that due diligence work we would do on the
acquisition would cover. You should know that Zappo's cost of equity is 12%. Both
GameStar and Zappo are financed entirely by equity.
(3) You will see from the notes of the board meeting, the directors are considering two
possible methods of financing the investments. Please can you comment on the impact
of the two alternative methods of financing.
(4) I have a few concerns about operational issues for Zappo if the purchase of GameStar
goes ahead, and I would appreciate your comments about the issues that Zappo faces
with regard to:
• the management of the company's brand, with suggestions about how the company
might develop a branding strategy
• obtaining information about footfall
• merging the operations of the two companies

Requirement
Respond to Ab Potts's email.
Total: 60 marks
Exhibit 1
Notes from the Zappo board meeting
The directors made three suggestions for improving Zappo's profitability.
(1) Acquire GameStar business and combine Zappo and GameStar
GameStar is a UK company in the same industry as Zappo and has a good
geographical fit (ie, there are few instances of GameStar and Zappo stores being co-
located and therefore in direct competition). GameStar has enjoyed much more
successful advertising than Zappo in recent years and, therefore, is much more popular
with the game-buying public, and more profitable.
GameStar is currently owned by Citrus Holdings plc and would be Zappo's first
acquisition if the board decided to purchase it. The proposal would be for Zappo to
acquire all of GameStar's share capital.
Given that the GameStar brand is stronger than Zappo's, if GameStar is acquired the
two businesses would be merged immediately post-acquisition by 'hiving down' the
trade and assets of Zappo into GameStar. At that time GameStar would be Zappo's
wholly owned subsidiary. The two businesses would then both be operated under the
more profitable 'GameStar' brand name. The acquisition would take place on 31
December 20X5.
(2) Launch of LeagueStar
LeagueStar is a new system comprising fixed plant and machinery installed into each
shop to allow live gaming competitions to be held. Members of the public may therefore
come into the shops to play games in national leagues. The idea is that this will increase
footfall into the stores, and therefore improve profitability significantly. Additionally,
buyers will want to purchase games chosen to be used for LeagueStar in order to
practise at home, which will allow Zappo to work with the suppliers of those games to
run promotions on those specific games. The LeagueStar system will cost £35 million,
and it is expected that the system will have a useful life of 10 years.
(3) Sell unproductive assets
This relates to Olde Towers, Zappo's office building in central London, which was
acquired for £20 million 10 years ago and, due to the subsequent strength of the
property market, is now expected to be sold for around £70 million. It has been too large
 for Zappo's requirements and now, given Zappo's financial predicament, there seems to
be good reason for selling it.
Zappo would relocate to GameStar's head office, a smaller building much more suitable
to its needs. GameStar currently leases this from Citrus Holdings, but the freehold will
be transferred to GameStar before the acquisition for its market value of £22 million. Its
original cost was £10 million.
Financing the acquisition
Zappo's majority shareholder owns 60% of its ordinary share capital and he has already
agreed to invest £24 million of new equity in the form of a rights issue. It is believed that the
non-controlling (minority) shareholders will subscribe at least a further £8 million. It is
anticipated that the balance of the funding requirements for the acquisition and the
investment in LeagueStar will be met from the sale of Olde Towers.

Zappo has agreed with its bankers that, in the event of a shortfall of funding, the bank will
make a loan available for the amount of the shortfall at an annual interest rate of 6%. The
company currently has no debt in its capital structure.

