CIMA 2010 Syllabus Strategy Level Specimen Exam Paper

CIMA 2010 Chartered Management Accounting Qualification – Specimen Examination Paper E3
Published November 2009
Pillar E
E3 – Enterprise Strategy
Specimen Examination Paper
Instructions to candidates
You are allowed three hours to answer this question paper.
You are allowed 20 minutes reading time before the examination begins
during which you should read the question paper and, if you wish, highlight
and/or make notes on the question paper. However, you will not be allowed,
under any circumstances, to open the answer book and start writing or use
your calculator during this reading time.
You are strongly advised to carefully read ALL the question requirements
before attempting the question concerned (that is all parts and/or sub-
questions). The requirements for all questions are contained in a dotted box.
ALL answers must be written in the answer book. Answers or notes written
on the question paper will not be submitted for marking.
Answer ALL compulsory questions in Section A on page 9.
Answer TWO of the three questions in Section B on pages 10 to 13.
Maths Tables are provided on pages 14 and 15.
The list of verbs as published in the syllabus is given for reference on the
inside back cover of this question paper.
Write your candidate number, the paper number and examination subject title
in the spaces provided on the front of the answer book. Also write your
contact ID and name in the space provided in the right hand margin and seal
to close.
Tick the appropriate boxes on the front of the answer book to indicate the
questions you have answered.
 The Chartered Institute of Management Accountants 2009

Power Utilities
Pre-seen Case Study
Background
Power Utilities (PU) is located in a democratic Asian country. Just over 12 months ago, the
former nationalised Electricity Generating Corporation (EGC) was privatised and became PU.
EGC was established as a nationalised industry many years ago. Its home government at that
time had determined that the provision of the utility services of electricity generation
production should be managed by boards that were accountable directly to Government. In
theory, nationalised industries should be run efficiently, on behalf of the public, without the
need to provide any form of risk related return to the funding providers. In other words, EGC,
along with other nationalised industries was a non-profit making organisation. This, the
Government claimed at the time, would enable prices charged to the final consumer to be
kept low.
Privatisation of EGC
The Prime Minister first announced three years ago that the Government intended to pursue
the privatisation of the nationalised industries within the country. The first priority was to be
the privatisation of the power generating utilities and EGC was selected as the first
nationalised industry to be privatised. The main purpose of this strategy was to encourage
public subscription for share capital. In addition, the Government’s intention was that PU
should take a full and active part in commercial activities such as raising capital and earning
higher revenue by increasing its share of the power generation and supply market by
achieving growth either organically or through making acquisitions. This, of course, also
meant that PU was exposed to commercial pressures itself, including satisfying the
requirements of shareholders and becoming a potential target for take-over. The major
shareholder, with a 51% share, would be the Government. However, the Minister of Energy
has recently stated that the Government intends to reduce its shareholding in PU over time
after the privatisation takes place.
Industry structure
PU operates 12 coal-fired power stations across the country and transmits electricity through
an integrated national grid system which it manages and controls. It is organised into three
regions, Northern, Eastern and Western. Each region generates electricity which is sold to 10
private sector electricity distribution companies which are PU’s customers.
The three PU regions transmit the electricity they generate into the national grid system. A
shortage of electricity generation in one region can be made up by taking from the national
grid. This is particularly important when there is a national emergency, such as exceptional
weather conditions.
The nationalised utility industries, including the former EGC, were set up in a monopolistic
position. As such, no other providers of these particular services were permitted to enter the
market within the country. Therefore, when EGC was privatised and became PU it remained
the sole generator of electricity in the country. The electricity generating facilities, in the form
of the 12 coal-fired power stations, were all built over 15 years ago and some date back to
before EGC came into being.
The 10 private sector distribution companies are the suppliers of electricity to final users
including households and industry within the country, and are not under the management or
control of PU. They are completely independent companies owned by shareholders.
The 10 private sector distribution companies serve a variety of users of electricity. Some,
such as AB, mainly serve domestic users whereas others, such as DP, only supply electricity
to a few industrial clients. In fact, DP has a limited portfolio of industrial customers and 3
major clients, an industrial conglomerate, a local administrative authority and a supermarket
chain. DP finds these clients costly to service.
Specimen Exam Paper 2 Enterprise Strategy

Structure of PU
The structure of PU is that it has a Board of Directors headed by an independent Chairman
and a separate Managing Director. The Chairman of PU was nominated by the Government
at the time the announcement that EGC was to be privatised was made. His background is
that he is a former Chairman of an industrial conglomerate within the country. There was no
previous Chairman of EGC which was managed by a Management Board, headed by the
Managing Director. The former EGC Managing Director retired on privatisation and a new
Managing Director was appointed.
The structure of PU comprises a hierarchy of many levels of management authority. In
addition to the Chairman and Managing Director, the Board consists of the Directors of each
of the Northern, Eastern and Western regions, a Technical Director, the Company Secretary
and the Finance Director. All of these except the Chairman are the Executive Directors of PU.
The Government also appointed seven Non Executive Directors to PU’s Board. With the
exception of the Company Secretary and Finance Director, all the Executive Directors are
qualified electrical engineers. The Chairman and Managing Director of PU have worked hard
to overcome some of the inertia which was an attitude that some staff had developed within
the former EGC. PU is now operating efficiently as a private sector company. There have
been many staff changes at a middle management level within the organisation.
Within the structure of PU’s headquarters, there are five support functions; engineering,
finance (which includes PU’s Internal Audit department), corporate treasury, human resource
management (HRM) and administration, each with its own chief officers, apart from HRM.
Two Senior HRM Officers and Chief Administrative Officer report to the Company Secretary.
The Chief Accountant and Corporate Treasurer each report to the Finance Director. These
functions, except Internal Audit, are replicated in each region, each with its own regional
officers and support staff. Internal Audit is an organisation wide function and is based at PU
headquarters.
Regional Directors of EGC
The Regional Directors all studied in the field of electrical engineering at the country's leading
university and have worked together for a long time. Although they did not all attend the
university at the same time, they have a strong belief in the quality of their education. After
graduation from university, each of the Regional Directors started work at EGC in a junior
capacity and then subsequently gained professional electrical engineering qualifications. They
believe that the experience of working up through the ranks of EGC has enabled them to
have a clear understanding of EGC’s culture and the technical aspects of the industry as a
whole. Each of the Regional Managers has recognised the changed environment that PU now
operates within, compared with the former EGC, and they are now working hard to help PU
achieve success as a private sector electricity generator. The Regional Directors are well
regarded by both the Chairman and Managing Director, both in terms of their technical skill
and managerial competence.
Governance of EGC
Previously, the Managing Director of the Management Board of EGC reported to senior civil
servants in the Ministry of Energy. There were no shareholders and ownership of the
Corporation rested entirely with the Government. That has now changed. The Government
holds 51% of the shares in PU and the Board of Directors is responsible to the shareholders
but, inevitably, the Chairman has close links directly with the Minister of Energy, who
represents the major shareholder.
The Board meetings are held regularly, normally weekly, and are properly conducted with full
minutes being taken. In addition, there is a Remuneration Committee, an Audit Committee
and an Appointments Committee, all in accordance with best practice. The model which has
been used is the Combined Code on Corporate Governance which applies to companies
which have full listing status on the London Stock Exchange. Although PU is not listed on the
London Stock Exchange, the principles of the Combined Code were considered by the
Government to be appropriate to be applied with regard to the corporate governance of the
company.
Currently, PU does not have an effective Executive Information System and this has recently
been raised at a Board meeting by one of the non-executive directors because he believes
Enterprise Strategy 3 Specimen Exam Paper

this inhibits the function of the Board and consequently is disadvantageous to the governance
of PU.
Remuneration of Executive Directors
In order to provide a financial incentive, the Remuneration Committee of PU has agreed that
the Executive Directors be entitled to performance related pay, based on a bonus scheme, in
addition to their fixed salary and health benefits.
Capital market
PU exists in a country which has a well developed capital market relating both to equity and
loan stock funding. There are well established international institutions which are able to
provide funds and corporate entities are free to issue their own loan stock in accordance with
internationally recognised principles. PU is listed on the country’s main stock exchange.
Strategic opportunity
The Board of PU is considering the possibility of vertical integration into electricity supply and
has begun preliminary discussion with DP’s Chairman with a view to making an offer for DP.
PU’s Board is attracted by DP’s strong reputation for customer service but is aware, through
press comment, that DP has received an increase in complaints regarding its service to
customers over the last year. When the former EGC was a nationalised business, break-
downs were categorised by the Government as “urgent”, when there was a danger to life, and
“non-urgent” which was all others. Both the former EGC and DP had a very high success rate
in meeting the government’s requirements that a service engineer should attend the urgent
break-down within 60 minutes. DP’s record over this last year in attending urgent break-
downs has deteriorated seriously and if PU takes DP over, this situation would need to
improve.
Energy consumption within the country and Government drive for increased efficiency
and concern for the environment
Energy consumption has doubled in the country over the last 10 years. As PU continues to
use coal-fired power stations, it now consumes most of the coal mined within the country.
The Minister of Energy has indicated to the Chairman of PU that the Government wishes to
encourage more efficient methods of energy production. This includes the need to reduce
production costs. The Government has limited resources for capital investment in energy
production and wishes to be sure that future energy production facilities are more efficient and
effective than at present.
The Minister of Energy has also expressed the Government’s wish to see a reduction in
harmful emissions from the country’s power stations. (The term harmful emissions in this
context, refers to pollution coming out of electricity generating power stations which damage
the environment.)
One of PU’s non-executive directors is aware that another Asian country is a market leader in
coal gasification which is a fuel technology that could be used to replace coal for power
generation. In the coal gasification process, coal is mixed with oxygen and water vapour
under pressure, normally underground, and then pumped to the surface where the gas can be
used in power stations. The process significantly reduces carbon dioxide emissions although
it is not widely used at present and not on any significant commercial scale.
Another alternative to coal fired power stations being actively considered by PU’s Board is the
construction of a dam to generate hydro-electric power. The Board is mindful of the likely
adverse response of the public living and working in the area where the dam would be built.
In response to the Government’s wishes, PU has established environmental objectives
relating to improved efficiency in energy production and reducing harmful emissions such as
greenhouse gases. PU has also established an ethical code. Included within the code are
sections relating to recycling and reduction in harmful emissions as well as to terms and
conditions of employment.

Introduction of commercial accounting practices at EGC

The first financial statements have been produced for PU for 2008. Extracts from the
Statement of Financial Position from this are shown in Appendix A. Within these financial
statements, some of EGC's loans were "notionally" converted by the Government into
ordinary shares. Interest is payable on the Government loans as shown in the statement of
financial position. Reserves is a sum which was vested in EGC when it was first nationalised.
This represents the initial capital stock valued on a historical cost basis from the former
electricity generating organisations which became consolidated into EGC when it was first
nationalised.
Being previously a nationalised industry and effectively this being the first "commercially
based" financial statements, there are no retained earnings brought forward into 2008.

APPENDIX A
EXTRACTS FROM THE PRO FORMA FINANCIAL STATEMENTS OF THE ELECTRICITY

GENERATING CORPORATION
Statement of financial position as at 31 December 2008

P$ million
ASSETS
Non-current assets 15,837
Current assets
Inventories 1,529
Receivables 2,679
Cash and Cash equivalents 133
4,341
Total assets 20,178
EQUITY AND LIABILITIES

Equity
Share capital 5,525
Reserves 1,231
Total equity 6,756
Non-current liabilities
Government loans 9,560
Current liabilities
Payables 3,862
Total liabilities 13,422
Total equity and liabilities 20,178
End of Pre-seen Material

SECTION A – 50 MARKS
[the indicative time for answering this section is 90 minutes]
ANSWER THIS QUESTION
Question One
Unseen material for Case Study
Background
EGC was privatised just over a year ago and is now Power Utilities (PU). The new Board of
Directors of PU is accountable to the shareholders, the major one being the Government
which holds 51% of the shares.
In an early move by PU, it has taken over two of the private electricity distribution companies.
One of these, DP, located in the Eastern Division of PU, serves a limited portfolio of industrial
customers and three major clients. The takeover was not disputed with DP’s Board
recommending to its shareholders acceptance of the bid. PU now holds 90% of DP’s shares.
The Board of Directors of PU has established a Management Board at DP which is
independently chaired by a nominee from PU’s Board. The previous Executive Directors on
DP’s board have all retained their posts and their remuneration includes a performance bonus
based on DP’s overall profitability. The previous Chairman of DP has retired.
Customer service
During the time when EGC was nationalised, customer break-downs had been categorised by
the Government as Urgent (when there was a danger to life) and Non-urgent (all other break-
downs).
There was a requirement for Urgent break-downs that a service engineer should be with the
customer within 60 minutes or less. Before privatisation the electricity distribution industry had
a very high success rate in meeting this requirement with 99.9% of customers being attended
within 60 minutes and nobody ever waited longer than 90 minutes for attention.
Non-urgent break-downs were attended to in turn but there was no maximum time
requirement for an engineer to attend. There were always a significant number of Non-urgent
break-downs to attend to and customers might wait as long as six months for attention.
During the last year there have been an increasing number of complaints to DP from its
customers regarding the slow attendance of service engineers following a reduction in their
numbers. It was often now the case that customers with Urgent break-downs had to wait for
up to a day for attention and the situation for customers with Non-urgent break-downs also
had got worse.
Options for change
The Technical Director (TD) of DP has been investigating the deteriorating standards of
customer service. He believes that there are two possible ways forward which he proposed to
put to the Board of Directors of DP.
The first would be to invest a considerable amount of resources to improve the existing in-
house customer service carried out by DP’s service engineers. The other response would be
to outsource customer service. The financial data relating to both these options is given
below:
Financial implications
In-house
If the customer service is kept in-house, DP will have to spend money recruiting additional
engineers and training and equipping all the engineers to a very high standard. In order to
meet the service targets of 100% attendance within 60 minutes for Urgent break-downs
(which it is estimated will amount to 6,000 each year) and also that up to 2,000 Non-urgent
break-downs are resolved each year, DP will employ 75 engineers. The cost of establishing
this new service network together with infrastructure, recruitment, training and equipment set-

up costs in the first year only will amount to P$50,000,000. In addition, there would be an
annual running cost of P$8,000,000.
Outsource
DP has had a quote from a reputable service company, RSC. RSC would employ 38 service
engineers and would charge DP P$250 for each Urgent break-down which it attended and
P$150 for each Non-urgent break-down which it attended. It has enough capacity to attend all
the break-downs which DP estimates will occur each year. However, it cannot commit to
attending 100% of Urgent break-downs within 60 minutes: RSC estimates it will only be able
to attend 99% of Urgent break-downs within 60 minutes. The remainder will take between 2
and 4 hours before RSC can get its engineers to the customer.
As a condition of RSC accepting the contract it will require a ‘one off’ payment of
P$30,000,000 when the contract is signed.
Other information
Industry history shows that there is a probability of fatality or serious injury when the response
to an Urgent break-down is delayed. In the case of DP, it is estimated that every urgent
break-down not attended by a service engineer within 60 minutes carries a 0.1% chance of a
fatality or serious injury.
Investments such as the one proposed by the TD are regarded by DP as having an
opportunity cost of capital of 10%.
The TD and the Management Accountant (MA)
In their discussions about the outsourcing of the customer service the MA had asked the TD if
it was possible to quantify the financial cost of fatality or serious injury caused by the non-
attendance of an engineer within 60 minutes to an Urgent break-down. The TD said it was not
worth doing this as the chance was so small and he did not want to distract the Board in its
decision making with irrelevant data. The MA agreed that the probability of a fatality or serious
injury was low but nevertheless as DP aspired to being a good corporate citizen and in the
interests of transparency this information should go before the Board.
The TD stated that these forecasts were his, he took responsibility for them and he would not
be placing the information about fatality and serious injury before the Board. The TD stated
that he would answer any question put to him by the Board but that the MA should
concentrate on his own job and let the TD get on with his.
The requirement for Question One is on page 9

Required
(a)
(i) Compare and contrast the rational planning model with the Incrementalist
approach to strategic planning.
(6 marks)
(ii) Advise the Board of Directors of DP of another approach to forming strategy
which would be most suitable for its organisation’s changed circumstances
as a privatised company.
(4 marks)
(b) (i) Analyse the two alternative methods of servicing DP’s customers.
Note: All 10 marks are for calculation in this requirement.
(10 marks)
(ii) Discuss the consequences of the two methods of servicing DP’s customers.
(5 marks)
(c) Evaluate the extent to which the views of the Technical Director regarding the
disclosure of information about non-attendance at Urgent break-downs within 60
minutes represents an ethical dilemma for the Management Accountant.
(10 marks)
(d) In the light of the changed circumstances of DP, and your findings and evaluation
above:
(i) recommend, with reasons, four Critical Success Factors (CSFs) which would
be appropriate for DP as a company
(8 marks)
(ii) discuss the main attributes for an effective Information System by which DP
would be able to manage the Urgent and Non-urgent breakdowns.
(7 marks)
(Total marks for Question One = 50 marks)
End of Section A
Section B starts on page 10
TURN OVER

