Case Study

CIMA
Approach to the Strategic Case Study

Tutor details

JANUARY 2020 RELEASE

ii Approach to the Strategic Case Study CIMA E3/P3/F3

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 CIMA E3/P3/F3 Approach to the Strategic Case Study iii

Contents

Page

INTRODUCTION i

1 Course materials viii

2 Overview of the Case Study Exam viii
3 Your role viii
4 Core Activities ix
5 Exam Format ix
6 Passing the exam x
7 Approach to the Case Study x
8 Seven Golden rules for passing the Case Study xii

PAPER E3 STRATEGIC MANAGEMENT 1

1: The process of strategy 3

1 The purpose and nature of strategy 3

2 Levels of strategy 4
3 Types of strategy 4
4 The strategy process 5

2: Analysing the organisational ecosystem 7

1 Markets and competition 7

2 Society and regulation 10
3 Drivers of change in the eco-system 10

3: Digital strategy 13

1 Digital transformation 13
2 Governance of digital strategy 16
3 Digital enterprise 16
4 Elements of digital strategy 17

4: The impact of the ecosystem on organisational strategy 19

1 The impact of strategic networks and platforms on organisational strategy 19

2 Supply chains 20
3 Impact on corporate social responsibility 21

5: Generating strategic options 23

1 The role of governance and ethics in strategy 23

2 Purpose, vision and values and impact on strategy 25

6: Generate and develop options 27

1 Diagnose organisation’s starting position 27

2 Forecast potential 28
3 Use frameworks to generate options 29
iv Approach to the Strategic Case Study CIMA E3/P3/F3

7: Making strategic choices 33

1 Frame key strategic questions 33

2 How to achieve strategic options 36
3 Value analysis 38
4 Criteria for evaluation (Suitable, Acceptable, Feasible) 38

8: Strategic control 39

1 Strategic performance management systems 39

2 Critical success factors 39
3 The balanced scorecard 40
4 Performance Pyramid (McNair, Lynch & Cross) 41
5 Fitzgerald and Moon’s models 42
6 Benchmarking 42
7 Divisional performance measures 43
8 Communication of performance targets 46
9 Resource audit 46

9: Change management I 47

1 Impact of strategies on the organisation 47

2 Change strategies and processes 49

10: Change management II 51

1 The role of the leader in managing change 51

2 Resistance 53

PAPER P3 RISK MANAGEMENT 55

1: Identifying risk 57

1 Types of risk 57
2 Specific risks 57
3 Risks in IS/IT systems 58
4 Risk of international operations 58
5 Tools for quantifying risk 58

2: Risk management strategy 59

1 CIMA’s Risk Management Cycle 59

2 Enterprise Risk Management (ERM) 61
3 The risk cube 63
4 Assurance maps 63

3: Corporate governance 65

1 Evaluate governance and ethical issues facing an organisation 65

2 Non-executive Directors (NEDs) 65
3 Audit committees 66
4 The UK Corporate Governance Code 66
5 The US approach to corporate governance 68
6 The CIMA Code of Ethics for Professional Accountants 68
CIMA E3/P3/F3 Approach to the Strategic Case Study v

4: Risks associated with formulation of strategy 69

1 Analysis of strategic choice 69

2 Managing disruptions to strategy 70
3 Reputational risk 71
4 Disruption 71

5: Responses to strategic risk 73

1 Management control systems 73

2 Divisional performance 74
3 Other aspects of performance measurement 76
4 The balanced scorecard (Kaplan and Norton) 77
5 Modern management accounting techniques 78

6: Control systems and information systems 79

1 Internal control systems 79

2 Fraud 80
3 Information systems 80
4 Big Data 83

7: Internal audit 85

1 The purpose of audit in the context of internal control systems 85

2 The audit process 86
3 Effective internal audit 86
4 The internal audit report 86

8: Cybersecurity risk 87

1 Cybersecurity risks 87
2 Types of cybersecurity risks 88
3 Cybersecurity organisational characteristics 89
4 Security controls 90
5 Cybersecurity tools and techniques 91
6 Cybersecurity risk reporting 92