Exhibit 2
Fran Simmons' memo to Zappo board
To: Zappo Board
From: Fran Simmons
30 April 20X5
Issues relating to the proposed purchase of GameStar
As you probably know, I am in favour of the purchase of GameStar. This memo sets out
some of the reasons behind my thinking on this matter.
Brand image
I have concerns about the Zappo brand image. The Zappo brand name is rather tired, and
recent feedback from some of our stores suggests that we have a 'down-market' image.
GameStar does not have the same image problem, and I am convinced that purchasing
GameStar and re-branding the existing Zappo stores will improve the image of our stores
and help to increase footfall.
The computer games industry
I also have concern about the changing nature of the market for selling electronic games. All
retail stores selling electronic games have been facing a challenge from downloaded games.
Many games users prefer to download games from the internet rather than visit stores to buy
them; and among users of smartphones and tablets there is a view that games should be
available free or for very little charge.
A current advantage that retail stores have is that downloading large games can take a long
time, so there is still motivation for customers to visit a games store. Downloading large
games will become easier in time, for example through cloud computing, so the challenge to
games stores could become more intense.
It is also reassuring that although smartphone and tablet users make extensive use of
electronic games, there are many consumers who like to buy games consoles and the
games that go with them.
I also think that our retail stores have a strong response to competition from downloading of
games.
(a) I believe that our planned investment in LeagueStar will attract more visitors to our
stores.
(b) The success and profitability of our stores is based on the ability of customers to bring
back used games to obtain a refund or credit. Given a choice between buying a game
online for £15 and buying one from a Zappo store for £40 but getting a refund of £30 or
more for taking it back within two weeks, there is a lot to be said for buying from a
games store.
If you are not aware of our returns policy, if a customer buys a new game, they can obtain a
cash refund or a credit for returning the game at any time, provided that the game is still in
working condition. The amount of the refund depends on the length of time since the game
was purchased. Returned games are then re-sold, but at a lower price; and customers can
return these too and get a refund. Downloading does not allow customers the same
opportunity.
Profit margins
As you know, profit margins at games stores depend on the amount of footfall. Profitability at
our stores may be low, but I believe that we can boost profits by increasing footfall. I asked
the managers of two stores recently to measure footfall over a seven-day period. One store
manager told me that in the week, there were 1,850 visitors to the store and sales turnover
was £13,250. The other store reported a footfall of just 1,200 visitors in the week, but
revenue was £12,600. There is a lot we can work on to improve performance.
Operational issues and the purchase of GameStar
Some of my colleagues have expressed concerns about the practical aspects of the
acquisition of GameStar. I consider these concerns to be excessive. Zappo stores have a
fairly high labour turnover: most of our stores staff are unskilled and opportunities for career
development are very limited. These staff are unlikely to show hostility to a merger of
operations with GameStar. I have already decided that after the purchase, we should switch
to using the GameStar IT systems, which appear to be better than the systems we use in
Zappo.
Conclusion
The purchase of GameStar will stimulate change and improvement for Zappo, and will
provide us with added competitive advantage over our competitors. I shall be arguing
strongly in favour of the proposed purchase at the next board meeting.

Exhibit 3
GameStar financial data: Profits after tax
Forecast
Years ended 31 December 20X3 20X4 20X5
£'000 £'000 £'000
Profit after tax 1,590 1,701 1,888

For the last three years, GameStar has distributed all its profits as dividends to its parent.
The above numbers were prepared without taking into account the proposed acquisition by
Zappo.
Q2 Archen plc
Archen plc is listed on the London Stock Exchange. It manufactures office furniture. The
company has been very successful in the UK, and in a couple of other Western European
countries, but has not expanded beyond these countries.
Potential acquisition
You are a senior working for the auditors and business advisors of Archen. The current date
is 31 March 20X9. The engagement partner called you into a meeting this morning and
came straight to the point.
As part of its strategy for expansion, the Archen board has identified the possible acquisition
of a company, Merry Ltd, which manufactures carpets, curtains and other home furnishings.
The majority of its trade is overseas. Merry has had a reputation for producing high-quality
furnishings and, as a result, it exports to all parts of Europe, to the US and to Asia.
Negotiations are only at a preliminary stage at the moment and information is therefore
limited, but the finance director of Archen, Toby Timmins, would like some help. He believes
that Merry would be a good strategic acquisition as it would open up a new market for
Archen in home furnishings and would also significantly enhance Archen's geographical
presence. He is, however, concerned about the financial information provided by Merry,
particularly as this information may form the basis of initial take-over valuation discussions.
He would therefore like us to evaluate Merry's financial performance.
Also, if the negotiations proceed further, we will probably be asked by Toby to do the
financial due diligence work. He would like some idea now of what we would consider to be
the key issues were we to undertake the due diligence work.
Archen's board believes that the acquisition of Merry will compel it to undertake a major
review of its risk management systems, in order to comply with corporate governance best
practice. We will need to consider the areas on which this review should concentrate.
A further aspect of the review will be an analysis of how Archen's risk profile will change as a
result of the acquisition, considering particularly the group's much wider international
presence. In relation to this, we need to identify the key risks that the board needs to
consider.
I have provided you with draft statements of profit or loss of Archen for the year ended 31
December 20X8 and of Merry for the years ended 31 December 20X7 and 20X8, together with
some notes to these draft statements of profit or loss (Exhibit 1). I have also provided brief
notes from the Archen finance director including his assumptions (Exhibit 2) and an email
from the chairman of Merry (Exhibit 3).
Performance management
During my discussions with Toby, he has indicated that, if the acquisition of Merry goes
ahead, it could provide him with an opportunity to introduce some changes to the
management reports which are currently produced at Archen. Although the Board have got
used to the reports they receive, Toby is concerned that they focus too narrowly on internal,
financial performance information. In particular, he feels this will not be sufficient to
understand and manage Merry's performance satisfactorily. He would like key non-financial
performance measures to be introduced into the Board reports, as well as some strategic
management accounting information.
Toby believes the Board will be resistant to the changes he would like to make to the Board
reports, and so has asked us for our thoughts on the potential benefits of his proposals.
After the meeting, the partner sent you an email, requesting that you prepare the following:
(1) An evaluation of Merry's financial performance in the year ended 31 December 20X8
compared to the year ended 31 December 20X7.
(2) Identify the key issues to be addressed in the financial due diligence, based upon your
analysis of the draft financial statements of Merry and the supporting notes (Exhibit 1).
Please also state the due diligence work we should carry out in respect of these issues,
assuming we will be given open access to the financial records of Merry.
(3) Highlight the areas on which Archen's review of its risk management system should
concentrate. Please also identify the key risks facing Merry which Archen's board need
to consider in relation to the acquisition, and how Archen's risk profile will change as a
result of the acquisition.
(4) A discussion of the reasons why it would be useful for Archen to include non-financial
performance measures alongside financial ones in its performance management
system, and advice on how strategic management accounting could help the directors
manage the performance of the group.
Requirement
Respond to the requests in the engagement partner's email.
Total: 40 marks
Exhibit 1