SECTION B – 50 MARKS
[the indicative time for answering this section is 90 minutes]
ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH
Question Two
ZZM is a multinational company which buys agricultural products for use in its manufacturing
process. ZZM has committed to observe all guidelines and codes of conduct for
multinationals. This policy was prompted by ZZM’s desire to be a good corporate citizen.
ZZM has been trading profitably for ten years with farmers’ co-operatives in Agriland, an
agricultural country. ZZM’s business is an important part of Agriland’s economy. ZZM has
made efforts to improve both the production techniques of the farmers and the living
conditions of farm workers and their families. ZZM has built a number of schools and also a
district hospital in Agriland.
The farmers’ co-operatives have freedom to trade with anyone but have chosen to deal
exclusively with ZZM. ZZM has enjoyed harmonious relationships within Agriland but this
now seems threatened by a number of factors.
The Government of Agriland has been under the control of the same political party for the
previous 15 years. Recently there have been allegations of corruption made against the
Government and its popularity has decreased: some analysts think it might lose the next
general election. The main opposition party is very nationalistic and opposed to free trade. It
has stated that if it is elected it will nationalise all foreign owned businesses without
compensation.
The farm workers’ union in Agriland has asked for an immediate 10% pay rise as farm
workers’ pay has not increased for two years although prices have increased by 20%. The
farm workers have never been militant but this is changing. In some areas of Agriland, farm
workers have gone on strike.
At a recent meeting between the President of Agriland and ZZM, the President said there was
a common interest in preventing the main opposition party from winning the next general
election. The President suggested a number of strategies which could be followed:
1. ZZM could give a substantial donation to the President’s party for its election funds.
2. ZZM could agree to an extra tax on its Agriland operations. This could be used to
increase the national minimum wage for farm workers.
3. ZZM could open an agricultural processes factory within Agriland to assist economic
development.
The President stated his strategies were not mutually exclusive. He added that if ZZM was
not able to help him, then he would seriously consider nationalising ZZM’s operations without
any compensation.
The requirement for Question Two is on the opposite page

Required
(a) Advise how stakeholder mapping could assist ZZM in deciding the options to
pursue with respect to Agriland.
Note: You are not required to draw Mendelow’s matrix
(4 marks)
(b) Construct a stakeholder analysis for ZZM’s business in Agriland.
(9 marks)
(c) Evaluate the options suggested by the President and one other option which
you have identified.
(8 marks)
(d) Recommend the option which you consider ZZM should follow. Explain the
reasons(s) for your recommendation.
(4 marks)
(Total for Question Two = 25 marks)
Section B continues over the page
TURN OVER

Question Three
RTF is an architectural practice owned by 3 partners and employing 20 other staff. Its vision
has been stated as: ‘Your future designed by RTF: Today!’ Its business is focused on
designing housing schemes for local governments and also individual houses for wealthy
clients. The emphasis in the housing schemes has been to produce high-quality homes to
standard designs and ensuring that the schemes were completed on time and within budget.
RTF has established a library of designs which it has successfully used and which can be re-
used. The relationships which RTF has established with local government employees have
been important for the successful completion of its contracts. RTF has a corporate contacts
database where every local government employee it has dealt with is recorded. This has
proved invaluable to RTF.
RTF’s other main income stream comes from the design of individual, ‘one-off’, houses for
wealthy clients. The partners have always enjoyed this work as it gives them the opportunity
to express their professional talents. However, the recently appointed Management
Accountant has concerns about this business as she believes the partners spend a
disproportionate amount of their time on this work. One fundamental control system within a
professional practice is the system for recording time which forms the basis for costing work.
Unlike most of its industry which uses proprietary software, RTF relies upon a manual system
for recording time spent on each project and the results are often inaccurate.
The partners have always believed that a staff development policy is important for success.
They have invested in improving the educational and technical background of their staff. RTF
has a strong relationship with its local university. One result of this relationship is a
computerised design package, ‘2020Design’, which RTF and the university jointly developed
and own. The package speeds up the design process and offers the possibility of significant
cost savings. If this package is applied within RTF it could result in either a greater throughput
of work from the existing staff, staff reductions or some combination of both of these.
RTF has carried out market research regarding the potential demand for 2020Design. This
research indicates that 2020Design will be a viable commercial product. In what will be a
significant strategic and cultural change for RTF it intends to market 2020Design and has
employed a Marketing Manager. The Marketing Manager intends to licence agents to sell
2020Design in RTF’s home country and abroad.
RTF does not have any systematic way of relating its operations to its vision or of measuring
performance. However, one of the partners has heard of the Balanced Scorecard and has
suggested that this might be an appropriate model for RTF to use.
Required
(a) Explain the four different perspectives of the Balanced Scorecard model.
(4 marks)
(b) For each of the four perspectives, discuss and recommend two appropriate
measures which would assist RTF.
(8 marks)
(c) Recommend how RTF could introduce and use the Balanced Scorecard to help it
achieve the required changes in strategy and culture.
(13 marks)
(Total for Question Three = 25 marks)
Section B continues on the opposite page

Question Four
GHK is a restaurant chain consisting of eight restaurants in an attractive part of a European
country which is popular with tourists. GHK has been owned by the same family for the
previous15 years and has always traded at a profit. However, a number of factors have meant
that GHK is now in danger of making a trading loss. There has been a substantial drop in the
number of tourists visiting the region whilst, at the same time, the prices of many of the
foodstuffs and drinks used in its restaurants has increased. Added to this, the local economy
has shrunk with several large employers reducing the size of their workforce.
The owners of GHK commissioned a restaurant consultant to give them an independent view
of their business. The consultant observed that the eight restaurants were all very different in
appearance. They also served menus that were very different, for example, one restaurant
which was located on a barge in a coastal town specialised in fish dishes, whereas another
restaurant 20 miles away had a good reputation as a steak house. The prices varied greatly
amongst the restaurants; one restaurant in a historic country house offered ‘fine dining’ and
was extremely expensive; yet another located near a busy railway station served mainly fast
food and claimed that its prices were ‘the cheapest in town’. Three of GHK’s restaurants
offered a ‘middle of the road’ dining experience with conventional menus and average prices.
Some of the restaurants had licences which enabled them to serve alcohol with their meals
but three restaurants did not have such licences. One restaurant had a good trade in
children’s birthday parties whereas the restaurant in the historic country house did not admit
diners under the age of 18.
The consultant recommended that GHK should examine these differences but did not suggest
how. The owners responded that the chain had grown organically over a number of years and
that the location, style and pricing decisions made in each restaurant had all been made at
different times and depended on trends current at that time.
Required
(a) Advise the owners of GHK how the application of Porter’s Three Generic
Strategies Model could assist them in maintaining or improving the profitability
of their restaurants.
Note: You are not required to suggest individual generic strategies for each of
GHK’s restaurants.
(10 marks)
(b) Advise how GHK could employ a range of organisational information systems
to support whichever generic strategy it chooses to adopt.
(15 marks)
(Total for Question Four = 25 marks)
End of Question Paper
Maths Tables and Formulae are on Pages 14 and 15

MATHS TABLES AND FORMULAE

Present value table
-n
Present value of $1, that is (1 + r) where r = interest rate; n = number of periods until payment or receipt.
Periods Interest rates (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years
1 (1 r )  n
r

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
Formulae
Annuity
Present value of an annuity of $1 per annum, receivable or payable for n years, commencing in one year, discounted
at r% per annum:
1 1 
PV = 1  n 
r  [1  r ] 
Perpetuity
Present value of $1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per
1
annum: PV 
r

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for
each question in this paper.
It is important that you answer the question according to the definition of the verb.
LEARNING OBJECTIVE VERBS USED DEFINITION
Level 1 - KNOWLEDGE
What you are expected to know. List Make a list of
State Express, fully or clearly, the details/facts of
Define Give the exact meaning of
Level 2 - COMPREHENSION
What you are expected to understand. Describe Communicate the key features
Distinguish Highlight the differences between
Explain Make clear or intelligible/State the meaning or
purpose of
Identify Recognise, establish or select after
consideration
Illustrate Use an example to describe or explain
something
Level 3 - APPLICATION
How you are expected to apply your knowledge. Apply Put to practical use
Calculate/compute Ascertain or reckon mathematically
Demonstrate Prove with certainty or to exhibit by
practical means
Prepare Make or get ready for use
Reconcile Make or prove consistent/compatible
Solve Find an answer to
Tabulate Arrange in a table
Level 4 - ANALYSIS
How are you expected to analyse the detail of Analyse Examine in detail the structure of
what you have learned. Categorise Place into a defined class or division
Compare and contrast Show the similarities and/or differences
between
Construct Build up or compile
Discuss Examine in detail by argument
Interpret Translate into intelligible or familiar terms
Prioritise Place in order of priority or sequence for action
Produce Create or bring into existence
Level 5 - EVALUATION
How are you expected to use your learning to Advise Counsel, inform or notify
evaluate, make decisions or recommendations. Evaluate Appraise or assess the value of
Recommend Advise on a course of action

Enterprise Pillar
Strategic Level Paper
Specimen Paper
Tuesday Morning Session

CIMA 2010 Chartered Management Accounting Qualification – Answers to Specimen Examination Paper E3
The Examiner's Answers – Specimen Paper

E3 - Enterprise Strategy
SECTION A
Answer to Question One

Requirement (a)(i)
The rational planning model (RPM) is arguably the model most associated with the formation
of strategy. CIMA has defined aspects of this model in the following ways:
‘Planning: the establishment of objectives and the formulation, evaluation and selection of the
policies, strategies, tactics and action required to achieve them. Planning comprises long-
term strategic planning, and short-term/operational planning.’
‘Strategy: a course of action, including the specification of resources required, to achieve a
specific objective.’
‘Strategic plan: a statement of long-term goals along with a definition of the strategies and
policies which will ensure achievement of these goals.’
RPM has the advantage of being well-known and it offers a procedure to enable organisations
to construct their strategies which articulate the organisation’s desired relationships with its
external environments. Added to this, the rational planning model when viewed at its short-
term perspective has an obvious interface with accounting constructs such as annual
accounts and budgets.
The use of RPM is often a requirement for organisations receiving funds from central
government such as hospitals and universities who are asked to produce, for example, one
year and five year plans.
RPM has as an underlying tenet the concept of maximization derived from classical economic
theory. In contrast, H Simon suggested that managers were more likely to pursue satisfactory
goals: that they were ‘satisficers’. This is associated with the idea of incrementalism: making
small and slow changes to strategy rather than radical changes, ‘Evolution not Revolution’.
Quinn described the process of logical incrementalism whereby strategy is made not by
planning but rather by gradual discrete changes allied to an underlying logic.
The two approaches represent different philosophies regarding the formation of strategy.
Arguably, there is no right way of formulating strategy; what is most suitable for an
organisation is contingent upon its individual circumstances.
Other approaches which have been observed in practice include, Mintzberg’s ‘crafting’
strategy and the antithesis of planning, ‘freewheeling opportunism’.
Requirement (a)(ii)
In the circumstances of DP having newly emerged from state control it is most likely that RPM
is the most familiar approach for them. If the contention that there is no right way of

approaching strategy is valid DP could continue with its RPM but adapt it and make it more
flexible by admitting the emergent. Thus, for example, it might shorten its planning period and
be willing to continuously monitor and change its strategy, if that should prove beneficial.
Requirement (b)(i)
Option 1 P$’000s Option 2 P$’000s
In-house Outsource
Capital cost 50,000 Capital cost 30,000
Yearly running cost 8,000 Yearly running cost
Urgent visits 6,000 Urgent visits 6,000 1,500 P$250

a visit
Non-urgent visits 2,000 Non-urgent visits 2,000 300 P$150
a visit
Yearly running cost 1,800
No. of engineers 75 No. of engineers 38
Service standard Service standard
Urgent 100% Urgent 99%
Non-urgent Within 1 Non-urgent ASAP

month
10 year period 10 year period
Year P$’000s P$’000s Year P$’000s P$’000s
0 -50,000 0 -30,000
1 to 10 8,000 1 to 10 1,800
Annuity factor
10 years/10% 6.145 -49,160 6.145 -11,061
Total -99,160 -41,061
Requirement (b)(ii)
The financial aspect of this decision indicates the adoption of outsourcing which is only 41% of
the cost of the in-house operation. However, the service attainment projected for this option is
inferior to that of the in-house: only 99% of the Urgent break-downs are attended to within 60
minutes and it is not clear when the Non-urgent break-downs will be attended to. This lower
standard of customer service is, presumably, a result of employing only half the number of
service engineers as compared to the in-house option.
The lower customer service standard also carries a small but arguably significant risk of a fatality
or serious injury due to non-attendance within 60 minutes:
6,000 break-downs x 1% = 60 breakdowns not attended to within 60 minutes
60 break-downs x 0.1% = 0.6 fatalities or serious injury.
The consequence in terms of human life of this lower service standard is that 0.6 or 1 person
could die each year. This could have serious financial consequences for DP and the image of
the company would be damaged if it was known that it had implemented a service policy with
this attendant risk of fatality and serious injury.

It is also possible that this risk may conflict with corporate values and it would certainly conflict
with the personal values of some of the employees of DP, for example, its service engineers.
Requirement (c)
The Chartered Institute of Management Accountants (CIMA) has adopted a Code of Ethics
(hereafter the Code) to give guidance to its members with regard to their behaviour.
CIMA has established fundamental principles of professional ethics for professional accountants
which include:
Integrity ‘A professional accountant should be straightforward and honest in all professional and
business relationships’.
CIMA further state that ‘A professional accountant should not be associated with reports etc.
where they believe that the information:
Omits or obscures information required to be included where such omission or obscurity would
be misleading’.
It is arguable that not telling the Board of Directors of DP about all the consequences of the out-
sourcing service option, namely the likelihood of a fatality or serious injury conflicts with
corporate and ethical values and is not behaviour that is ‘straightforward and honest’.
Objectivity ‘A professional accountant should not allow bias, conflict of interest or undue
influence of others to override professional or business judgements’.
The principle of objectivity imposes an obligation on all professional accountants not to
compromise their professional or business judgement because of bias, conflict of interest or the
undue influence of others.’
It is arguable that the Technical Director is using his position and personality to keep the
Management Accountant silent, on the aspect of safety, which is a conflict under the Code.
The situation in which the Management Accountant is in with regards to the non-disclosure of the
information about a potential fatality or serious injury should the out-sourcing service option be
followed is potentially in conflict with two of the fundamental principles of the Code.
As such the Management Accountant has an ethical dilemma to resolve and should seek further
guidance from the Code as to how to proceed.
All the quotations in this section are from the CIMA Code of Ethics for Professional Accountants,
October 2007.
Requirement (d)(i)
CIMA defines Critical Success Factors (CSFs) as: ‘CSFs are elements of the organisational
activity which are central to its future success. CSFs may change over time and may include
items such as product quality, employee attitudes, manufacturing flexibility and brand
awareness’.
Product quality
DP’s product is electricity and its supply should be fit for purpose. This implies continuity of
supply and that means that DP must work to ensure that power fluctuations and interruptions are
kept to a minimum. DP would need to specify CSFs to monitor these aspects which would be
amenable to ratio analysis and also variance analysis. Examples would be :
 % number of minutes supply was interrupted
 Cost of interruptions in penalty payments
Employee attitudes
DP’s employees have undergone a significant change in their working lives due to change in
ownership structure. This change from nationalised industry to private sector company has
many cultural implications. These changes will have impacted upon employee morale and DP
would be concerned whether the changes have had beneficial or detrimental effects.

Examples of CSFs in this area would include:

 Employee turnover
 Absenteeism
Manufacturing flexibility
Not discussed as it would require specialist knowledge of the electricity distribution industry.
Brand awareness
In a free market environment and given that electricity is an homogenous product, from the point
of view of the customer, it is comparatively easy for customers to change their suppliers.
Suppliers will try to reduce the rate at which customers move between them, the churn rate, by
offering loyalty incentives and by competing on price.
A further competitive option which is available to producers of homogenous products is to try to
establish some form of brand identity. An example of this in the UK is the energy company
E.ON which sponsors a major English sporting competition, the FA Cup.
DP could establish CSFs such as:
 % of market aware of the DP brand
 Number of customers moving to DP in the previous period
 Number of customers moving from DP in the previous period
Note: The CSFs given in this section are examples and not an exhaustive list. Candidates would
also be rewarded for other appropriate examples.
Requirement (d)(ii)
DP needs to manage breakdowns which have important implications for customer service and
safety. Whatever system it employs it must have the characteristics of being robust, flexible and
comprehensive.
An essential element of such a system is a database with its allied database management
system. The database should hold, and allow access to, for example, details of all of DP’s
customers including their service histories, geographic and contact details. The database should
also include, for bigger/industrial customers, layout plans of their electrical equipment and have
the ability to access and transmit to the service engineers fault-finding information and
manufacturers’ drawings and information.
The service engineers would need to be equipped with wireless computers which could
communicate with the database whilst the service engineer is attending a break-down and
provision should be made for alternate communication in areas of poor wireless reception. They
will also require a suitable GPS device to assist in locating the break-downs.
The information system should also incorporate software to identify where each service
engineer is located and their current status. The software should also incorporate algorithms to
optimise the responses of the service engineers to break-downs.