PAPER F3 FINANCIAL STRATEGY 93

1: Business objectives 95

1 Objectives of organisations 95
2 Ratio analysis 96

2: Sustainability and integrated reporting 99

1 The GRI and Sustainability Reporting 99

2 Integrated reporting 100
3 Pros and cons of non-financial reporting 102

3: Financial strategy 103

1 Key decisions of financial management 103

2 Internal constraints on performance 103
3 External constraints on performance 104
vi Approach to the Strategic Case Study CIMA E3/P3/F3

4: Overview of finance sources and Equity finance 105

1 Overview of sources of finance and financial markets 105

2 Issuing equity finance 107
3 Cost of equity 108

5: Debt finance 111

1 Debt finance – borrower’s perspective 111

2 Debt finance - lender’s perspective 111
3 Market issue of bonds 112
4 Cost of debt 112

6: Capital structure 115

1 Practical considerations 115

2 Weighted Average Cost of Capital (WACC) 116
3 Business and financial risk 116
4 Dealing with a change of business risk 117
5 Dealing with a change of gearing 118
6 Impact of capital structure on company value 120
7 Practical considerations 120

7: Dividend policy 121

1 Dividend policy 121

8: Business valuations 123

1 Valuing a business 123

2 Asset based valuations 124
3 Earnings based valuations 124
4 Cash flow based valuations 125
5 Valuation of intangible assets 127
6 Efficient market hypothesis (EMH) 128

9: Mergers and acquisitions 129

1 Mergers and acquisitions (M&A) 129

2 Share exchanges 131
3 Regulation of takeovers 132
4 Defensive tactics 133
5 Post-acquisition integration 133
6 Impact on stakeholders 134

10: Business reorganisations 135

1 Reasons to divest 135

2 Methods of divestment 135

11: Risk management and currency risk 137

1 Financial risks facing an organisation 137

2 Foreign exchange rates and currency risk 138
3 Currency movements 138
4 Internal hedging techniques 140
5 External hedging techniques 140
CIMA E3/P3/F3 Approach to the Strategic Case Study vii

12: Advanced currency risk management 141

1 Money market hedges 141

2 Currency futures (FX futures) 142
3 Currency options 142
4 Arbitrage 144
5 Value at Risk (VaR) 144

13: Interest rate risk 145

1 Interest rate risk 145

2 Internal methods for hedging interest rate risk 145
3 External methods of interest rate risk management 145
4 Forward Rate Agreements (FRA) 146
5 Interest rate futures 146
6 Interest Rate Guarantees (IRGs) 147
7 Exchange traded interest rate options 148
8 Interest rate swaps 148
9 Currency swaps 149

SAMPLE ASSESSMENT 151

Preseen Extracts 153

Sample Assessment Questions 157

ANSWERS 165

Sample Assessment Answers 167

Marking Guide 173

viii Approach to the Strategic Case Study CIMA E3/P3/F3

1 Course materials
To help you prepare for your case study exam, you are being provided with:
 Topic review notes – these should give you an overview of the key topics from each of the three
core papers with additional guidance on how each topic might be examined from the point of
view of the case study. For more detail you also have online access to our full core paper notes
and lectures.
 Your pre-seen document – giving you information about the organisation and industry that will
be tested in your exam. It is essential that you familiarise yourself with this material. A soft copy
of this will be available to you during the actual exam.
 Practice exams – 5 in total, all specifically written around your pre-seen material. Two of these
are practice exercises to be broken down and used to develop exam technique. The other three
you will attempt in full, under timed conditions in our online environment as mock exams.
Question practice under exam conditions is vital to passing the case study exam.
 Additional questions based on real previous cases.