Draft summary statements of profit or loss for the years ended 31 December
Archen Merry
20X8 20X8 Merry
Draft Draft 20X7
Notes unaudited unaudited Final
£'000 £'000 £'000
Revenue 1 840,000 360,000 400,000
Cost of sales 2 (560,000) (240,000) (250,000)
Depreciation 3 (80,000) (40,000) (50,000)
Administration costs 4 (110,000) (30,000) (32,000)
Impairment 5 – – (5,000)
Provision 6 – – (28,000)
Write-back of unutilised provision 6 – 14,000 –
Financing income/(costs) 7 4,000 (18,000) (12,000)
Profit before tax 94,000 46,000 23,000
Tax (at 23%) (21,620) (10,580) (5,290)
Profit after tax 72,380 35,420 17,710

Notes
1 Due to competitive conditions Merry has not changed the selling prices of its products
since 1 January 20X7 and it has no plans to do so in the foreseeable future.
2 Cost of sales for Merry consists of approximately: 60% variable costs; and 40% fixed
costs.
3 Merry reviewed the useful lives of its non-current assets during the year to 31 December
20X8. As a result of this review, it extended the remaining lives of these assets
substantially. Had it not changed the asset lives, the depreciation charge for the year to
31 December 20X8 would have been £50 million.
4 Administration costs are all fixed costs.
5 The impairment in the year to 31 December 20X7 related to a major non-current asset.
6 The provision in the year to 31 December 20X7 related to legal claims against Merry for
poor workmanship. Lawyers for Merry are fighting these claims. By early 20X8, the
directors of Merry believed that, on reassessment, some of the provisions were no
longer required, although the legal cases were still outstanding.
7 Archen has on deposit £80 million cash earning 5% per annum.

Exhibit 2

Information and working assumptions from the Archen finance director

Matters are rather unclear at the moment so I have made some working assumptions. These
include:
(a) The consideration for the acquisition would be: one Archen ordinary share plus £3 in
cash for every two Merry shares. Archen currently has 500 million £1 ordinary shares in
issue. Merry has 200 million £1 ordinary shares in issue, of which 25% are currently
owned by its directors.
(b) We aim to acquire 90% of the ordinary share capital of Merry and leave 10% in the
hands of its directors to give them incentives.
(c) I am assuming that we would make the acquisition of Merry on 31 May 20X9 if the deal
goes ahead.

Exhibit 3

Secure email
From: Harry.Harrison@Merry.com
To: Toby.Timmins@Archen.com
Date: 22 March 20X9
Subject: Potential take-over: confidential
Merry would be a good acquisition for Archen. The company is really going places. The year
to 31 December 20X7 was great for us, but we have doubled profit in the year to 31 December
20X8 so there is a very high growth rate and we would expect this to be reflected in the price
paid in any acquisition.
Confidentiality prevents us disclosing too much at the moment, but I have provided a draft
statement of profit or loss for the year to 31 December 20X8 and some draft notes (included
in Exhibit 1) – although our auditors are yet to make their main audit visit. Unfortunately, our
auditors are taking their time and I would like to get on and complete this deal rather than
wait for them to report.
Harry Harrison
Chairman – Merry Ltd