SECTION B
Answer to Question Two

Requirement (a)
A stakeholder analysis for ZZM's operations within Agriland would enable ZZM to identify the
degree of interest and power possessed by each group or stakeholder. As an example,
consider both the President of Agriland and a farm worker in one of the co-operatives. Both
have an interest in ZZM’s business but that of the President is very great whilst the farm
workers’ is much smaller. Similarly, the power to affect ZZM’s business is very high in the
case of the President but would be negligible in the case of the farm workers.
Having identified the stakeholders, it would be clear to ZZM whose support it will need in
order to be successful. It will also identify any stakeholders who may have the power or
potential power to disrupt its business.
Having categorised the stakeholders, ZZM then has guidance as to how it should manage
these and their expectations in the future. Mendelow’s suggested stances are:
 Minimal effort
 Keep informed
 Keep satisfied
 Must secure agreement
Requirement (b)
Using Mendelow’s model the following stakeholders are present for ZZM’s operations within
Agriland:
High power/High interest
These would include the President of Agriland and also the Government of the country. The
main opposition party has the potential to also be included in this category. However, unless
and until it wins the general election it does not possess high power. The farmworkers’ union
is in a similar position to the main opposition party as its power seems low at present but
could grow with increased militancy.
High power/low interest
ZZM’s shareholders have ultimate power over the company should they choose to exercise it.
However, as Agriland represents only one of the many countries where ZZM does business
the shareholders are unlikely to have a high level of interest in it.
Low power/High interest
The main opposition party and the farmworkers’ union both have high levels of interest in
ZZM’s business but, at present, have little power.
Other groups
The farmers’ co-operatives, the farmers and the farmworkers and their families would all
probably have interests ranging from medium to high. The amount of power which they
possess is not clear. It could range at its highest for the co-operatives if they were to take
combined action with respect to ZZM, to low to non-existent in the case of an individual
member of a farmworker’s family.
Low power/low interest
There are no groups mentioned in the scenario which fall into this category.

Requirement (c)
ZZM could give a substantial donation to the President’s party for its election funds.
Given the concerns about corruption this option seems questionable and it may conflict with
the codes of conduct which ZZM supports. It would create a definite association between
ZZM and the President so that, if the President did not win the election, it could prove very
difficult for ZZM to carry on business within Agriland. However, if the main opposition party
wins the election ZZM will be nationalised without compensation.
ZZM could agree to an extra tax on its Agriland operations. This could be used to
increase the national minimum wage for farmworkers.
The effect of this tax may make ZZM’s business in Agriland uneconomic. Although ZZM is an
important part of Agriland's economy, it does not directly employ the agricultural workers.
ZZM may consider that this proposal is unreasonable and, if agreed to, may create a bad
precedent both within Agriland and also in other countries where ZZM trades.
ZZM should open an agricultural processes factory within Agriland to assist economic
development.
The economic viability of this proposal needs to be examined. It could prove to be a realistic
option and the contribution which it makes to the development of the economy of Agriland is
important.
The President stated that his strategies were not mutually exclusive. He added that if
ZZM was not able to help him then he would seriously consider nationalising ZZM
operations without any compensation.
Of the three options proposed by the President only the last one seems to be potentially
acceptable. The President’s further comments suggest that he may be requiring that ZZM
agrees to all three proposals and he has also threatened ZZM with nationalisation without
compensation.
Taken as a whole, the President’s views could lead ZZM to a strategy of its own; withdrawal
from Agriland. This would have the disadvantages of the loss of profits from the business in
Agriland and the effects upon the economy and people of Agriland. However, depending upon
the results of the next general election, or even earlier depending upon the President’s
actions, ZZM may lose its business anyway.
Requirement (d)
It is not obvious which option ZZM should follow. It will depend upon a number of factors,
including an assessment of the likely results of the next general election and also how much
the President’s suggestions represent a bargaining stance and how much they are definite
plans. ZZM also needs to evaluate changes in social conditions; the rise in militancy within
the farmworkers and the climate of corruption within Agriland. ZZM should also always have
the interests of its shareholders in mind. Against these factors must be set the damage which
will be incurred to ZZM’s profits and also to the people and economy of Agriland should ZZM
withdraw. Based on current information it is recommended that ZZM prepares to withdraw
from doing business in Agriland.

Answer to Question Three

Requirement (a)
The Balanced Scorecard model was developed by Kaplan and Norton (1992, 1996) as a
means to integrate an organisation’s vision, strategy and operations. It is a multi-dimensional
model which contains four perspectives which embrace both financial and non-financial
control measures.
The four perspectives are:
Financial: where the question posed is ‘To succeed financially how should we appear to our
shareholders?’
Customer: similarly asks, ‘To achieve our vision how should we appear to our customers?’
Learning and growth: demands, ‘To achieve our vision, how will we sustain our ability to
change and improve?’
Internal business process: asks, ‘To satisfy our shareholders and customers, what business
processes must we excel at?’
The inclusion of the organisation’s vision is central to the model.
Requirement (b)
The following are sample measures which would be appropriate for RTF to use within the
Balanced Scorecard model.
Financial measures:
Gross profit: it is expected that RTF already calculates this but it is an important measure
which should be reported upon regularly.
Net profit: the same comment applies as for gross profit.
Profit per contract: as RTF undertakes a variety of work it should be able to identify the
profitability of each of these aspects.
Return on Capital employed: an important and well-known measure which captures the
totality of the business.
Customer measures:
Number of new customers in period: it is important for RTF, as with any company, that it
continues to attract new business.
Number of customer complaints: this measure gives an indication of the quality of the work
produced by RTF.
Amount of repeat business: RTF has built up relationships with local government and also
spends time and money maintaining its corporate contacts database. This measure will give
an indication if this effort is worthwhile.
Market share: RTF operates in a competitive market and needs to know the size of its market
share and the trend in its growth or decline.
Learning and growth measures:
Number of academic and professional qualifications possessed by staff: in what is essentially
a knowledge and craft industry, it is important that RTF maintains a high level of academic
and professional ability within its personnel.
Number of technical qualifications possessed by staff: this measure demonstrates the level of
technical expertise possessed by the business.
Number of new designs added to library: this measure indicates directly one aspect of RTF’s
creativity.
Number of ‘one-off’ houses designed in period: these houses give opportunity for RTF to
express their creativity. This measure indicates the degree of innovation within the business.

Internal business process measures:

Average design time spent per contract: it is important that the time of the business’s staff is
used efficiently. This measure gives an indication of staff efficiency.
Time spent each week by partner on design work: it is important to utilise the design skills of
the partners to best advantage.
Number of contacts in corporate database: relationships are important in this business and
this measure shows how extensive these relationships are.
Number of contacts added to database in period: this measure supplements the one
immediately above and it shows the rate at which the corporate contracts are growing.
Requirement (c)
The use of the Balanced Scorecard is a departure from RTF’s previous practice. It will now
have a systematic way of reporting on its performance from four different perspectives which
are linked to the achievement of its vision. It is also going to be transformed from a purely
architectural practice to one that has a valuable commercial computerised design package to
market and sell. Furthermore, it will be bringing people into the business that may not
necessarily have a background in architecture.
Although there is not a single right way to help RTF successfully make the transition, a
number of elements can be identified which are important:
Translating the vision
Vision is at the centre of the Balanced Scorecard. With the developments that are taking
place within the company it may be that the vision, ‘Your future designed by RTF: Today!’
should be re-negotiated. There needs to be an opportunity for this to be discussed and for a
consensus to be formed within RTF about what their vision should be. The implications of the
(new) vision need to be understood by all the participants in the business.
Communication and linkage
An important part of the cultural change introduced by the Balance Scorecard is the system of
performance management which has not existed within RTF previously. The essence of the
Balanced Scorecard is one of integration of vision with strategy and operations. Therefore,
the aspirations of the vision should find expression in both departmental and individual
objectives. Some organisations have associated the achievement of these objectivises with
reward systems and introduced performance related pay. RTF would have to evaluate if
performance related pay is appropriate for the type of work carried out by its staff.
Business planning
RTF now has the opportunity to develop a business plan, or plans, which should be integrated
with the staffs’ individual plans as well as the departmental ones. The Marketing Manager will
have an important role in identifying the potential sales for the 2020Design package
Change and learning
There is going to be a period of change and learning for RTF as it adjusts to the development
and implementation of the Balanced Scorecard and also to its new commercial venture the
2020Design package. RTF should actively encourage its staff to embrace this opportunity for
learning. There may also be an opportunity to involve stakeholders outside the business, such
as customers and suppliers, who are in a good position to offer feedback.

Answer to Question Four

Requirement (a)
Porter’s ‘Three Generic Strategies Model’ was developed in 1980 and since then has gained
international dissemination. The model analyses how firms can achieve competitive
advantage which Porter suggests can come about by adopting one of the following policies:
Overall cost leadership: the firm is the lowest cost producer relative to its competitors.
Differentiation: the firm can create something which is unique and for which consumers will
pay a premium.
Focus: the firm serves a narrow strategic target more effectively than its competitors who are
competing more broadly.
Porter asserts that each generic strategy requires different attributes and, therefore, it is
unlikely that any firm can pursue more than one generic strategy simultaneously and be
successful. He cautions against firms becoming ‘stuck in the middle’.
As well as Porter’s model being used analytically, it can also be used pro-actively to help a
firm design its competitive strategy. In the case of GHK no coherent strategy has been
followed with respect to its eight restaurants. A preliminary analysis suggests that the
following strategies are being followed:
Overall cost leadership: (the firm is the lowest cost producer relative to its competitors), at the
restaurant near the busy railway station.
Differentiation: (the firm can create something which is unique and for which consumers will
pay a premium) at the ‘fine dining’ restaurant in the historic country house.
Focus: (the firm serves a narrow strategic target more effectively than its competitors who are
competing more broadly) at the fish restaurant, the steak restaurant, the restaurant offering
children’s birthday parties.
Stuck in the middle: three ‘middle of the road’ restaurants with conventional menus and
average prices.
The generic strategy which GHK decides to follow will be linked to a marketing strategy. It is
not necessarily the case that GHK is wrong to follow a number of generic strategies because
if each restaurant is taken as a strategic business unit it will have a particular catchment area
from which it draws its customers and looked at in isolation that strategy might be the optimal
one for that restaurant. However, a systematic examination of each restaurant using the logic
of Porter’s model and examining the basis by which that restaurant competes and whether
this will yield a long-term competitive advantage will be invaluable.
With respect to the restaurant near the busy railway station, if this is attempting to compete on
the basis of being the lowest cost producer and, therefore, charging its customers the lowest
prices, it is doubtful that this can give a long-term competitive advantage. The prices of a
restaurant’s inputs, mainly food and labour, are set within their local markets and available to
any competitor. The technology and processes of restaurants are mature ones and it is
unlikely that GHK could innovate in this area to secure competitive advantage.
The three restaurants which are ‘stuck in the middle’ should be given immediate attention as
Porter’s model suggests they are unlikely to be successful.
If the owners of GHK use Porter’s ‘Three Generic Strategies Model’ it will give them an
appreciation of the basis upon which their various restaurants compete and should prompt
them to make modifications to their strategy and attempt to secure long-term competitive
advantage.
It may be the case that GHK treat each of its restaurants as a strategic business unit and,
therefore, employ a number of different generic competitive strategies. Alternatively, GHK
may wish to trade as a homogenous entity which would imply it would use only one of the
three generic competitive strategies to avoid being ‘stuck in the middle’.

Requirement (b)
Information systems could support GHK’s chosen strategy in the following ways:
Strategic
In order to decide which of the generic strategies would be appropriate, GHK will require
information to construct a PEST analysis. It will need detailed market and demographic
information, for example, to decide whether a particular restaurant has access to a hinterland
of customers who are willing to pay a premium price. This would then indicate the suitability of
a differentiation strategy. Marketing research could then indicate the type of differentiation for
which these customers are willing to pay a premium. It could be the case that the
differentiation strategy would be suitable not only for the restaurant in the historic country
house but also for the fish and the steak restaurants. Statistics of market share would
demonstrate GHK comparative position. The degree of success of the strategy it was
following would be monitored by periodic reporting of market share.
GHK owners could utilise an executive information system to help them in their decision-
making. Inputs to this system would include both their own researches and data and also data
from specialist external databases.
If GHK wanted to pursue a strategy of overall cost leadership (although the answer in (a)
suggests that this is unlikely to be successful) an information system which tracked market
prices for restaurant supplies would be required.
GHK could use information systems to help it determine the most appropriate generic
competitive strategy for its business. However, it should also recognise that the information
systems which it chooses to deploy can, of itself, be a source of competitive advantage for its
business. An example of this could be that GHK, through its PEST and market research, may
identify profitable groups of customers whose needs are not being met at present, such as
vegans. GHK may be able to construct a website offering a booking service for restaurants in
its regions and link this with an affinity or loyalty card. This would then generate valuable
current data about the restaurant which GHK could incorporate in its strategic review
processes.
Operational
At the operational level there is much that good information systems and management
accountancy can contribute to a successful generic strategy for GHK. Porter’s ‘Three Generic
strategies model’ is essentially about achieving and maintaining competitive advantage: that
is out-performing its rivals. For its basic requirements GHK would require a comprehensive
database, allied to a system for capturing real-time operational data, and a reporting package.
Given these requirements, GHK could address such important parameters as its capacity
utilisation. The management accountant using real-time information could provide timely
information about the number of customers served each day. This information could be
further analysed to reveal variations in demand by both day and time: Which day are we
busiest? What time of day is the quietest? Such analysis could be presented in management
accounting reports and would assist in decisions such as: At what times should the
restaurants be open? Is it worth opening every day of the week?
The restaurants could also equip its waiters with PDA’s (Personal Digital Assistants)to record
orders and ‘Smart-tills’ to record and analyse its sales receipts. At the operational level GHK
could use proprietary industry software to cost and plan its menus. These functions could be
integrated to order ingredients and monitor stock levels. This information allied to the real-
time information about orders and sales would enable real-time profitability information to be
generated by the management accountant.
The results emanating from the operational level would indicate the degree of success of the
generic strategy. It would also indicate either the continuance of that strategy or could
suggest that it was time for a strategic review and a possible change of strategy.

CIMA 2010 Chartered Management Accounting Qualification – Specimen Examination Paper F3
Pillar F
F3 – Financial Strategy
before attempting the question concerned (that is all parts and/or sub-
Maths Tables are provided on pages 17 to 21.
The list of verbs as published in the syllabus is given for reference on the
inside back cover of this question paper.
to close.
Tick the appropriate boxes on the front of the answer book to indicate which

Power Utilities
Pre-seen Case Study
Background
kept low.
Industry structure
weather conditions.
Specimen Exam Paper 2 Financial Strategy

Structure of PU
headquarters.
Governance of EGC
company.
Financial Strategy 3 Specimen Exam Paper

of PU.
Capital market
improve.
the environment.)


nationalised.

APPENDIX A


P$ million
ASSETS
Current assets
Inventories 1,529
Receivables 2,679
4,341
Total assets 20,178

Equity
Share capital 5,525
Reserves 1,231
Total equity 6,756
Current liabilities
Payables 3,862

[Note: The indicative time for answering this section is 90 minutes]
Question One
Background
Assume today is 20 May 2009.
Power Utilities (PU) is located in an Asian country. It is planning to diversify its business
activities by moving away from total reliance on coal fired power stations and building a
hydroelectric power station to produce electricity using natural resources. A dam would need
to be constructed to create a reservoir of water above the dam. Electricity would be
generated by releasing water from the upper reservoir through the dam. Modern
hydroelectric power stations can be very responsive to consumer demand and it is expected
that the power station would be able to generate up to 100 megawatts of electricity within 60
seconds of the need arising.
Hydroelectric power stations do not directly produce harmful emissions such as carbon
dioxide. However, some carbon dioxide will be produced during the construction phase.
There is also a potential source of harmful greenhouse gases in the form of methane gas
from decaying plant matter in flooded areas.
Public opinion on the project has been very mixed and there is a significant risk of opposition
to the project from local people. Their housing and farming businesses will be seriously
affected by the proposed development which will require flooding of local land to construct the
dam.
Corporate objectives
Corporate objectives in line with a recent government drive include:
 Improved efficiency of energy production;

 Reduction in harmful emissions such as greenhouse gases.
Financial objectives include maintaining group gearing (debt:debt plus equity) below 40%
based on market values.
Hydroelectric power station project
Initial research has shown that a major river in the south of the country may be suitable for
use in this project.
Extensive engineering and environmental studies have already begun to assess the viability
of the project. These are expected to cost US$15,000,000 in total, payable in three equal
instalments at the end of the calendar years 2008, 2009 and 2010. The payment for 2008
has already been made. PU is committed to pay the 2009 instalment but a clause in the
contract would enable it to cancel the payment due in 2010 if it decides to withdraw from the
project and future viability studies before the end of 2009.
Construction costs will be payable in US$. Other project costs and all project revenue will be
in PU’s functional currency, P$.