2 Overview of the Case Study Exam

The case study exam is designed to test the knowledge, skills and techniques from all three pillars of
the syllabus within a simulated business scenario. The exam aims to consolidate your learning by
asking you to tackle something which reflects a real-life situation, where cross-functional working is
often required.
In addition to your technical knowledge, you will be expected to demonstrate a wide range of other
qualities and competencies such as communication, business acumen, professional scepticism,
professional judgement, ethical awareness and leadership.
Tasks in the exam will be practical and applied, rather than theoretical. Questions will not be set that
require specific calculations but you may need to undertake analysis or calculations to support your
answers. You are also very likely to be asked to explain or interpret figures and calculations that you
are presented with in the exam.

3 Your role
The case study exam will place you in a job role matched to the relevant competency level.
At the Operational level, the role is a finance officer working within a department that is responsible
for the preparation of budgets and other reports. The role focuses on the short term and the
implementation of decisions.
At the Management level the role is a finance manager with responsibility for monitoring and
implementing strategy. The job focus here is on the medium term.
At the Strategic level you will be a senior finance manager advising the organisation’s leaders in the
development of business strategy to create value. The job focus is on long term strategic decision
making.
You will be assessed based on your performance in a number of core activities that are relevant to
your role. A weighting range is given for each core activity. This represents the amount of time that
will be allocated to each core activity in the examination.
 CIMA E3/P3/F3 Approach to the Strategic Case Study ix

4 Core Activities
Core Activities Assessment Outcome Weighting
A. Develop business I can evaluate strategic options (digital and otherwise). 15—25%
strategy. I can recommend strategic decisions (digital and otherwise).
I can evaluate potential acquisitions and divestment
opportunities.
I can recommend responses to opportunities and threats arising
from digital technologies.
B. Evaluate business I can select and apply suitable strategic analytical tools. 15—25%
ecosystem and business I can conduct an analysis of stakeholder needs and recommend
environment appropriate responses.
I can recommend appropriate responses to changes in the
business ecosystem.
I can recommend KPIs that encourage sound strategic
management. I can recommend responses to economic,
political and currency risks.
C. Recommend financing I can recommend suitable sources of finance. 15—25%
strategies I can recommend dividend policy.
I can recommend and apply business valuation models.
D. Evaluate and mitigate I can evaluate risks and recommend responses and can 15—25%
risk. maintain the corporate risk register.
I can identify ethical dilemmas and recommend suitable
responses. I can evaluate and mitigate cyber risks.
I can recommend internal controls.
E. Recommend and I can apply internal audit resources. 15—25%
maintain a sound control I can recommend appropriate controls and evaluate the
environment implications of compliance failures.
I can recommend responses to the threats arising from poor
governance.

5 Exam Format
The exam is 3 hours long and will take the form of a ‘day in the life’ of the role being simulated.

It will consist of three (SCS) or four (OCS and MCS) sections or tasks, which are equally weighted. More
than one core activity will normally be assessed within each task. There may be more than one sub-
task within each section and you will be told the weighting of each sub-task.

There is a countdown clock in the top right of the screen, counting down to the end of the section.
Once your time is up, you will be automatically moved onto the next section. You may finish a task
early and move on to the next but you cannot return to previous tasks in the time remaining.

Each task in the exam will begin with a trigger. This will be new information provided as an
introduction to the work that you are required to complete. For example:
 A briefing by your superior
 A newspaper article
 Information or extracts from internal reports.
 x Approach to the Strategic Case Study CIMA E3/P3/F3

You will be expected to integrate this new information with the analysis you have performed on the
pre-seen material to produce a coherent and well informed response.
The tasks will require written responses in the form of common business communications such as
emails, reports, briefing notes and memos.
There are five different “variants” of the case which will be sat over a 3 day window. You could sit any
one of these variants on any day.

6 Passing the exam

The case study exam is human marked and results are available after 6 weeks.
In order to pass you need to achieve a scaled score of 80 out of 150 marks. A scaled score is an
adjusted score based on the level of difficulty of each exam variant.
There is no requirement to obtain a pass or meet a minimum threshold for each core activity but
feedback on performance against each core activity will be provided.

7 Approach to the Case Study

7.1 Analysis of the pre-seen
The pre-seen material provides an introduction to the company you will be “working for” in the case
study. You should use the material to prepare for the examination by immersing yourself in the
simulated scenario and considering the organisation’s current position and future strategy.

You will probably receive information on the following:

 Industry background
 History of the business
 Management and key personnel
 Current business/industry issues
 Financial statements

Tips for analysing the pre-seen:

 Review each piece of information in detail – What does the information mean? Why might it
have been provided? What are the key issues and their implications for the organisation?
 Based on your review identify and familiarise yourself with the technical topics that may be
relevant from the three core subjects.
 Carry out any appropriate financial analysis e.g. ratios (profitability, liquidity, gearing), cash
flow, costing calculations.
 Analyse the industry (PEST, five forces, stage in life cycle, impact of globalisation).
 Summarise the key issues facing the organisation as a result of its environment (it may be
helpful to think about risks and possible ways to mitigate them).
 Carry out appropriate background research on the industry involved to better understand the
context.
 Complete a position analysis of the organisation (SWOT) and identify the key points.
CIMA E3/P3/F3 Approach to the Strategic Case Study xi

7.2 The exam

The new information provided in the exam will usually update the pre-seen and develop some of the
issues that are contained within it.
Your answer must be driven by the new information and specific requirements in the tasks and not by
your desire to demonstrate all the work you have done analysing the pre-seen information or the
requirements you had previously anticipated.

7.3 Approach on the day

Plan your time and stick to it
As a rough guide, spend at least 10% of your time reading and planning.
Assimilate the new information
 What are the key issues and their impact?
 What information might be relevant/needs to be integrated from the pre-seen?
 What competencies and skills are relevant here and which papers are they drawn from?
Remember to develop your thinking
 WHAT has happened?
 HOW has it happened (e.g. if profits are falling, is the problem revenue or costs?)
 WHY has it happened - what are the underlying causes?
 WHEN did this happen - what are the timescales involved (eg if there has been a change
part way through the year, next year’s impact may be even greater)?
 SO WHAT – what are the consequences of this analysis?
Plan your answer (mind maps/spider diagrams/list of points)
 Make sure you have identified all the individual elements that make up the task requirement(s).
 Identify the context of the task - who are you and who are you writing to?
 Brainstorm ideas based on your assimilation of the information - look for any linkages.
 Decide on priorities – which are the key points to include first.
 If you have been asked for a conclusion or recommendation, decide what it is going to be.
 Plan the structure of your answer so it flows logically.
Produce your answer
Presentation and communication skills are key at this point
 What format have you been asked for (report/memo/e mail/notes)? You should pay as much
attention to spelling and grammar in an email as in any form of communication.
 How can you make it easy to mark? Using sub-headings and short paragraphs with gaps in-
between is a good idea.
Go back to the task requirement
Check that your answer addresses it. Remember to check that you have done exactly what you have
been asked to do.
xii Approach to the Strategic Case Study CIMA E3/P3/F3

8 Seven Golden rules for passing the Case Study

(1) Be familiar with the pre-seen. Although it will be available in the exam you will not have time to
browse through it to look for information that may or may not be there;
(2) Plan your answer. Think about appropriate sub-headings and the prioritisation of your points;
(3) Relate your answer to the pre-seen and make sure your answer reflects your role in the
organisation;
(4) Refer to some distinct fact from the preseen / name of the organisation in EVERY paragraph you
write (e.g. “An advantage of good corporate governance is that it can help attract new
investment and ABC Ltd need to raise finance to extend their distribution facilities in 2016 as
confirmed by CEO in her recent press release.”);
(5) Use the correct format, for example report, email, memo etc;
(6) Use clear sub-headings and lay your answer out in short paragraphs, leaving a gap between
each paragraph;
(7) Where relevant, refer to a real-life example from your industry research.
CIMA E3 Topic Reviews Approach to the Strategic Case Study 1

Paper E3
Strategic Management
2 Approach to the Strategic Case Study CIMA E3 Topic Reviews
 3