Construction and operating cash flows for the project are as follows:
Year(s) US$ million P$ million
Construction costs 3 and 4 60 payment -

each year
Pre-tax net operating cash flows 5 to 24 - 150 receipt
each year
Additional information:
 Time 0 is 1 January 2010;
 Cash flows should be assumed to arise at the end of each year;
 Business tax is 30% and is payable a year in arrears; also note that the government
has announced plans to reduce the tax rate to 10% from 1 January 2014 on “clean”
energy schemes such as this one (and would therefore only affect the tax position of
the operating cash flows); however, this still needs to be approved by parliament and
there is a risk that approval will not be obtained;
 Tax depreciation allowances of 100% can be claimed on construction costs but no tax
relief is available on the cost of the engineering and environmental studies;
 The assets of the project have no residual value;
 Exchange rate as at today, 20 May 2009, is US$/P$6.3958 (that is, US$1 = P$6.3958).
Some economic forecasters expect this exchange rate to remain constant over the
period of the project but other forecasts predict that the US$ will strengthen against the
P$ by 5% each year;
 PU normally uses a cost of capital net of tax of 10% to assess investments of this type.
Financial information for PU
Extracts from the latest available financial statements for PU are provided in the pre-seen
material. The ordinary share capital consists of P$1 shares and the current share price on
20 May 2009 is P$2.80. The long term government borrowings shown in the statement of
financial position are floating rate loans and the amount borrowed is unchanged since
31 December 2008
Financing the project
Two alternative financing schemes are being considered which would each raise the
equivalent of US$130 million on 1 January 2012. These are:
(i) A five-year P$ loan at a fixed interest rate of 5% per annum;
(ii) A subsidised loan denominated in US$ from an international organisation that

promotes “clean energy” schemes. There would not be any interest payments
but US$145 million would be repayable at the end of the five year term.
The requirement for Question One is on page 9

Required:
(a) Calculate the NPV of the project as at 1 January 2010 for each of the two
different exchange rate forecasts and the two tax rates.
(14 marks)
(b) Write a report to the Directors of PU in which you, as Finance Director,

address each of the following issues:
(i) Explain your results in part (a) and explain and evaluate other relevant
factors that need to be taken into account when deciding whether or
not to undertake the project. Conclude by advising PU how to proceed;
(15 marks)
(ii) Explain and evaluate the costs and risks arising from the use of foreign
currency borrowings as proposed by financing scheme (ii) and advise
PU on the most appropriate financing structure for the project. Up to 7
marks are available for calculations;
(11 marks)
In the event, the Board of Directors of PU decided to go ahead with the project and
it has now been operational for six years. The Board has, however, now decided to
dispose of the hydroelectric power station. To assist with these plans, a new entity,
PP, has been formed and the plant and its operations have been transferred to PP.
(c) Discuss why PU might wish to dispose of the hydroelectric power station and
advise the Directors of PU on alternative methods for achieving the
divestment.
(10 marks)
(Total for Question One = 50 marks)
End of Section A
TURN OVER

SECTION B – 50 MARKS
[Note: The indicative time for answering this section is 90 minutes]
ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH
Question Two
AB is a large retailing organisation with revenue in the last financial year exceeding €1 billion.
Its head office is in a country in the euro zone and its shares are listed on a major European
stock exchange. Over the last few years AB has opened several new stores in a number of
European capital cities, not all of them in the euro zone. AB is planning to allow all of its
stores to accept the world’s major currencies as cash payment for its goods and this will
require a major upgrade of its points of sale (POS) system to handle multiple currencies and
increased volumes of transactions
AB has already carried out a replacement investment appraisal exercise and has evaluated
appropriate systems. It is now in the process of placing an order with a large information
technology entity for the supply, installation and maintenance of a new POS system. The
acquisition of the system will include the provision of hardware and software. Routine
servicing and software upgrading will be arranged separately and does not affect the
investment appraisal decision.
AB is considering the following alternative methods of acquiring and financing the new POS
system:
Alternative I
 Pay the whole capital cost of €25 million on 1 January 2010, funded by bank
borrowings. This cost includes the initial installation of the POS system.
 The system will have no resale value outside AB
Alternative 2
 Enter into a finance lease with the system supplier. AB will pay a fixed amount of
€7.0 million each year in advance, commencing 1 January 2010, for four years.
 At the end of four years, ownership of the system will pass to AB without further
payment.
Other information
 AB can borrow for a period of four years at a pre-tax fixed interest rate of 7% a
year. The entity’s cost of equity is currently 12%.
 AB is liable to corporate tax at a marginal rate of 30% which is settled at the end
of the year in which it arises..
 AB accounts for depreciation on a straight-line basis at the end of each year
 Under Alternative 1, tax depreciation allowances on the full capital cost are
available in equal instalments over the first four years of operation.
 Under Alternative 2, both the accounting depreciation and the interest element of
the finance lease payments are tax deductible.
 Once a decision on the payment method has been made and the new system is
installed, AB will commission a post completion audit (PCA).
The requirement for Question Two is on the opposite page

Required:
(a)
(i) Calculate which payment method is expected to be cheaper for AB and
recommend which should be chosen based solely on the present value of the
two alternatives as at 1 January 2010
(10 marks)
(ii) Explain the reasons for your choice of discount factor in the present value
calculations.
(3 marks)
(iii) Discuss other factors that AB should consider before deciding on the method
of financing the acquisition of the system
(3 marks)
(Total for part (a) 16 marks)
(b) Advise the Directors of AB on the following:
 The main purpose and content of a post completion audit (PCA).

 The limitations of a PCA to AB in the context of the POS system.
(9 marks)
NOTE: A REPORT FORMAT IS NOT REQUIRED IN THIS QUESTION
TURN OVER

Question Three
CD is a privately-owned entity based in Country X, which is a popular holiday destination. Its
principal business is the manufacture and sale of a wide variety of items for the tourist market,
mainly souvenirs, gifts and beachwear. CD manufactures approximately 80% of the goods it
sells. The remaining 20% is purchased from other countries in a number of different
currencies. CD owns and operates 5 retail stores in Country X but also sells its products on a
wholesale basis to other local retail outlets.
Although CD is privately owned, it has revenue and assets equivalent in amount to some
entities that are listed on smaller stock markets (such as the UK's Alternative Investment
Market (AIM)). It is controlled by family shareholders but also has a number of non-family
shareholders, such as employees and trade associates. It has no intention of seeking a listing
at the present time although some of the family shareholders have often expressed a wish to
buy out the smaller investors.
CD has been largely unaffected by the recent world recession and has increased its sales
volume and profits each year for the past 5 years. The directors think this is because it
provides value for money; providing high quality goods that are competitively priced at the
lower end of its market. Future growth is expected to be modest as the directors and
shareholders do not wish to adopt strategies that they think might involve substantial increase
in risks, for example by moving the manufacturing base to another country where labour rates
are lower. Some of the smaller shareholders disagree with this strategy and would prefer
higher growth even if it involves greater risk.
The entity is financed 80% by equity and 20% by debt (based on book values). The debt is a
mixture of bonds secured on assets and unsecured overdraft. The interest rate on the
secured bonds is fixed at 7% and the overdraft rate is currently 8%, which compares to a
relatively recent historic rate as high as 13%. The bonds are due to be repaid in 5 years’ time.
Inflation in CD’s country is near zero at the present time and interest rates are expected to
fall.
CD’s treasury department is centralised at the head office and its key responsibilities include
arranging sufficient long and short term financing for the group and hedging foreign exchange
exposures. The Treasurer is investigating the opportunities for and consequences of
refinancing.
CD’s sole financial objective is to increase dividends each year. It has no non-financial
objective. This financial objective and the lack of non-financial objectives are shortly to be
subject to review and discussion by the board. The new Finance Director believes
maximisation of shareholder wealth should be the sole objective, but the other directors do
not agree and think that new objectives should be considered, including target profit after tax
and return on investment.
The requirement for Question Three is on the opposite page

Required:
(a) Discuss the role of the treasury department when determining financing or re-
financing strategies in the context of the economic environment described in the
scenario and explain how these might impact on the determination of corporate
objectives.
(15 marks)
(b) Evaluate the appropriateness of CD's current objective and of the two new
objectives being considered. Discuss alternative objectives that might be
appropriate for CD and conclude with a recommendation.
(10 marks)
(Total 25 marks)
TURN OVER

Question Four
EF is a distributor for branded beverages throughout the world. It is based in the UK but has
offices throughout Europe, South America and the Caribbean. Its shares are listed on the
UK's Alternative Investment Market (AIM) and are currently quoted at 180 pence per share
Extracts from EF’s forecast financial statements are given below.
Extracts from the (forecast) income statement for the

year ended 31 December 2009
₤’000
Revenue 45,000
Purchase costs and expenses 38,250
Interest on long term debt 450
Profit before tax 6,300
Income tax expense (at 28%) 1,764
Note: Dividends declared 1,814
EF - Statement of financial position as at 31 December 2009
₤’000
ASSETS
Current assets
Inventories 5,250
Trade receivables 13,500
Cash and bank balances 348
19,098
Total assets 33,829

Equity
Share capital (ordinary shares of 25
pence) 4,204
Retained earnings 16,210
Total equity 20,414
(Secured bonds, 9% 2015) 5,000
Current liabilities
Trade payables 8,415

You have obtained the following additional information:
1. Revenue and purchases & expenses are expected to increase by an average of 4%

each year for the financial years ending 31 December 2010 and 2011.
2. EF expects to continue to be liable for tax at the rate of 28 per cent. Assume tax is
paid or refunded the year in which the liability arises.
3. The ratios of trade receivables to sales and trade payables to purchase costs and
expenses will remain the same for the next two years. The value of inventories is
likely to remain at 2009 levels for 2010 and 2011.
4. The non-current assets in the statement of financial position at 31 December 2009
are land and buildings, which are not depreciated in the company's books. Tax
depreciation allowances on the buildings may be ignored. All other assets used by
the company are currently procured on operating leases.
5. The company intends to purchase early in 2010 a fleet of vehicles (trucks and vans).
These vehicles are additional to the vehicles currently operated by EF. The vehicles
will be provided to all its UK and overseas bases but will be purchased in the UK. The
cost of these vehicles will be £5,000,000. The cost will be depreciated on a straight
line basis over 10 years. The company charges a full year's depreciation in the first
year of purchase of its assets. Tax depreciation allowances are available at 25%
reducing balance on this expenditure. Assume the vehicles have a zero residual
value at the end of ten years.
6. Dividends will be increased by 5% each year on the 2009 base. Assume they are
paid in the year they are declared.
EF plans to finance the purchase of the vehicles (identified in note 6) from its cash balances
and an overdraft. The entity’s agreed overdraft facility is currently £1 million.
The company's main financial objectives are to earn a post-tax return on the closing book
value of shareholders’ funds of 20% per annum and a year on year increase in earnings of
8%
Assumption regarding overdraft interest
It should be assumed that overdraft interest that might have been incurred during 2009 is
included in expenses (that is, you are not expected to calculate overdraft interest for 2010 and
2011).
The requirement for Question Four is on the next page
TURN OVER

Required:
Assume you are a consultant working for EF
(a) Construct a forecast income statement, including dividends and retentions for
the years ended 31 December 2010 and 2011.
(6 marks)
(b) Construct a cash flow forecast for each of the years 2010 and 2011. Discuss,
briefly, how the company might finance any cash deficit.
(9 marks)
(c) Using your results in (a) and (b) above, evaluate whether EF is likely to meet
its stated objectives. As part of your evaluation, discuss whether the
assumption regarding overdraft interest is reasonable and explain how a
more accurate calculation of overdraft interest could be obtained.
(10 marks)
(Total for Question Four = 25 marks)
Maths Tables and Formulae are on Pages 17 - 21

Present value table

Present value of 1.00 unit of currency, that is (1 + r)-n where r = interest rate; n = number of
periods until payment or receipt.

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

Cumulative present value of 1.00 unit of currency per annum
Receivable or Payable at the end of each year for n years  r

1(1 r ) n 
 

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

Formulae
Valuation models
(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-
div value:
d
P0 =
k pref
(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div
value:
d
P0 =
ke
(iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g,
where P0 is the ex-div value:
d1 d 0 [1  g ]
P0 = or P0 =
ke g ke g
(iv) Irredeemable bonds, paying annual after-tax interest, i [1 – t], in perpetuity, where P0 is the ex-interest
value:
i [1  t ]
P0 =
k d net
i
or, without tax: P0 =
kd
(v) Total value of the geared entity, Vg (based on MM):
Vg = Vu + TB
(vi) Future value of S, of a sum X, invested for n periods, compounded at r% interest:
S = X[1 + r]n
(vii) Present value of 100 payable or receivable in n years, discounted at r% per annum:
1
PV =
n
[1  r ]
(viii) Present value of an annuity of 100 per annum, receivable or payable for n years, commencing in one
year, discounted at r% per annum:
1 1 
PV = 
r 
1
n 
[1  r ] 
(ix) Present value of 100 per annum, payable or receivable in perpetuity, commencing in one year,
discounted at r% per annum:
1
PV =
r
(x) Present value of 100 per annum, receivable or payable, commencing in one year, growing in perpetuity
at a constant rate of g% per annum, discounted at r% per annum:
1
PV =
r g

Cost of capital
(i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a
current ex-div price P0:
d
kpref =
P0
(ii) Cost of irredeemable bonds, paying annual net interest, i [1 – t], and having a current ex-interest price
P0:
i [1  t ]
kd net =
P0
(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div
price P0:
d
ke =
P0
(iv) Cost of ordinary (equity) shares, having a current ex-div price, P0, having just paid a dividend, d0, with
the dividend growing in perpetuity by a constant g% per annum:
d1 d 0 [1  g ]
ke = g or ke = g
P0 P0
(v) Cost of ordinary (equity) shares, using the CAPM:
ke = Rf + [Rm – Rf]ß
(vi) Cost of ordinary (equity) share capital in a geared entity :
VD [1  t ]
keg = keu + [keu – kd] VE
(vii) Weighted average cost of capital, k0 or WACC
 VE   VD 
WACC = ke    k d [1  t ]  
 VE  VD   VE  VD 
(viii) Adjusted cost of capital (MM formula):
Kadj = keu [1 – tL] or r* = r[1 – T*L]
(ix) Ungear ß:
 VE   VD [1  t ] 
ßu = ßg   + ßd  
 VE  VD [1  t ]   VE  VD [1  t ] 
(x) Regear ß:
VD [1  t ]
ßg = ßu + [ßu – ßd] VE
(xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect)
1  annual discount rate B$ Future spot rate A$/B$ in 12 months' time


1  annual discount rate A$ Spot rate A$/B$
where A$/B$ is the number of B$ to each A$

Other formulae
(i) Expectations theory:
1  nominal countryB interest rate

Future spot rate A$/B$ = Spot rate A$/B$ x
1  nominal countryA interest rate
where:
A$/B$ is the number of B$ to each A$, and
A$ is the currency of countryA and B$ is the currency of country B
(ii) Purchasing power parity (law of one price):
1  countryB inflation rate

Future spot rate A$B$ = Spot rate A$/B$ x
1  countryA inflation rate
(iii) Link between nominal (money) and real interest rates:

[1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]
(iv) Equivalent annual cost:
PV of costs over n years

Equivalent annual cost =
n year annuity factor
(v) Theoretical ex-rights price:
1
TERP = [(N x cum rights price) + issue price]
N 1
(vi) Value of a right:
Theoretica l ex rights price  issue price
where N = number of rights required to buy one share.