The process of strategy

1 The purpose and nature of strategy

Strategy is the direction and scope of an organisation over the long term, which achieves an advantage
for the organisation through its configuration of resources within a changing environment, to meet the
needs of markets and to fulfil stakeholder expectations. (Johnson, Scholes and Whittington)

1.1 Essential features and characteristics of strategy

 Concern the long-term direction of firm
 Consider scope of activities
 Involve a search for “strategic fit” with the business environment
 Build on the organisation’s resources and competences (capability)
 Affected by the values and expectations of stakeholders
Such decisions are therefore likely to:
 Be complex
 Be made in conditions of uncertainty
 Affect operational decisions
 Require an integrated approach
 Involve considerable change

1.1.1 Strategy in a not-for-profit organisation

Not-for-profit organisations are likely to have multiple objectives and it may be difficult to measure
them. They need to decide how they should fulfil their purpose, adapt to changing environmental
challenges and meet the targets and standards set by stakeholders (government in the case of public
sector organisations, donors and beneficiaries in the case of charities).
 Effectiveness –is the organisation meeting its objectives (right things)
 Efficiency – doing things in the right way (things right)
 Economy – minimise the cost of resources (using minimum to do right things)
 4 1: The process of strategy CIMA E3 Topic Reviews

2 Levels of strategy
2.1 Corporate strategy
Corporate strategy is concerned with the overall purpose and scope of the firm and how value will be
added to the different parts of the firm.

2.2 Business strategy

Business strategy is concerned with how to compete successfully in particular markets and determines
the activities of strategic business units (SBU) that have distinct markets.
An SBU is a part of an organisation for which there is a distinct external market for goods or services
that is different from another SBU.

2.3 Operational strategies

Operational strategies are concerned with ‘making it happen’, how the component parts of the
organisation effectively deliver the corporate and business level strategies in terms of resources,
processes and people.

3 Types of strategy
3.1 The rational model
Position Review &
audit control

Mission & Strategic option Strategic

Corporate Strategic
objectives generation evaluation &
appraisal implementation
choice

Environmental analysis

3.2 Logical incrementalism (Quinn)

Strategic management involves guiding actions and events towards a conscious strategy in a series of
small scale steps.

3.3 Freewheeling opportunism

Freewheeling opportunism involves taking opportunities as they arise and little formal planning.
CIMA E3 Topic Reviews 1: The process of strategy 5

3.4 Crafting emergent strategies (Mintzberg)

Strategies are not always deliberate – they also emerge over time as organisations innovate and
respond to their markets.
The roles of senior managers are to:
 Manage stability
 Detect discontinuity (constant environmental scanning)
 Know the business
 Manage patterns
 Reconcile change and continuity
Formal planning alone is not the best way for managers to develop strategy. Managers need an
intuitive understanding of the business and organisation as well as facts and numerical data. They
need to be able to explore and develop ideas and have the freedom to fail.

3.5 Uncertainty and bounded rationality

Williamson believed the market or contractual approach would prove unsatisfactory in the long term
due to a combination of uncertainty and bounded rationality.
Environmental uncertainty refers to the changing of economic relationships over time.
Bounded rationality refers to the acceptance of the fact that it is not possible to have perfect
knowledge, in advance, of what these changes will be.

4 The strategy process

4.1 Strategic management (Johnson and Scholes)
Divided into three equally important related elements:
 Choice (of strategic options)
 Implementation (and control)
 Analysis (of organisational ecosystem)

Strategic
analysis (where
we are now)

Strategic Strategic
choice implementation
(Deciding which (Putting
options to decisions into
implement) action)
6 1: The process of strategy CIMA E3 Topic Reviews

4.2 Organisational ecosystem

 James Moore’s ‘natural environment’ analogy
 Developed in 1990s
 Used by high tech companies
A business ecosystem is an economic community supported by a foundation of interacting
organizations and individuals—the organisms of the business world.
 How to function in the ecosystem = strategy
 Business evolution (if you will)
 7

Analysing the organisational

ecosystem

1 Markets and competition

1.1 SWOT analysis
Generally done with a grid split into four factors:
Strengths
Internal, and relative to the competition
Weaknesses
Opportunities
External and potentially relevant for all, PEST is a good source of O,T.
Threats
A strategic approach might include the following:
 Strengths – maintain, build and leverage
 Weaknesses – remedy or exit
 Opportunities – prioritise and optimise
 Threats – counter
SWOT should not be limited to profit-seeking organisations.