Level 1 - KNOWLEDGE
State Express, fully or clearly, the details of/facts of
Explain Make clear or intelligible/State the meaning or
purpose of
consideration
something
How you are expected to apply your knowledge. Apply Put to practical use
Calculate/compute To ascertain or reckon mathematically
Demonstrate Prove with certainty or to exhibit by
practical means
Level 4 - ANALYSIS
How are you expected to analyse the detail of Analyse Examine in detail the structure of
between
How are you expected to use your learning to Advise Counsel, inform or notify
Recommend Propose a course of action

Financial Pillar
Specimen Paper
Thursday Morning Session

CIMA 2010 Chartered Management Accounting Qualification – Answers for Specimen Examination Paper F3

F3 - Financial Strategy
SECTION A

Requirement (a)
Appendix A
1. Assume constant exchange rate
Project years 1 3 4 5 5 to 24 6 to 25
Calendar years (31 December) 2010 2012 2013 2014 from 2014 from 2015
for 20 years for 20 years
US$m US$m US$m US$m US$m US$m
Final payment for engineering/environmental (5.0) ‐ ‐ ‐ ‐ ‐
Initial investment ‐ (60.0) (60.0) ‐ ‐
US$ cashflows (5.0) (60.0) (60.0) ‐ ‐ ‐
FX rate (P$ per US$) 6.3958 6.3958 6.3958
P$m P$m P$m P$m P$m P$m
P$ equivalent of US$ cashflows (32.0) (383.7) (383.7) ‐ ‐ ‐
Tax relief on initial investment 115.1 W1 115.1
Operating net cash inflows in P$ ‐ ‐ ‐ ‐ 150.0 ‐
Less tax at 30% ‐ ‐ ‐ ‐ ‐ (45.0)
Net total cashflows expressed in P$ (32.0) (383.7) (268.6) 115.1 150.0 (45.0)
Discount factor at 10.0% 0.909 0.751 0.683 0.621 5.815 W2 5.287 W3
PV (29.1) (288.2) (183.5) 71.5 872.3 (237.9)
Total NPV in P$ millions: 205.1
W1: 115.1 = 383.7 x 30%
W2: 5.815 = 8.514 x 0.683
W3: 5.287 = 8.514 x 0.621
2. Assume that the US$ will strengthen against the P$ by 5% each year
P$m P$m P$m P$m P$m P$m
Project years 1 3 4 5 5 to 24 6 to 25
Calendar years (31 December) 2010 2012 2013 2014 from 2014 from 2015
for 20 years for 20 years
P$ equivalent of US$ cashflows (above) (5.0) (60.0) (60.0) ‐ ‐ ‐
FX rate reflecting 5% increase in US$ value 6.9206 7.6300 W4 8.0115 ‐ ‐

Adjusted US$ cash flows expressed in P$ (34.6) (457.8) (480.7) ‐ ‐ ‐
Tax relief on initial investment 137.3 W5 144.2
P$ cash flows (from above) ‐ ‐ ‐ ‐ 150.0 (45.0)
Total cashflows expressed in P$ (34.6) (457.8) (343.4) 144.2 150.0 (45.0)
Discount factor at 10.0% (from above) 0.909 0.751 0.683 0.621 5.815 5.287
PV (31.5) (343.8) (234.5) 89.5 872.3 (237.9)
Total NPV in P$ millions: 114.1

In both cases:
Saving if tax rate dropped to 10% is P$ 158.6million where 158.6 = 237.9 x (30‐10)/30
So result in 1 above becomes P$363.7m (= 205.1 + 158.6)
and result in 2 above becomes P$272.7m (= 114.1 + 158.6)
W4: Exchange rates
Assuming the US$ strengthens against the P$ by 5% a year, future rates are:
Date Year FX Rate Workings
01 January 2010 0 6.5911 6.3958 1.05^(225/365) where 225 days is:
31 December 2010 1 6.9206 6.5911 x 1.05 May 11
31 December 2011 2 7.2667 6.9206 x 1.05 Jun 30
31 December 2012 3 7.6300 7.2667 x 1.05 Jul 31
31 December 2013 4 8.0115 7.6300 x 1.05 Aug 31
31 December 2014 5 8.4121 8.0115 x 1.05 Sep 30
Oct 31
Nov 30
W5: 137.3 = 457.8 x 30% and 144.2 = 480.7 x 30% Dec 31
225
Requirement (b)
To: The Directors of PU

From: Finance Director
Date: Today’s date
Subject: Hydroelectric power station project – project appraisal
Introduction
The purpose of this report is to present the findings of recent exercises to evaluate:
 the likely financial contribution of the proposed project and examine other relevant
factors that might affect the decision on whether or not to undertake the project; and
 suitable financing structures to fund the project.
Investment appraisal
Financial appraisal based on project cash flows
A full financial appraisal has been undertaken based on the present value of future cash flows
arising from the project. There are several important uncertainties surrounding the project. In
particular:
 a large proportion of US$ costs are involved which could vary in P$ terms, and
 it is possible that the tax rate for such projects may fall from 30% to 10% from 2014
The investment appraisal model was therefore run for each combination of these base
assumptions. Summary results are given below.
Summary of results - NPV as at 1 January 2010 of forecast project cash flows:
Tax rate 30% Tax rate 10%
Constant exchange rate P$205.1 million P$363.7 million
US$ strengthening by 5% per

annum P$114.1 million P$272.7 million
Full results of the exercise are attached at Appendix A.

Other relevant factors to take into consideration
Impact of movement in exchange rate

If the US$ were to strengthen against the P$ by 5% a year, the NPV of the project would fall
by approximately P$90 million under both tax rate scenarios. For example, assuming a tax
rate of 30%, the NPV of the project falls to P$114.1million from P$205.1million once the
strengthening of the US$ has been taken into account.
This is a very large exchange rate risk and could be hedged by the use of short-term hedging
instruments such as forward contracts. These forward exchange rates can then be used in
the investment appraisal of the project and a revised NPV result obtained based on the hedge
cash flows.
Forward contracts cannot be cancelled, so they should only be entered into if and when a firm
decision has been taken to proceed with the project.
Impact of tax rates

The results in part (a) show that a fall in the tax rate in 2014 from 30% to 10% would result in
a large increase in the NPV of the project from P$205.1million to P$363.7million, assuming a
constant US$/P$ exchange rate.
A real option open to PU is to delay the project until a decision has been made on the future
tax rate. In the meantime, the entity should lobby the government to try and influence the
decision in its favour.
Reliability of base data

The investment appraisal exercise has been based on best estimates. Changes to the
estimates could occur as a result of changes in underlying data such as:
 construction costs;
 market demand/prices for electricity that would impact on operating revenues;
 accuracy of estimates of maintenance costs;
 possible delays due to local objection to the scheme and how that might impact on
costs and viability of the project;
 accuracy of estimates of relocation costs for people who are living or working on land
that will be flooded as a result of the construction of the dam.
Sensitivity analysis would be useful to examine the impact of changes in the underlying data
on the financial appraisal.
Suitability of the discount rate

The discount rate should be reviewed to see if:
 it meets the underlying risk expectations of the project;
 it needs to be adjusted to reflect a change in capital structure of PU as a result of
proceeding with the project.
The project is not large enough to change the capital structure of the entity and so this is not a
relevant issue here.
However, the project is moving the entity into a completely new and untested area of
business and the discount rate may therefore need to be adjusted upwards to reflect the
higher risks arising from this project.
Results of the environmental studies exercise

The environmental studies investigation is still on-going. Although it is considered highly
unlikely that the project will be cancelled at this stage, final approval to proceed can only be
made once the full results of the studies are known.

Impact on corporate and financial objectives

Financial objective: Gearing
Gearing is currently 38% (based on market values at 20 May 2009) against a maximum
gearing target of 40%.
The project is so small in size in relation to the entity as a whole that it would not be expected
to have a major impact on gearing levels. However, the size of the borrowing is still sufficient
to push the gearing level just above the maximum gearing target of 40%. The new gearing
level is estimated as 40.4%, an increase of approximately 2% from the current level of 38.2%.
Workings:
Current Gearing:
Equity P$15,470million (= 5,525million x P$2.80)
Debt P$9,560million
So, current gearing is 38.2% (= 9,560/(9,560 + 15,470))
New gearing after taking into account the project and the following additional assumptions:
 tax rate of 30%;
 an increase of 5% a year in the value of the US$ against the P$;
 a share price that has already moved to reflect the increase in shareholder value as
represented by the NPV of the project.
So new figures for equity and debt are:
Equity P$15,584million (= 5,525million x P$2.80 + P$114.4million (the project NPV)
Debt P$10,552million (= P$9,560million + P$992 (see workings W1))
So the new gearing level is: 40.4% (= 10,552/(10,552 + 15,584))
W1: US$130million x 7.6300 = P$992million
Other corporate objectives

The new power station is unlikely to improve efficiency rates of energy production but it would
make a major contribution to reducing harmful emissions such as greenhouse gases when
generating electricity. It is inevitable that some harmful emissions will be emitted during the
construction process and there may also be some carbon dioxide emitted from decomposing
vegetable matter that is flooded as part of the project. Overall, however, the hydroelectric
power station would be expected to generate only a very small proportion of the harmful
emissions that would have been generated by a coal fired power station with a similar output.
Conclusion – whether or not to undertake the project
It is recommended that PU should:

 wait for the full results of the environmental studies exercise before reaching a
decision;
 recalculate the investment appraisal using forward exchange rates;
 perform a sensitivity analysis to determine the results under a “worst case scenario”
and determine the probability of the project showing a loss if some of the key
assumptions are changed;
If a decision is taken to proceed with the project, all US$ cash flows should be hedged using
forward contracts to fix the exchange rate on these cash flows.
Overall recommendation: Only proceed with the project if satisfactory outcomes are
obtained from all the above research and if the revised figures for the project using forward
exchange rates still show a profit, even under a “worst case” scenario.

Financing structure
A significant exchange rate risk would arise in respect of US$ borrowings as proposed in
financing structure (ii). At a constant exchange rate, the US$ borrowings are very attractive
and have a significantly lower cost than the P$ borrowings. However, if the US$ were to
strengthen by 5% a year against the P$, the US$ borrowings becomes comparatively more
expensive.
The cash flows arising under the US$ borrowings and the effective cost of the borrowings (on
a yield to maturity basis) under each exchange rate scenario are shown below:
US$ loan assuming a constant exchange rate
Year Cash flow Exchange Cash flow DF @ 3% PV @ 3% DF @ 2% PV @ 2%

US$ million rate Local $ million
0 ‐130.0 6.3958 ‐831.5 1 ‐831.5 1 ‐831.5
5 145.0 6.3958 927.4 0.863 800.3 0.906 840.2
‐31.2 8.7
YTM by interpolation: 2.2% = 2% + 1% x 8.7/(8.7 + 31.2)
US$ loan assuming the US$ strengthens against the local $ by 5% a year
Year Cash flow Exchange Cash flow DF @ 6% PV @ 6% DF @ 8% PV @ 8%

US$ million rate Local $ million
0 ‐130.0 7.2667 (W1) ‐944.7 1 ‐944.7 1 ‐944.7
5 145.0 9.2744 (W2) 1344.8 0.747 1004.6 0.681 915.8
59.9 ‐28.9
YTM by interpolation: 7.3% = 6% + 2% x 59.9/(59.9 + 28.9)
Workings:
W1 7.2667 is the exchange rate on 1 January 2012 (see workings W4 in part (a))
W2 9.2744 = 7.2667 x 1.05^5
Ignoring any investment income on funds that are not needed in the first year, and assuming
exchange rates stay constant, the US$ borrowings have an effective cost of 2.2% but this
rises to an effective cost of 7.3% if the US$ were to strengthen against the P$ by 5% a year.
This compares with a known cost of 5% under alternative financing structure (i).
If such a high risk is unacceptable, US$ borrowings should only be considered if it is possible
to guarantee the exchange rate for the interest and capital repayments used to service the
borrowings. This may be possible to arrange by using hedging instruments such as forward
contracts or a cross currency swap.
Note that there is no US$ income that could be used to set off against US$ payments to
service the borrowings.
Recommendation
Exchange rate risk arising on the borrowings could be effectively eliminated if PU were to
enter into a cross currency swap contract to fix the exchange rate on the US$ borrowings.
Calculations should be performed of the cost of debt for the hedged borrowings and this
should be compared to the cost of the P$ borrowings. The calculations should also be
adjusted to take account of any investment income that could be earned before the funds are
required in the project. The cheapest method should then be chosen.

Requirement (c)
Possible reasons for disposing of the hydroelectric power station.
There are a number of possible reasons why PU might wish to dispose of the hydroelectric
power station.
The most likely reason is one of strategic planning:

 to refocus the business on coal fired power stations and concentrate on the main area
of management expertise - the hydroelectric power station may not have proved to be a
good fit of business alongside the coal fired power stations;
 to raise funds for use in moving into new business areas such as developing new
power stations using alternative fuels;
 to lower cost of capital by disposing of a high risk business.
PU may also have encountered problems in running the hydroelectric power station such as a
failure to manage it efficiently or realise its full profit potential. There may be a potential buyer
who has the expertise to run the hydroelectric power station more efficiently.
PU itself may have suffered a fall in business and need to raise cash by selling the
hydroelectric power station.
Methods for achieving the divestment

1. Sell-off
In a sell-off, PP would be sold to another entity, usually in return for cash. This is most likely
to be achieved by setting up PP as a separate subsidiary entity and selling the entire entity as
a going concern. Shares in the acquirer would be of no interest to PU if its objective is to
move out of this area of business and use the cash raised for other purposes.
2. Spin-off
In a spin-off, PP would be constructed so that it is owned by the same shareholders as PU.
This is normally known as a demerger. A spin-off can lead to a clearer management structure
as management of PP can concentrate solely on that business without reference back to PU.
3. Management buyout
A management buyout is where the business is purchased by members of the management
team, generally in association with a financing institution.
__________________________________________________________________________

SECTION B

Requirement (a)(i)
The discount rate to be used in this type of evaluation is the after-tax cost of debt, which is
7% x (1 - 03 = 4.9%) say 5%.
Alternative 1 – Evaluation of ‘borrow and buy’
Year 0 1 to 4
€million €million
Purchase cost (25)

Tax relief on tax depreciation
allowances (W1) 1.875
DF @5% 1.000 3.546
DCF (25) 6.649
Present value (18.4)
W1: €1.875 million = 30% x €25 million/4
Alternative 2 – Evaluation of the finance lease
Base data
€million
Lease payments in advance 7.0 pa Total payments: 4 x 7 = €28 million
Cost of leased asset 25 but use £18m in the calculations because
the first lease payment is made in advance
and should be deducted from the cost
Finance charge 3 = 28 - 25
Number of interest periods 3 Ignore the final period as there is no interest element
Examiner’s note: As the question does not specify which method to use to allocate implicit
interest between years, either the actuarial method or the sum of digits method would be
acceptable. Both are shown here as a guide to students.

Method 1 – Actuarial method
Firstly, calculate the implied interest rate using IRR:
The annuity factor for the interest can be found by dividing the cost of the asset by the annual
lease payment.
We will use a net cost of €18million and 3 interest periods.
So three year annuity factor = 18/7.0 = 2.5714
This approximates to an interest rate of 8% (which has a three year annuity factor of 2.577).
Examiner's note: if there is no exact match, use interpolation to find the implied interest rate.
Actuarial method – interest allocation (and proof of interest allocation)
Accounting year 1 2 3
€million €million €million
Opening balance 18.0 12.44 6.44
Interest (add) 1.44 (=8% x 18.0) 1.00 (=8% x 12.44) 0.52 (=8% x 6.44)
Repayment (lease rental) (7.0) (7.0) (7.0)
Closing balance 12.44 6.44 (0.04)
Actuarial method – present value calculation of finance lease
Time 0 1 2 3 4
€million €million €million €million €million
Calculation of tax shield
based on accounting
figures:
Depreciation 0 (6.25) (6.25) (6.25) (6.25)
Implicit interest 0 (1.44) (1.00) (0.52) 0
Total eligible for tax relief 0 (7.69) (7.25) (6.77) (6.25)
Cash flows:
Tax relief at 30% 0 2.31 2.18 2.03 1.87
Finance lease (7.0) (7.0) (7.0) (7.0) 0
Total cash flows (7.0) (4.69) (4.82) (4.97) 1.87
DF @5% 1.000 0.952 0.907 0.864 0.823
DCF (7.0) (4.46) (4.37) (4.29) 1.54
Method 2 - Sum of digits
Base the sum of digits calculation on three interest periods as before.

The sum of digits is 6. Workings: 6 = n (n+1)/2 = 3 x (3 + 1)/2
So the interest in the first period is 3m x 3/6 and in the 2nd period is 3m x 2/6 etc.
Sum of digits – interest allocation (and proof of interest allocation)
Accounting Year 1 2 3
€million €million €million
Opening balance 18.0 12.5 6.5
Interest (add) 1.5 (=3m x 3/6) 1.0 (=3m x 2/6) 0.5 (=3m x 1/6)
Repayment (lease rental) (7.0) (7.0) (7.0)
Closing balance 12.5 6.5 0.0

Sum of digits – present value calculation of finance lease
Time 0 1 2 3 4
€million €million €million €million €million
Calculation of tax shield
based on accounting
figures:
Depreciation 0 (6.25) (6.25) (6.25) (6.25)
Implicit interest 0 (1.5) (1.0) (0.5) 0
Total eligible for tax relief 0 (7.75) (7.25) (6.75) (6.25)
Cash flows:
Tax relief at 30% 0 2.33 2.17 2.03 1.87
Finance lease (7.0) (7.0) (7.0) (7.0) 0
Total cash flows (7.0) (4.67) (4.83) (4.97) 1.87
DF @5% 1.000 0.952 0.907 0.864 0.823
DCF (7.0) (4.45) (4.38) (4.29) 1.54
(Which gives the same result as that obtained using the actuarial method)
On the basis of the present value analysis, there is a marginal benefit from choosing
alternative 1, giving a relatively small saving of approximately €200,000. However, this is
small in relation to the size of the project and other factors may have a greater impact on the
choice of financing structure.
Requirement (a)(ii)
The two main possible discount rates to consider are:

 The cost of capital to the entity (which has presumably been used to evaluate the
decision to acquire the POS) or
 The cost of the next best alternative means of finance (here, bank borrowings).
The discount rate that should be used in financing decisions is the opportunity cost. Finance
leases are considered a direct substitute for borrowing, the opportunity cost of leasing is the
after-tax cost of borrowing.
Requirement (a)(iii)
 Consideration must be given as to how or when the borrowings are to be repaid if

alternative 1 is chosen.
 Tax benefits appear to have a significant influence on the decision; a sensitivity
analysis should be carried out to determine the impact on the decision if tax rates or
regulations change.
Requirement (b)
The main purpose of a PCA:
A post-completion audit (PCA) can be defined as “an objective and independent appraisal of
all phases of the capital expenditure process as it relates to a specific project”. The main
purposes include: project control; improving the investment process; and assisting the
assessment of performance of future projects.
A major requirement of a PCA is that the objectives of the investment project must be clear
and an adequate investment proposal should have been prepared. The objectives should
also be stated, wherever possible, in terms that are measurable. If these have not been done
before the POS system was acquired then a PCA is not possible.

The PCA should provide a source of information that will help future management decision
making and should include an assessment of the reasons for any variance from the expected
performance, cost and time outcomes. This should improve project control and governance
and enable changes to be introduced to put the project back on track in a timely manner.
The key factors of importance of a PCA to AB:
 It enables a check to be made on whether the performance of the system corresponds

with the expected results. If this is not the case, the reasons should be sought. This
could form the basis for improvements in development of the system.
 It generates information, which allows an appraisal to be made of the managers who
took the decision to upgrade the system. Managers will therefore tend to arrive at more
realistic estimates of the advantages and disadvantages of the proposed investments.
 It can provide for better project planning in the future. If, in the evaluation, it is found
that the planning of the investment programme was poor, provision can be made to
ensure that it is better for future acquisitions.
The limitations of a PCA to AB in the context of the POS system:
 Sufficient resources are often not allocated to the task of completing PCAs so often are
not undertaken.
 They can be time consuming and costly to complete.
 They are sometimes seen as tools for apportioning blame, so even where undertaken
the lessons are often not disseminated and are not then embedded in future projects.
If undertaken by the managers of the project, they may claim credit for all that went well
and blame external factors for everything that did not.

Requirement (a)
The scenario in this question concerns a privately owned entity based in a holiday destination.
Inflation is near zero and interest rates are expected to fall. The treasury department needs
to decide how to deal with the challenges and opportunities the specific set of circumstances
provide and evaluate the impact on the entity’s capital structure.
Finance theory suggests that entities should use a certain amount of debt in their capital
structure to lower the cost of capital. Debt is cheaper than equity because interest payments
(usually) attract tax relief and expected returns are lower. This is because interest is (usually)
secured and providers of debt do not participate in profits. Here we have a mixture of
secured and unsecured debt, but the entity appears sound and of high credit worthiness so
should be able to borrow at comparatively favourable rates.
This might even be an argument in favour of increasing gearing which will provide the ability
to undertake a share buyback, as seems to be the desire of the major, family shareholders.
The opposite argument is that in a period of low and falling interest rates, fixed rate debt
becomes a burden. Some of the reasons are as follows:
 The real value of debt is not being eroded when there is low or no inflation, so one of
the benefits of debt disappears.
 If growth is expected to be modest, debt interest may have to be paid out of static (or
even falling) profits, lowering returns to shareholders.
 Although nominal interest rates may fall, they never become negative, so the real cost
of borrowing increases.
Raising equity is safer if profits are falling as dividends do not have to be paid and the
shareholders do not get their money back in a liquidation. However, raising new equity in a
private entity is more difficult than in a public entity and this method of raising new capital
raises many additional issues such as whether to plan for a public listing or a rights issue and
how to value the shares.
In theory (according to Modigliani and Miller), the mix of debt and equity does not affect the
value of the entity, other than the value of the tax shield, but it does have an effect on the
attribution of profits to three groups of stakeholders: lenders, government and owners
(shareholders).
The main issue for the treasury department to decide is what combination of dividend policy
and capital structure is likely to maximise the present value of cash flows to shareholders.
This is where the financing strategies adopted contribute to the determination of the
objectives of the entity.
The treasury department needs to specifically:

 Look at the terms of existing borrowing to see if refinancing at lower rates is feasible,
recognising any possible penalties for early retirement of loans.
 Discuss with the major shareholders the possibility (or even probability) that returns are
likely to be lower; the lower the rate of interest, the lower the cost of capital and
therefore the lower the returns that can be expected.
Requirement (b)
Theory supports the Finance Director, suggesting that maximisation of shareholder wealth is
the only true objective of the entity but this is now considered an extreme view. Many entities
now establish objectives that aim to maximise shareholder wealth while recognising
constraints, legally enforceable or voluntary, imposed by society. A major problem with this

objective in the circumstances of CD is that this is a private entity that does not have a quoted
share price. Shareholder wealth, as traditionally valued, is difficult to determine.
In addition, although dividend levels may have no direct impact on shareholder wealth, there
may well be private family shareholders who rely on a steady and predictable dividend stream
from entity CD.
Looking only at dividends as an objective has its limitations, for example dividends could
increase while earnings fall. The dividend ratio therefore needs to be considered alongside
dividend payout. Other objectives mentioned such as profitability as measured by returns
after tax and return on investment have some advantages. For example they are well
understood measures and recognised guidelines are available in the form of International
Accounting Standards. Also, shareholders expect and understand profitability.
Disadvantages of accounting-based measures include:

 They are historic and backward-looking;
 They can be subject to manipulation;
 A variety of accounting policies are available – even within Accounting Standards;
 Tax can be affected by factors outside the control of managers;
 They do not take account of non-financial objectives.
Recommendation
Maximisation of shareholder wealth, using the theoretical definition, is difficult to apply in the
circumstances of CD. However, it would be worth introducing an objective that incorporates
earnings growth as well as dividend growth.
A range of objectives could be considered, such as risk-related returns to investors, but again
this is more difficult with a private entity than one with a share listing.
The entity needs to consult its shareholders and, possibly, consider using a balanced
scorecard approach to determine a range of objectives appropriate for an entity such as CD.


Requirement (a)
Forecast income statements for the years ended 31 December

2009 2010 2011
£000 £000 £000
Revenue 45,000 46,800 48,672
Purchase costs and expenses (38,250) (39,780) (41,371)
Depreciation 0 (500) (500)
Profit before finance costs 6,750 6,520 6,801
Less: Interest on long term debt (450) (450) (450)
Profit before tax 6,300 6,070 6,351

Tax @ 28% (see note) (1,764) (1,490) (1,656)
Profit after tax (earnings) 4,536 4,580 4,695
Dividends declared and paid (1,814) (1,905) (2,000)
Retained earnings for year 2,722 2,675 2,695
Examiner’s Note: the question did not require candidates to show the figures for 2009, they
are shown here in italics for convenience.
Tax depreciation allowances:

Cost of vehicles 5,000
2010 WDA @ 25% (1,250)
Written Down Value 3,750
2011 WDA @ 25% (938)
Written Down Value 2,812
Note: Tax is calculated on profit before tax and depreciation less capital allowances:
2010 (6,070 + 500 - 1,250) x 28% = 1,490
2011 (6,351 + 500 - 938) x 28% = 1,656
Examiner’s note: it was not intended that candidates should consider the impact of deferred
taxation in their answer here. Credit was available for those who did so.
Requirement (b)
Cash flow forecasts for 2010 and 2011
Calculations of cash receivable and cash payable:

2010 2011
£000 £000
Revenue 46,800 48,672
O/B trade receivables 13,500 14,040
C/B trade receivables at 30% (14,040) (14,602)
(13,500/45,000 x 100)
Cash receivable 46,260 48,110
Costs and expenses 39,780 41,371

O/B trade payables 8,415 8,752
C/B trade payables (8,752) (9,102)
(at 22% of costs and expenses
= 8,415/38,250 x 100)
Cash payable 39,443 41,021

Cash flow forecasts

2010 2011
£000 £000
Cash received from sales 46,260 48,110
Costs and expenses 39,443 41,021

Vehicles 5,000 0
Tax 1,490 1,656
Dividends 1,905 2,000
Interest 450 450
Total outflows (48,288) (45,127)
Net cash flows (2,028) 2,983

Opening cash balance 348 (1,680)
Closing cash balance (1,680) 1,303
An alternative, equally acceptable, approach to presenting the cash flow forecasts is as

follows. Note that IAS7 allows for some discretion in the presentation format of cash flow
statements. The question here required a forecast rather than a published statement and any
sensible format gained credit.
2010 2011
£000 £000
Operations
Profit before financing costs 6,520 6,801
Add back depreciation 500 500
Change in receivables (540) (562)
Change in payables 337 350
Subtotal 6,817 7,089
Interest paid (450) (450)
Taxation (1,490) (1,656)
Net cash flows from operations 4,877 4,983
Investments
New vehicles (5,000) 0
Financing
Dividends paid (1,905) (2,000)
Total net cash flows (2,028) 2,983
Opening cash balance 348 (1,680)
Closing cash balance (1,680) 1,303
There is need to finance a cash shortfall of £1,680,000 by the end of 2010. Of course, if the
vehicles are bought early in 2010, there may well be a requirement to finance a much greater
cash shortfall earlier in the year. There is insufficient information in the question to comment
further on this. By the end of 2011 there is a positive cash balance of ₤1,303,000 by just over
half way through the year (if cash flows are spread more or less evenly throughout the year).
If sales increase as forecast the cash balance is likely to become positive earlier.
As the shortfall is caused by the purchase of new assets, there should be no problem
increasing the overdraft limit given the size of the entity and the relatively short period of time
this facility is needed. Other possibilities include supplier credit or short-term leasing.
It could be argued that as these are long term assets they should be funded by long-term
finance but the amount is relatively small compared to the value of the entity.
A problem that needs to be addressed is the disparity between the ratio of trade receivables
to sales and trade payable to purchase costs & expenses. The former is 30% and the latter
22%. However a breakdown between cost of sales and operating expenses is necessary to
analyse the problem further.

Requirement (c)
Key aspects and implications

Preliminary calculations:
2009 2010 2011
£000 £000 £000
Total equity:
Share capital 4,204 4,204 4,204
Retained earnings 16,210 18,885 21,580
Total equity 20,414 23,089 25,784
Return on shareholders’ funds 22.2% 19.8% 18.2%
EPS – pence 27.0 27.2 27.9

% increase - 0.7 2.6
DPS – pence 10.8 11.3 11.9
Return on shareholders’ funds:

EF met this objective in 2009 but narrowly falls short in 2010 and the ratio declines even
further in 2011. The new assets might begin to contribute to an improvement but they are
clearly replacement assets for an existing facility and as such are unlikely to have a significant
impact.
The management of working capital needs to be addressed as noted above.
Investment and financing:

No investment appraisal appears to have been carried out for the purchase of the new assets.
This should be done before the investment is made, even though the entity appears more
than capable of funding the purchase.
Increase in earnings:
The increase in earnings is well below EF’s target for 2010 and 2011 but is moving in the right
direction. The main impact in 2010 was the sudden increase in depreciation (although there
was a tax benefit as tax depreciation allowances were higher than book depreciation). EF
needs to examine its costs and expenses as these are increasing in line with sales. There
might be scope for reducing costs by reviewing its suppliers and/or terms of trade, and
possible elimination of some expenses.
Dividends:
DPS are growing at 5% as per the scenario. If earnings increase in the future at the target
rate of 8% then this implies EF will build up its retained earnings for future investment
(assuming finance is available). The entity should perhaps review its dividend policy in the
light of investment opportunities.
Key assumption regarding overdraft interest:

The removal of the simplifying assumption regarding overdraft interest can be expected to
have a significant effect on forecast cash flows after tax. Indeed, the increase in earnings that
is observed above is so small that an increase in overdraft interest in 2010 could reduce
earnings to the point at which earnings actually decline in 2010 from 2009 levels.
I would advise the compilation of a more accurate calculation of overdraft interest (or deposit
interest if there is a positive cash balance) and the associated tax benefit (or tax expense).
This would involve identifying the timing of large items such as tax and dividend cash flows in
order to calculate an average cash balance for each year. An estimate of overdraft interest or
deposit interest could then be calculated based on that average cash balance and an

assumed average overdraft or deposit rate. Note that any overdraft or deposit interest and
associated tax cash flows will affect the closing cash balance for the year and therefore also
impact on average cash balance and interest and tax cash flows in the following year.

CIMA 2010 Chartered Management Accounting Qualification - Specimen Examination Paper P3
Pillar P
P3 – Performance Strategy
before attempting the question concerned (that is, all parts and/or sub-
Maths Tables are provided on pages 13 and 16.
The list of verbs as published in the syllabus is given for reference on page
17
to close.
Tick the appropriate boxes on the front of the answer book to indicate which

Power Utilities
Pre-seen Case Study
Background
kept low.
Industry structure
weather conditions.
Specimen Exam Paper 2 Performance Strategy

Structure of PU
headquarters.
Governance of EGC
company.
Performance Strategy 3 Specimen Exam Paper

of PU.
Capital market
improve.
the environment.)


nationalised.

APPENDIX A


P$ million
ASSETS
Current assets
Inventories 1,529
Receivables 2,679
4,341
Total assets 20,178

Equity
Share capital 5,525
Reserves 1,231
Total equity 6,756
Current liabilities
Payables 3,862

[The indicative time for answering this section is 90 minutes]
Question One
New investment
Following the privatisation of PU, the board are now considering the investment needed to
retain and improve the productive capacity available to the company. Currently, PU operates
12 power stations which were all built over 15 years ago. Life expectancy for coal fired power
stations is around 25 to 30 years. This means that all 12 power stations will need replacing
within 10 to 15 years. This will be a significant capital cost for PU which will almost certainly
have to be financed by borrowing or other forms of external investment.
Although the Asian country PU operates in does have coal reserves to fuel new coal fired
power stations, the board are keen to investigate other methods of power generation such as
gas, nuclear and more environmentally friendly alternatives such as wind and wave power. If
coal fired power stations are built they will have to meet new environmental legislation in the
Asian country, as well as global agreements to decrease the amount of Carbon Dioxide
emissions from this type of power station. This will mean that the cost per power station will
be higher in real terms than when the power stations were first built.
The non-executive directors in PU have recently identified that there is a lack of an effective
Executive Information System for the Board. This means that board members cannot either
monitor the current management and financial information produced within PU, or appraise
new investment projects. One option to replace coal fired power stations is coal gasification.
In this process, coal is mixed with oxygen and water vapour under pressure, normally
underground, and then pumped to the surface where the gas can be used in power stations
or converted into petrol and other similar fuels. The process has the benefit of significantly
reducing carbon dioxide emissions although the technology is not widely used at present and
not on any significant commercial scale.
One of the non-executive directors is aware that country Zee is a market leader in coal
gasification processes. Country Zee is located in Africa; while Zee appears to be financially
stable, there is some political unrest caused partly from ethnic divergence and issues of
inequitable income distribution. Country Zee appears keen to retain its lead in this
technology; at present the technology has only been made available to one other company in
another country. The government of country Zee required this company to establish a
subsidiary in Zee and manufacture the gasification equipment in Zee prior to export to the
other country. This is the only method currently available to obtain the technology. To repeat
the process, an initial investment will be required in Zee$, although the government
guarantees to purchase the subsidiary at prevailing market prices in Zee after five years. A
further requirement was that 80% of the workforce had to be drawn from the population of
country Zee.
Environmental information
Legislation in the Asian country requires PU to provide environmental information each year
on its activities, with specific reference to emissions of carbon dioxide from its power stations.
This environmental information is collated at each power station and then forwarded to PU’s
head office for inclusion within PU’s overall environmental report. Information from each
power station is audited on a rotational basis by PU’s internal audit department.
This year, power station N3 was part of the rotational audit. The internal audit department
discovered significant discrepancies between the published emissions information and actual
information obtained from the records maintained in the power station itself. The manager of
the power station indicated that emissions were actually higher than expected due to faulty

extraction filters fitted to the power station. Although PU’s head office was aware of the
problem, funds were not made available to rectify this. The matter was reported by the head
of internal audit to the Managing Director with the recommendation that the emissions
information was amended to show actual emissions.
Required:
Working as a consultant to the board of PU:
(a) The board of PU needs to assess methods of power generation in

preparation for replacing the existing coal fired power stations. Advise the
board how to develop an Information strategy to support this objective.
(12 marks)
(b) Evaluate the financial and other risks affecting PU if a subsidiary is

established in Zee to manufacture coal gasification equipment.
(16 marks)
(c)
(i) PU’s internal audit department may be asked to participate in the environmental
audit of PU.
Explain the term “environmental audit” and evaluate the attributes that PU’s
internal audit department should have prior to carrying out this work.
(8 marks)
(ii) There is a discrepancy in environmental returns from power station N3.