1.2 Stakeholder analysis (Mendelow’s matrix)

 Internal – staff
 Connected – owners, lenders, customers, suppliers Primary stakeholders
(some form of financial relationship)
 External – government, local and central, pressure groups,
Secondary stakeholders
local community
8 2: Analysing the organisational ecosystem CIMA E3 Topic Reviews

(1) Identify key stakeholders in scenario

(2) Assess their interests in the organisation (what do they want)
(3) Assess the ways in which these interests may affect the organisation (what can stakeholders do
to help or hinder)

1.2.1 Mendelow’s matrix for prioritising stakeholders

Power (how can they help/hinder us) / Interest (what do they want from us)

Level of Interest
Low High
Minimal effort required Keep informed
e.g. Individual householders living nearby (may e.g. local community, pressure groups, local govt
Low join together and move into the high interest possibly, media. Risk that they influence those
low power section). stakeholders with high power.

Power Keep satisfied Key player

e.g. Central govt, passive major shareholder, e.g. key customer, active major shareholder,
High national media. Risk that they acquire a high trade unions, secured lender. These stakeholders
level of interest. will have a real influence on the future strategic
direction of the organisation.

1.2.2 Stakeholder power

 Position held
 Resources controlled, e.g. union leader
 System power, e.g. political access, due to being close to a major customer
 Expert power, e.g. knowledge of a critical process
 Personal power, charisma, communication skills, being liked

1.2.3 Managing relationships with stakeholders

 Make someone responsible
 Create a team with a range of skills and opinions
 Allocate resources to problem relationships
 Lots of contact, ideally face to face
 Formal reporting
 Good website, with blogs, FAQ’s
 Consider carefully how to resolve conflicting stakeholder objectives (satisficing, sequential
attention, fulfilling other objectives)

1.3 Competitor analysis (Porter’s five forces)

An assessment of the strengths and weaknesses of current and potential competitors
 Identify competitors
 Analyse competitors – where competing, objectives and assumptions, key strengths, resources,
competences
 Draw up response profile – predictability, strength and selectivity of response-
CIMA E3 Topic Reviews 2: Analysing the organisational ecosystem 9

1.3.1 The five forces

 Supplier power
 Buyer power
 New entrants
 Substitutes
 Competitive rivalry
Government regulations and policies, for example on competition or tax, can also be a significant
influence.

1.3.2 Limitations of five forces model

 Less useful in a fast-changing environment
 Some industries are collaborative, e.g. some car makers share platforms
 Ignores the impact of government on profitability
 Focuses on profitability, obviously irrelevant for not for profit organisations
 Implies we are “at war” with our customers, whereas most successful firms work closely with
customers

1.4 Wider ecosystems (Porter’s diamond)

Strategy,
structure and
rivalry

Demand
Factor conditions
conditions

Related and
supporting
industries

Porter’s Competitive Advantage of Nations advocates lobbying government to support the Diamond by
supporting markets, providing infrastructure and grants, creating a culture of enterprise and
stimulating demand by investment and acting as a customer.

1.5 Industry eco-systems

1.5.1 Seven ways government can affect the structure of an industry (Porter)
 Capacity expansion, e.g. via tax relief, grants, investment in infrastructure
 Demand, e.g. government as a customer
 Divestment, government may block a sale to an overseas buyer
 Control, e.g. fracking licences
 Create entry barriers, e.g. prevent foreign players entering the market
 Competition policy, e.g. large players forced to split/ sell divisions to prevent dominance
 Product regulation, e.g. new drugs, car safety regulations
10 2: Analysing the organisational ecosystem CIMA E3 Topic Reviews

2 Society and regulation

2.1 PESTEL analysis
PESTEL: Political, Economic, Social, Technological, Environmental and Legal, and Industry Analysis
comprise the model.

2.2 Braithwaite and Drahos

Braithwaite and Drahos state that the rules laid down in legislation made by individual nations are
created by discussion, lobbying, negotiation and agreement between individuals, pressure groups,
associations, corporations etc.
Forming successful relationships with governments and other participants in civil society can form the
basis of sustained competitive advantage:
 Non-market strategy encourages an organisation to think seriously about its corporate social
responsibility issues and its core values
 Corporate political activity can take a number of forms: lobbying government, appointing
influential non-execs to the board and steering public opinion

3 Drivers of change in the eco-system

3.1 Globalisation
 Growth in communications and transport causing shrinking world
 Growth in global industries/companies (MNOs)
 Changes in political structures (eg fall of Soviet Russia, rise of China)
 Cost differentials

3.1.1 Impacts
 Relocation of industries
 Increased competition
 Cross-border alliances and mergers
 New growth markets
 New and increased economic divides
 To be considered as part of a PESTEL

3.2 Geopolitics
 Link between geography and politics
 Eg Middle East/oil
 Human geography (eg migration) and politics (eg Brexit)
 Feature of ‘political’ analysis in PESTEL
CIMA E3 Topic Reviews 2: Analysing the organisational ecosystem 11

3.3 Demography
 Statistics of humans
 Influence on product/marketing
 Feature of ‘social’ analysis in PESTEL

3.4 Customer empowerment

 By organisations – eg decision-making tools
 By digital technology – eg price comparison
 By governments – eg legal protection or facilitation

3.5 Digitech
 Significant factor in customer empowerment
 Drives change in relationship between organisation and
customer/supplier/employees/owners/lenders/regulators/government/society
 Data empowers organisations
 Need to use well for competitive advantage

3.6 Automation
 Use of software/robots to perform low level repetitive tasks
 Impact on costs
 Impact on human resource
 Impact on customer experience
12 2: Analysing the organisational ecosystem CIMA E3 Topic Reviews
 13

Digital strategy

1 Digital transformation
1.1 Cloud computing
Use of ‘cloud computing’ where the business carries out activity using the Internet reduces the need to
invest in and maintain significant infrastructure.

1.1.1 Impact on strategy

 Changes the way that business operate (flexible)
 How individuals and organisations collaborate (multi-person use documents saved in cloud)

1.2 Big data analytics

KEY TERM
Big data is a term given to collections of data that are so large that traditional methods of
data collection are insufficient. Developments in technology have been such that the
amount of data that can be collected has grown exponentially. A good example is the traffic
on social networks or data from financial markets.

 Described using the 4Vs:

 Volume – the amount
 Variety – the sources
 Velocity – the speed at which it changes
 Veracity – its truthfulness
14 3: Digital strategy CIMA E3 Topic Reviews

1.2.1 Impact on strategy

 Big data can support focused decision-making and can drive strategy in many areas

1.3 Process automation

KEY TERM
Process automation is the use of software to carry out low level tasks.

 Robots are used to perform repetitive, rules-based tasks

 Cost saving
 ‘Human’ resource can be repurposed to more sophisticated value-added tasks

1.3.1 Strategy
 Can robots provide a better/more constant/faster service to customers?

1.4 Artificial intelligence

KEY TERM
Artificial intelligence is technology that can be used to make decisions.

Artificial intelligence is not designed to replace or even replicate human intelligence but is in effect ‘a
learning machine’. Such systems have been shown to make effective decisions that can be more
effective than human decision-making systems.
Artificial intelligence and human intelligence can be complimentary and used together so that the best
decisions are made.

Benefits of machine-learning
 Machines can process more data than humans can –link with Big Data
 Machines may be able to identify patterns that humans would not
 Machines do not suffer from bias, tiredness or boredom!