Recommend the actions (apart from reporting to the Managing Director)
that the internal audit department of PU should undertake regarding this
situation.
(8 marks)
(d) Discuss the extent to which false reporting of environmental information is

a source of risk to PU and explain control mechanisms that may be used
to avoid false reporting.
(6 marks)
(Total for question One = 50 marks)
End of Section A

SECTION B
[The indicative time for answering this section is 90 minutes]
ANSWER TWO OF THE THREE QUESTIONS – 25 MARKS EACH.
Question Two
The Y company produces a range of dairy products such as yoghurts, cream and butter from
one factory. The main ingredient for these products is milk, which is obtained from 27
different dairy farms (fields where cows are allowed to graze and produce milk) within a 60 km
radius of the factory. Y requires that milk must be delivered within 6 hours of being obtained
from the cows and that the farms themselves use “organic” principles (farming without using
manmade pesticides, growth hormones etc.). Transportation systems in Y’s country are good
and milk is rarely delivered late.
Each farm provides a quality certificate on each batch of milk produced confirming adherence
to these standards (this is important to Y although customer satisfaction surveys show Y
products are sold on taste, not sourcing of ingredients).
In Y’s factory, yoghurt is produced in batches. The inputs to each batch such as milk, fruit,
appropriate bacteria and other ingredients, are recorded in the batch database showing the
source of that ingredient, that is the specific farm. During production, Y’s quality control
department tests each batch for purity (lack of contamination from harmful bacteria etc) and
acceptable taste, with the results being recorded in the quality control database. Any batches
not meeting quality standards are rejected and destroyed. Y’s costing systems have
maintained a 5% failure rate in production for the last 6 years which is now well in excess of
the industry average.
On completion of each batch, the quality control department again undertakes purity control
and taste testing. Batches are rejected where standards are not met; a further 2% failure rate
is expected at this stage.
Batches of yoghurt etc are packed on Y’s premises and then despatched for sale via retail
outlets such as supermarkets; Y does not sell direct to the consumer. However, Y has an
excellent brand name resulting from innovative advertising and high product quality. Product
reviews in magazines and news websites have always been favourable meaning that Y does
not need to pay much, if any, attention to customer feedback.
Required
(a) Evaluate the control systems in Y for the manufacture of yoghurt,
recommending improvements to those systems where necessary.
(12 marks)
(b) Explain the process of risk mapping and construct a risk map for Y. Discuss
how risk mapping can be used within the Y organisation.
(13 marks)

Question Three
A is a small company based in England. The company had the choice of launching a new
product in either England or France but lack of funding meant that it could not do both. The
company bases its decisions on Expected Net Present Value (ENPV) and current exchange
rates. As a result of this methodology, and the details shown below, it was decided to launch
in England (with an ENPV of £28,392) and not France (with an ENPV of £25,560).
England France
Probability Probability
Launch Costs Launch Costs
£145,000 0·1 £190,000 1·0
£120,000 0·9
Annual Cash Flows Annual Cash Flows

£65,000 0·4 £90,000 0·5
£42,000 0·4 £70,000 0·2
£24,000 0·2 £30,000 0·3
Required:
(a) Discuss the risks associated with each launch option. Advise how these risks may be
managed by the company.
(12 marks)
(b) Company A wishes to raise 3 year £500,000 floating rate finance to fund the product
launch and additional capital investments. Company A has a choice between:
Alternative A: floating rate finance at LIBOR + 1·2% or
Alternative B: fixed rate finance at 9·4%, together with an interest rate swap at a
fixed annual rate of 8·5% against LIBOR with a swap arrangement fee of 0·5% flat
payable up front
Required:
(i) Discuss the potential benefits and hazards of interest rate swaps as a tool
for managing interest rate risk.
(8 marks)
(ii) Ignoring the time value of money, calculate the total difference in cost
between the two alternative sources of finance available to Company A.
(5 marks)
(Total for part (b) = 13 marks)

(Total for question Three = 25 marks)

Question Four
X is an organisation involved in making business-to-business sales of industrial products. X
employs a sales team of 40 representatives and assigns each a geographic territory that is
quite large. Sales representatives search for new business and follow up sales leads to win
new business, and maintain contact with the existing customer base.
The sales representatives spend almost all their time travelling to visit clients. The only time
when they are not doing this is on one day each month when they are required to attend their
regional offices for a sales meeting. Sales representatives incur expenses. They have a
mobile telephone, a fully maintained company car and a corporate credit card which can be
used to pay for vehicle expenses, accommodation and meals and the cost of entertaining
potential and existing clients.
The performance appraisal system for each sales representative is based on the number and
value of new clients and existing clients in their territory. All sales representatives are required
to submit a weekly report to their regional managers which gives details of the new and
existing clients that they have visited during that week. The regional managers do not get
involved in the daily routines of sales representatives if they are generating sufficient sales.
Consequently, sales representatives have a large amount of freedom.
The Head Office Finance department, to whom regional managers have a reporting
relationship, analyses the volume and value of business won by sales representatives and
collects details of their expenses which are then reported back monthly to regional managers.
At the last meeting of regional managers, the Head Office Finance department highlighted the
increase in sales representatives’ expenses as a proportion of sales revenue over the last two
years and instructed regional managers to improve their control over the work representatives
carry out and the expenses they incur.
Required:
(a) Explain what an internal control system is, how it relates to the control
environment and its likely costs, benefits and limitations.
(8 marks)
(b) Discuss the purposes and importance of internal control and risk management
to the X company and recommend action that should be taken to overcome any
perceived weaknesses identified in internal control and/or risk management
systems.
(12 marks)
(c) Recommend how substantive analytical procedures could be used in the

internal audit of X’s sales representatives’ expenses.
(5 marks)


Present value table
Present value of $1, that is 1 r 

n
where r = interest rate; n = number of periods until
payment or receipt.
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n
1 (1 r )  n
years r

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

Formulae
Annuity
Present value of an annuity of £1 per annum receivable or payable for n years, commencing
in one year, discounted at r% per annum:
1 1 
PV = 1  
r  [1  r ] n 
Perpetuity
Present value of £1 per annum, payable or receivable in perpetuity, commencing in one year,
discounted at r% per annum:
1
PV =
r
Growing Perpetuity
Present value of £1 per annum, receivable or payable, commencing in one year, growing in
perpetuity at a constant rate of g% per annum, discounted at r% per annum:
1
PV =
r g


Level 1 - KNOWLEDGE
State Express, fully or clearly, the details/facts of
Explain Make clear or intelligible/State the meaning
or purpose of
consideration
something
How you are expected to apply your knowledge. Apply To put to practical use
Calculate/compute Ascertain or reckon mathematically
Demonstrate To prove with certainty or to exhibit by
practical means
Level 4 - ANALYSIS
How you are expected to analyse the detail of Analyse Examine in detail the structure of
between
How you are expected to use your learning to Advise Counsel, inform or notify
Recommend Propose a course of action

Performance Pillar
Specimen Paper
Wednesday Morning Session

CIMA 2010 Chartered Management Accounting Qualification – Answers for Specimen Examination Paper P3

SECTION A

Requirement (a)
Business strategy
In this situation, the business strategy has been clearly defined; that is the coal fired power
stations need to be replaced and the board will require information on the power generation
options available the relevant merits, costs etc. of each alternative. The Information Strategy
must therefore support this business strategy. In terms of Anthony’s generic IT strategies,
system development will follow the Business Led “leg”.
Information strategy
The Information strategy will therefore need to focus on the specific information required by
the board to enable an informed investment decision to be made. Information requirements
will focus on the strategic level information. In this situation information requirements will
include:
 Analysis of the different power generation options or coal, gas, nuclear and
wind/wave including costs and benefits of each option.
 Feasibility of each option for PU taking into account existing knowledge base,
resources available (eg funds) etc.
 Feasibility of each option in terms of establishing that power generation system within
the Asian country. For example, the availability of gas (as compared to coal) or
regions with sufficient wind for turbines must be considered.
Initially the information strategy must be to obtain and start to analyse this data; this may
involve the recruitment of a management accountant with appropriate skills to obtain the data.
Development of the strategy can then be divided into three specific sections:
Information Systems Strategy

The IS strategy will determine the actual systems required to provide the strategic
information. The need for an information specialist has already been noted. However, there
will also be information collection requirements in terms of obtaining internal and external
information. The information requirements list identifies the need for data from PU’s existing
accounting systems (costs of running coal fired power stations) as well as external links to
obtain data on other power generation methods (use of the Internet / access to providers of
power stations etc will be essential). Consideration will also be required of future information
needs and where appropriate, planning carried out to ensure that those needs will be met.

Information Technology Strategy

The IT strategy will determine the actual hardware and software requirements to provide the
information identified in the IS strategy. As information is being provided to the board,
provision of systems capable of detailed graphical output as well as ability to analyse different
financial options quickly would be expected. Large computer systems, significant processing
power and storage are expected.
Information Management Strategy

The IM strategy will determine how the information collected is provided to users and
protected or backed up securely as required. IT infrastructure must ensure links from the
information specialists to the board as well as offsite backup of data. A further consideration
will be security of information produced for the decision. While external links will be
necessary to collect data, information on alternatives will be sensitive and only accessible by
the board of PU. Provision of data via a secure firewall to the board EIS, possibly with no
other external access for security, will maintain information integrity.
Costs
Finally, the cost of the strategies must be determined and a budget agreed by the board
ready to establish the necessary information systems to analyse the investment decision.
Requirement (b)
Economic risks
Economic risk is the risk that exchange rate movements might reduce the international
competitiveness of a company and/or that the company’s future cash flows may be reduced
by adverse exchange rate movements.
Economic risk can affect PU in two ways:
 Firstly, as parts for the gasification process would have to be manufactured in Zee,
PU would have to transfer funds to Zee to pay for that manufacture. If the currency of
Zee appreciates over time then PU would have to remit additional funds to pay to
continue to obtain the same quantity of manufactured items.
 Secondly, PU would be required to establish a subsidiary in Zee. The government of

Zee indicate that the subsidiary can be sold after the gasification equipment is
manufactured. However, if the currency of Zee depreciates against the Asian country
then the value of that investment will fall. PU will therefore make a loss when the
subsidiary is sold.
Translation Risk
This is the risk that an organisation will make exchange losses when the accounting results of
foreign subsidiaries are translated back into the home currency.
If PU establishes a subsidiary in Zee, then that subsidiary would be consolidated into PU’s
financial statements each year. The rate used will be the date of the statement of financial
position. Translation losses will mean that the value of the subsidiary will fall over time,
showing a lower value in the financial statements of PU. While this has no effect on cash flow
until the subsidiary is sold (see economic risk above) any fall in value could still affect the
investor’s attitudes to PU and may make it more difficult for PU to raise additional funds if
subsidiary values fall significantly.
Transaction Risk
This is the risk that an organisation will be subject to exchange gains on losses where goods
are imported or exported and the settlement date for the contract for import or export is at
some future date. The risks it that the exchange rate changes between import/export and the
receipt/payment of monies for those goods.

If PU establishes a subsidiary in Zee, then goods will be sent to Zee and/or back to PU’s
home country. Where exchange rate movements are expected, either PU or the subsidiary
could delay payment/receipt for those goods if that exchange rate movement is favourable for
that entity.
Exchange rate changes will also affect any internal transfer prices which may mean
monitoring of these changes to ensure that the transfer price does not become uncompetitive
compared to third party suppliers.
Political risk
Political risk is simply the risk that political action affects the position and value of a company.
Various political risks could affect PU as follows:
 Firstly, PU will be required to employ a given percentage of workers from within Zee.
There is a risk that sufficient employees with appropriate skills may not be found,
limiting the ability of PU to manufacture gasification equipment. Alternatively, higher
wages will have to be paid to attract workers with the necessary skills. Late delivery
of equipment will have a financial impact on PU due to late start date for the projects
and delaying income streams results from the sale of fuel.
 Secondly, political uncertainty could result in workers striking, again delaying

manufacture and installation of equipment. PU may incur costs for late delivery /
installation of equipment.
 Thirdly, additional export controls could be imposed on PU, limiting ability to transfer
equipment from Zee to its Asian home country. Although this is unlikely due to Zee
wanting to encourage investment, the risk could still crystallise with a change in
government, for example. PU could be adversely affected financially if equipment
has to be manufactured outside of Zee, especially where contracts are given to a
third party. Alternatively, PU may have to pay higher taxes perhaps in the form of
export duties, which again will have a financial impact on the company.
Product risks
Product risks include produces not meeting specific legislative requirements, potential breach
of copyright through to the product not performing as specified.
Product risk can affect PU in various ways including:
 Firstly, the coal gasification process has not, as yet, been developed on a large
commercial scale. There is a risk therefore that the process does not work as
specified in the Asian country. The financial impact on PU may be significant unless
appropriate insurance has been obtained or indemnities from the government of Zee.
 Secondly, the process may work, but not as expected. The gasification process itself
may be unstable and cause environmental or other damage in the Asian country. PU
may incur rectification costs unless again appropriate insurance or indemnities have
been obtained.
Trade and credit risk

Trade and credit risk relate to a business trading in more than one jurisdiction.
PU will be effectively buying the gasification equipment from another jurisdiction (Zee). Risks
in this category which will have a financial impact on PU should be limited to risk of damage
or loss of equipment in transit not met by insurance. PU will be purchasing from its own
subsidiary which will limit the possibility of other risks such as default in payments. However,
transaction risk will also need to be considered as noted above.

Requirement (c)(i)
An environmental audit is, according to CIMA, a systematic, documented, periodic and

objective evaluation of how well an entity, its management and equipment are performing with
the aim of helping to safeguard the environment by facilitating management control of
environmental practices and assessing compliance with entity policies and external
compliance with entity policies and external regulations.
In terms of PU, the main focus of the audit will be the power stations with specific focus on the
carbon dioxide emissions those stations produce. The importance of monitoring and limiting
these emissions is important not only from the Asian countries legislation but also from global
agreements to limit this “greenhouse gas” in the future.
Prerequisites for the internal audit department of PU which may be involved in an

environmental audit of PU include:
Skills and experience

Staff in the department will need appropriate skill and experience in conducting audits. This
does not necessarily mean they need to be qualified accountants, but they must be able to
understand the process of internal audit and apply this to the work being carried out. Of vital
importance is the ability to recognise errors and discrepancies identified as part of their work.
Knowledge of subject material

Staff must be aware of the criteria being used as part of the audit. In this situation, they must
understand the environmental legislation, the standards to be adhered to and then the
reporting requirements within that legislation.
They must also then be able to obtain the relevant information from within PU, compare this
to the environmental standards.
Organisational standing
The internal audit department itself must be sufficiently independent to be able to produce
reports without bias that will be acted on by the board of PU. In this situation, the department
must report to the audit committee of PU. As the audit committee will comprise non-executive
directors, they can ensure that the reports of internal audit are acted on and appropriate
disclosure of any discrepancies is made.
Requirement (c)(ii)
Actions that the internal audit department of PU should undertake regarding falsification of
environmental returns from power station N3 include:
Report to the audit committee

The internal audit report must clearly state the work carried out and the findings in respect of
the false reporting and therefore opinion on that report. The responsibility of internal audit
technically ceases when the report is made to the audit committee although the head of
internal audit may also want to ensure appropriate action is taken in respect of the report by
the committee.
Remedial actions – previous reports

The integrity of previous environmental reports is called into question as the N3 power station
information is incorrect this year. Internal audit may decide to review prior year reports from
N3 to ensure they are correct.
Review of results from other power stations

Following on from the above point, reports from other power stations where reported
emissions are better than expected could also be audited, even if they are not part of the
standard rotational audit this year. This additional work will help to determine whether the N3
power station report was an isolated case or more endemic across the whole of PU.

Remedial actions – control systems

The internal audit department could also recommend additional control procedures to try and
avoid false reporting in the future. One option would be to increase internal audit work on the
reports to review all reports annually rather than on a rotational basis. Alternatively, another
responsible official could be tasked with checking and signing off the environmental report
from each power station. While the latter would not remove false reporting, some collusion
would now be necessary to perpetrate the false report.
Requirement (d)
False reporting of environmental information in PU is potentially a source of risk because:
 Environmental reports will be inaccurate. This will potentially undermine the integrity
of other reports from PU and may provide adverse publicity for the company.
 Breach of environmental legislation may result in monetary fines being levied against
PU. Again, imposition of a fine may result in adverse publicity for PU.
 False reporting may be indicative of an inappropriate management attitude to risk and

control within PU. If false reporting is effectively condoned in one area (the MD being
in agreement with the report) then staff may see this as an excuse to produce false
reports in other areas. The whole control and reporting system within PU could be
undermined.
Control mechanisms that could be used to avoid false reporting include:
 Use of an internal audit department (as PU have at present) as both a check on the
accuracy of reporting as well as a deterrent against false reporting; the fact that
internal audit may identify false reports should deter false reporting initially.
 Management setting the appropriate “tone” within the organisation. The MD

condoning the false reporting is obviously not appropriate in this respect.
 Contracts of employment clearly stating that ethical principles are important and
breach of principles will result in disciplinary action.
 For important positions such as board membership or managers of power stations,

ensuring that the post holder is a member of a professional organisation (such as
CIMA) where members are expected to follow ethical principles.

SECTION B
Requirement (a)
Inputs
Y obtains the milk and other ingredients for its products from farms within a 60 km radius of its
main processing factory. The milk etc. needs to be assessed for quality (freshness and
organically produced) prior to entering the production process. At present, Y relies on a
statement of quality from each individual farm. While the farms reputation and future sales
would be decreased should the quality certificate be incorrect, there is no independent check
on the quality of input. This weakness can be overcome in two ways:
 Firstly, an independent company can be appointed to verify the accuracy of the quality
certificate produced by each farm. Milk delivered to Y needs to be produced by “organic”
cows. In the UK, companies such as the Soil Association (in South Africa AFRISCO)
provide this service. As the verifier is independent of the farm, their report can be trusted
to confirm the organic quality.
 Secondly, Y can perform quality control checks on milk received before it enters the
production processes. Assessing quality during the production process may be too late
as whole batches of product will have to be destroyed, and it may not be possible to
identify the precise farm that the milk or other ingredient was derived from due to mixing
of inputs during processing.
Processing – quality control

During manufacture, Y’s quality control department tests products for contamination from
bacteria as well as meeting expectations regarding taste and flavour. Any batches of product
not meeting quality control standards are rejected. However, information on the reasons for
rejection are them simply stored as independent records in a database; there is no attempt to
feedback reasons for quality deviations into the processing system to either amend inputs or
identify where potentially contaminated batches of input were obtained.
Given that inputs into each batch of production are recorded on one database, and quality
control reports on another, information concerning quality failures can be easily matched by
comparing database records. Providing this matching would help Y improve product quality
by identifying farms where poor quality milk was obtained, and by identifying how the product
mix can be improved to enhance taste.
Processing – batch rejection rate

A 5% batch rejection rate is expected during production. It is not clear how the 5% figure was
derived or whether this rate is “achieved” within Y. Ideally, rejection rates should be below
5% with feedback from quality control providing reasons for batch failure which can be used
to minimise batch failures in the future. The discrepancy compared to industry average would
support this view. As the 5% rejection figure has not been amended for 6 years, it appears
this feedback control is lacking. Implementing the control as part of quality management
would reduce rejection rates, allowing the rejection rate to be set at a lower target in future
budgeting periods. Overall production costs would also fall with fewer rejected batches.
Output
Testing of outputs from Y production systems appears to be satisfactory. All batches are
tested and again batches rejected where quality control standards are not met. As with
processing, the lack of feedback control means batch quality may not be improved over time.
The main weakness with output controls is lack of use of customer feedback. In this respects,
Y is a closed system in that comments from customers are not used to enhance product taste

or quality. Although Y does have a good brand name, this does not mean that either existing
products cannot be changed or that new products (such as new yoghurt flavours) cannot be
suggested by customers. Providing some formal feedback mechanism via the company’s
website help Y to ensure that its products continue to be aligned to customer requirements.
In other words, Y’s quality systems should be “open” to external suggestions and
improvements.
Requirement (b)
Risk mapping is a method of determining the potential importance and impact of risks on an
organisation. The map can be constructed as a 2 x 2 or 3 x 3 matrix, depending on the level
of detail required. In some situations, even larger maps will be necessary.
In the map below, the Y axis shows the severity or potential impact of a risk on Y with the X
axis showing how likely that specific risk is to actually occur.
 High likelihood, high impact risks are risks which will have a significant impact on the
business and are likely to occur. Risks is this category must be monitored closely and
either control systems put in place to ensure those risks do not occur or that any
potential damage is mitigated as far as possible.
 High likelihood, low impact risks, while likely to occur, will not necessary have a
significant effect on the company. These risks require monitoring to ensure they do not
move into the high severity category.
 Low likelihood, high impact risks will have a significant effect on the company, show
they actually occur. Again, control systems will be required to ensure that the risks are
monitored and action taken should it appear that the risk will crystallise.
 Finally, low likelihood, low impact risks are unlikely to have any significant impact on
the company and are normally ignored.
In Y, a risk map can be constructed as follows:
Likelihood
High Low
• Batches of product pass • Late delivery of milk – production is
quality control which should disrupted and possible loss of quality
fail. Although quality control of product.
tests appear good, releasing
sub-standard food has risks • Customers change tastes – unlikely
of causing illness and in the short term but lack of analysis
consequent adverse of customer feedback means Y may
High
publicity. not amend product in line with

customer expectations.
Impact
• Adverse impact on brand

name causes loss of sales. • Products are considered not to be
“tasty” by consumers – Y’s main
selling point is taste. Potential loss
of market share.
• Milk does not have quality • Insufficient inputs are obtained (has
certificate (less important to contracts with a range of farms).
Low
Y’s customers.

Risk maps can be used within Y as follows:
 Firstly, to provide a framework around which risks applicable to Y can be analysed.

This will specifically show the “hi:hi” category risks – as in those for which a risk
response must be determined.
 Secondly, to ensure that appropriate controls and risk management systems are in
place to mitigate the impact of any risks actually crystallising. The main risk not
sufficiently well covered is that customers may change “taste” causing demand to fall
for Y’s products.
 Thirdly, to recommend improvements to internal control systems to mitigate risks where

control systems are poor. Within Y, there is a need to actively monitor customer
feedback to ensure products do continue to meet customer “tastes”.

SECTION C

Requirement (a)
There are two types of risks faced by A in making its launch decision. The first set of risks
relate to the market conditions, strategic implications and cash flow risks of the two alternative
locations. The second set of risks relates to the limitations of the methodology chosen for
decision- making.
Overseas expansion
The risks associated with expanding overseas are very different to the risks of focusing on the
domestic market. There are issues of cultural understanding, language, exchange rate risk,
and broader market knowledge that all need to be taken into account in the decision process.
Some of these risks can be reduced by additional market research and changes in company
strategy such as the use of a joint venture arrangement. Others may be more difficult to
eradicate and the potential threat they pose to cash flows needs to be incorporated into
decision making.
Expansion opportunities – home or overseas marketplace

By launching in the UK rather than France, A‘s decision ignores the broader strategic
considerations, and their associated risks, with the result that the company forfeits potential
expansion opportunities. These opportunities may not appear financially viable over the time
frame used for the investment decision, but may be important for the long term development
of the business. In the absence of additional information, if A is assumed to be a UK based
company, then a UK launch simply means that it is expanding its position within the domestic
market place. This may bring good short term growth levels for the business, but may not
offer the longer term potential of a move into Europe, which could open up a significant range
of new opportunities.
This risk is difficult to mitigate as A will never know the results of the alternative investment
decision, had it been made. Risk mitigation will focus on ensuring that A has a balanced
project portfolio, minimising the risk to A overall of one country providing less than acceptable
returns, or one type of project providing less than acceptable returns.
Exchange rate risk

In purely financial terms France seems to pose less risk because the launch costs appear
certain, but this is not actually true in reality. There is a risk that the exchange rate will change
between the date of the decision and the date at which the costs are incurred, but this could
be managed relatively easily by the use of a forward contract that would fix the exchange
rate.
Cash flow risk

The exchange rate risk extends to affect the cash flows throughout the life of the product.
Even a small change in the exchange rate can reverse the project rankings in terms of their
ENPV.
The risk can be better understood via the application of sensitivity analysis on the NPV using
different exchange rate scenarios, and the resulting exchange rate uncertainties can be
managed via the use of a range of different hedging tools. These may include both internal
and external hedging, such as netting, forward contracts, futures, or currency swaps. The
exchange rate risk implicit in the launch in France may be regarded as significantly affecting
the project’s risk profile relative to the UK launch, and consideration must be given as to
whether this additional risk is acceptable to the Board of Directors.

Product margin not achieved

The relative risk for the UK is that the contribution margin is comparatively low, which leaves
limited scope for price cutting if the launch is not successful. This is counterbalanced by the
fact that the probability schedule indicates that higher rather than lower sales levels are the
most likely, but even these are not certain.
The risk of low margins can be managed by detailed market research to evaluate the price
elasticity of demand for the product. It may be that the net contribution could be increased by
raising prices (and margins) in combination with lower sales volumes.
Project risk – discount rate used

One possible approach to dealing with different levels of risk across projects would be to
adopt different discount rates with a higher rate being applied to the project perceived as
carrying the greater expected risks. This method creates a problem insofar as each additional
risk has to be allocated a value in terms of a discount rate adjustment and this requires the
use of subjective judgement. Additionally, a discount rate adjustment may not be necessary
for some of the risks, such as exchange rate volatility because these may be managed via the
use of hedging tools.
An alternative approach, as used in this case, is to use a common discount rate for both
France and the UK. The final choice is then made by subjectively comparing the resulting
ENPVs. Making this type of judgement is also difficult, however, because the ENPV for the
UK is just £2,832 higher than that for France.
NPV calculations
The NPV calculations are based on expected costs and expected contribution levels. In
practice it is unlikely that the expected values will ever be realised, which means that there is
a possibility that the ENPV for the UK may actually be lower than expected or even lower than
in France. Furthermore, the cash flow forecasts are based upon just four years of data, whilst
the effective product life may be much longer. As a result, the decision may be based upon
incomplete information.
There is a limit to how far this risk can be mitigated as the future is uncertain. Attempting to
ensure that the cash flow forecasts are as accurate as possible by having them prepared and
reviewed by competent professional staff will help.
Requirement (b)
Interest rate swaps are a useful tool for the management of interest rate risk because they
allow a company to switch between fixed and variable rate loans, and therefore take a
position on the future direction of interest rates. For example, a company may believe that
interest rates have “bottomed out” and hence choose to swap its variable rate loans for fixed
rate ones set at the current low interest rate level. In making this swap, the company is
affirming its belief that future rates will rise ie taking a position.
In many but not all cases, swaps are used to obtain funding at a lower rate than that available
elsewhere, but they can also be used beneficially to manage future cash flow patterns. If, for
example, a company is operating in a market where its incoming cash flows are uncertain, it
may wish to use a swap to ensure that it has fixed rate commitments that are wholly
predictable. In so doing, it minimises uncertainty of outgoings even if it cannot eliminate the
uncertainty in respect of incoming cash.
Interest rate swaps may also be used to manage interest rate risk in respect of investments
rather than borrowings. In such cases a swap may be useful in enhancing the returns via
speculation on interest rate movements. One such example would be a decision to swap a
variable rate for a fixed rate investment in the belief that interest rates will fall.
A key advantage of interest rate swaps is that because they are an over the counter product,
they can be tailored to meet the specific needs of the company, in terms of both their duration
and value. Where the swap is arranged without the use of an intermediary, transaction costs

are also kept to a minimum, although this also results in a disadvantage because it creates a
counterparty credit risk. In the absence of an intermediary, there is no guarantee that the
counterparty will fulfil their part of the contract, although this credit risk can be minimised by
seeking a credit rating on the counterparty before agreeing to a swap.
Another disadvantage of swap arrangements is that the binding nature of the agreement
means that a company may find itself unable to take advantage of changing interest rates that
move in its favour. This problem is reinforced by the lack of a secondary market for swaps
which means that it is difficult if not impossible to liquidate a contract.
Alternative A
Pay annual interest of: (LIBOR + 1·2%)
Alternative B:
Pay interest on borrowing of: (9·4%)
Pay interest under swap of: (LIBOR)
Receive interest under swap of: 8·5%
So pay net annual interest of: (LIBOR + 0·9%)
Annual interest saving 0·3%

Total interest saving over 3 years 0·9%
Less arrangement fee (0·5%)
Net total cost saving 0·4%, that is £2,000


Requirement (a)
Internal control system and the control environment
Internal control is the whole system of financial and other internal controls established in order
to: provide reasonable assurance of effective and efficient operation; internal financial control;
and compliance with laws and regulations. While the internal control system includes all the
policies and procedures, the control environment is the overall attitude, awareness and
actions of directors and management regarding internal controls and their importance to the
organisation and encompassing management style, corporate culture and values.
A system of internal control will reflect its control environment and include: control activities;
information and communication processes; and processes for monitoring the effectiveness of
the internal control system. The system of internal control should be embedded in the
operations of the company and form part of its culture; be capable of responding quickly to
evolving risks; and include procedures for reporting immediately to appropriate levels of
management any significant control failings or weaknesses.
Costs, benefits & limitations

The costs of internal control will comprise the time of regional managers and any opportunity
costs resulting from this plus costs associated with introducing and operating new systems
and reports. However, it is difficult to differentiate between internal controls and policies and
procedures that are simply good business practice, e.g. human resource practices and
accounting procedures. A cost of internal control may be restrictions on the flexibility,
creativity and responsiveness of the organisation.
The benefits of internal control may be difficult to identify but can be largely considered to be
an improvement in the efficiency and effectiveness by which sales representatives use their
time to win business, and the improved management of costs associated with their activities.
These are largely concerned with eliminating both waste and fraud. Losses incurred from
ineffective internal control can be estimated based on their level compared to targets or by
benchmarking representatives against each other or by observing the trend over time. To the
extent that effective internal control provides assurance to external auditors it can be used in
negotiations to reduce the external audit fee.
A system of internal control cannot eliminate: poor judgement in decision-making; human

error; the deliberate circumvention of control processes (especially where collusion occurs);
the overriding of, or lack of emphasis on, controls by senior management; and unforeseeable
circumstances.
Requirement (b)
Internal control and risk management systems are established in an organisation in order to
ensure that activities are carried out in accordance with the policies and procedures of the
organisation and any risks of those policies and procedures not being followed is mitigated as
far as possible.
In X, there appear to be two key risks that need to be considered:
 the lack of control over the activities of sales representatives that may result in them
not spending their time efficiently and effectively on business activities; and
 the incurrence of costs that are unauthorised or unnecessary.
The first results in paying salaries for representatives but obtaining inadequate or
inappropriate efforts from them. This has both a financial and an opportunity cost. The second
results in excessive financial costs. Both are largely a problem of agency in which there is
information asymmetry between the sales representative and regional manager. There is also
an issue of moral hazard in which there is the potential for ‘shirking’ behaviour. Implementing

appropriate internal control and risk management systems will help to ensure that these risks
are avoided.
From the scenario, it would appear that these risks are not being appropriately monitored, due
to the lack of internal controls identified by the Finance Director. The risks of not spending
contracted time with the company and incurring unauthorised costs is compounded by factors
such as:
 Lack of direct control over sales representatives; sales managers attend their office
infrequently and overall performance is not monitored unless sufficient sales are not
generated.
 There is a performance imperative to visit new and existing clients (the main focus of
the sales representatives reports) which may mean expenditure is incurred on
unnecessary visits (such as frequent visits to small clients),
 The reporting regime for expenses is to the finance department and then back to
regional managers; the finance department may not have the knowledge to determine
whether expenses are unreasonable. The delay in reporting back to regional
managers also means that by the time expenses are queried, they have already been
paid.
 In other words, prior to the approach by Finance to regional managers, there appears
to have been no assessment, reporting or mitigation of risk in X. This is an internal
control weakness which must be rectified by implementing appropriate internal controls
to mitigate the possibility of loss being incurred by X.
The controls that should be introduced should include an appropriate mix of financial controls,
non-financial quantitative controls, and non-financial qualitative controls. Appropriate controls
will have to be implemented to overcome each weakness, and then the control tested to
ensure that it works.
For example, in relation to expenses, initial authorisation should be by the regional managers,
cross referencing expense claims with clients visited. Only then should the claim be sent to
the finance department for payment.
Implementing the appropriate controls then mitigates the risks already identified above,
ensuring that company resources are being used to achieve company objectives.
Requirement (c)
Substantive analytical procedures involves the examination of ratios, trends and changes,
between periods, to obtain a broad understanding of financial position and the results of
operations. It can help to identify any items requiring further investigation. It is an important
audit technique used to identify errors, fraud, inefficiency and inconsistency. Its purpose is to
understand what has happened in a system, to compare this with a standard and to identify
weaknesses in practice or unusual situations that may require further examination.
Appropriate substantive analytical procedures for X may include:
 Ratio analysis of sales expenses to sales revenue with comparisons over time and
between regions and sales representatives. Benchmarking data may be available from
other sources or internally developed from identified best practice;
 Review, by sales representative, the proportions of new and existing business

generated;
 Compare data, by representative, on the loss of customers.

_________________________________________________________________________

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CIMA 2010 Chartered Management Accounting Qualification – Specimen Examination Paper E3

Published November 2009

You are allowed three hours to answer this question paper.

Answer ALL compulsory questions in Section A on page 9.

Answer TWO of the three questions in Section B on pages 10 to 13.

Maths Tables are provided on pages 14 and 15.

 The Chartered Institute of Management Accountants 2009

Specimen Exam Paper 2 Enterprise Strategy

Enterprise Strategy 3 Specimen Exam Paper

Specimen Exam Paper 4 Enterprise Strategy

Introduction of commercial accounting practices at EGC

Enterprise Strategy 5 Specimen Exam Paper

EXTRACTS FROM THE PRO FORMA FINANCIAL STATEMENTS OF THE ELECTRICITY

Statement of financial position as at 31 December 2008

EQUITY AND LIABILITIES

End of Pre-seen Material

Specimen Exam Paper 6 Enterprise Strategy

Enterprise Strategy 7 Specimen Exam Paper

The requirement for Question One is on page 9

Specimen Exam Paper 8 Enterprise Strategy

Enterprise Strategy 9 Specimen Exam Paper

The requirement for Question Two is on the opposite page

Specimen Exam Paper 10 Enterprise Strategy

Section B continues over the page

Enterprise Strategy 11 Specimen Exam Paper

Section B continues on the opposite page

Specimen Exam Paper 12 Enterprise Strategy

End of Question Paper

Maths Tables and Formulae are on Pages 14 and 15

Enterprise Strategy 13 Specimen Exam Paper

MATHS TABLES AND FORMULAE

Periods Interest rates (r)

Periods Interest rates (r)

Specimen Exam Paper 14 Enterprise Strategy

Periods Interest rates (r)

Periods Interest rates (r)

Enterprise Strategy 15 Specimen Exam Paper

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS

Specimen Exam Paper 16 Enterprise Strategy

Strategic Level Paper

Tuesday Morning Session

Enterprise Strategy 17 Specimen Exam Paper

The Examiner's Answers – Specimen Paper

Answer to Question One

Enterprise Strategy 1 Specimen Exam Paper

Capital cost 50,000 Capital cost 30,000

Yearly running cost 8,000 Yearly running cost

Urgent visits 6,000 Urgent visits 6,000 1,500 P$250

No. of engineers 75 No. of engineers 38

Service standard Service standard

Urgent 100% Urgent 99%

Non-urgent Within 1 Non-urgent ASAP

10 year period 10 year period

Year P$’000s P$’000s Year P$’000s P$’000s

Total -99,160 -41,061

Specimen Exam Paper 2 Enterprise Strategy

Enterprise Strategy 3 Specimen Exam Paper

Examples of CSFs in this area would include:

Specimen Exam Paper 4 Enterprise Strategy

Answer to Question Two

Enterprise Strategy 5 Specimen Exam Paper

Specimen Exam Paper 6 Enterprise Strategy

Answer to Question Three

Enterprise Strategy 7 Specimen Exam Paper