Limitations
 The machine can only work with input data (human generated from humans/may contain bias)
 The machine may not have access to the appropriate data to make the decision required

1.4.1 Impact on strategy

 Forecasting: AI systems may recognise and interpret past patterns to create better budgets and
projections for the future
 Decision-making: AI systems may be able to process more data into the decision-making process
CIMA E3 Topic Reviews 3: Digital strategy 15

1.5 Data visualisation

KEY TERM
Data visualisation is the communication of data in a user-friendly, diagrammatic way to
facilitate understanding

1.5.1 Impact on strategy

 Better decisions may be made if understanding of background data is improved.

1.6 Blockchain

KEY TERM
Blockchain is a continuously growing data record.

 At its simplest level, blockchain is effectively a digital ledger which lists transactions in individual
‘blocks’ and which continues to grow with the addition of subsequent transactions to create a
permanent record. Inherently, removal of a block will show digitally meaning that the digital
record is transparent and accurate.

1.6.1 Impact on strategy?

 May facilitate on-line trading and record keeping
 Adds assurance to systems, so grows confidence of members of the ecosystem.

1.7 Internet of things

KEY TERM
The internet of things (IoT) refers to the increasing connection of devices to the internet via
new technologies such as cloud computing.

 If ‘off-site’ machines are communicating with us, engineers don’t need to make expensive,
routine service visits.
 Real-time consumer needs and demand can be monitored and met or used

1.7.1 Impact on strategy?

 After-care
 Replacement programmes

1.8 Mobile
Increasingly, in connection with cloud computing and via wifi technology, companies and customers
use mobile technology allowing access anywhere, anytime from a range of devices, enabling
computing to be carried out where people want it rather than being tied to a physical location. This
has transformed how companies connect with and serve their customers.

1.8.1 Impact on strategy?

 Organisation is available 24/7.
16 3: Digital strategy CIMA E3 Topic Reviews

1.9 3-D printing

KEY TERM
3-D printing is simply printing 3-D objects from a variety of materials, for example, plastic,
metal and even human tissue. It is sometimes called additive manufacturing (AM).

3-D printing has the power to transform manufacturing (and is already doing so).
It can contribute to greater efficiency and therefore, ultimately, reduced costs.

1.9.1 Impact on strategy

 Can revolutionise manufacturing
 Raises issues for procurement/distribution.

2 Governance of digital strategy

 Digital mindset (broad overview) essential
 Change management likely…scope of changes significant

3 Digital enterprise
 Lower costs (e.g. automated booking )
 Improved pre-purchase information (web sites, bulletin boards)
 Easier purchasing (online ordering)
 Quicker delivery (real time processing, tracked delivery)
 Shorter development cycle (CAD, CAM)
 Improved reliability (e.g. computer diagnostics, engine management systems,)
 Improved after sales service (e.g. automated service reminders, email updates)
 Improved communication
Johnson and Scholes believe that of these, service provision will be more important than product
features. “All organisations should conceive of their business as a service company that supplies a
product rather than the other way around.”
Note: Competence in knowledge management is not enough, capability in logistics, both in the supply
chain and distribution are also essential. (Bricks and clicks).

3.1 Decision-making
Big data involves capturing and processing data on a vast scale and converting it into information that
is able to be utilised by the organisation. Big Data is often too large or changes too rapidly to be
handled using traditional database or software techniques, so it also includes the storage facilities,
processes and techniques that an organisation requires.
 Source of competitive advantage
 Identification of operational efficiencies
Build a better picture of customers, making better decisions based on knowledge of customer thinking
and product usage. Can be applied in all areas of organisation, not just customer based.
CIMA E3 Topic Reviews 3: Digital strategy 17

3.2 Markets and products

Digitech is revolutionising both products and markets:
 Digital products (eg downloaded books/music)
 Digitised tangible products (eg chipped products that report back to manufacturer on status,
enabling targeted after-care)
 Virtual stores instead of or as well as physical stores

4 Elements of digital strategy

 SWOT analysis – IT can appear in any of the quadrants – i.e. it can be an organisation’s strength,
a weakness, an opportunity to be exploited or pose a threat.
 IT can be applied to counter the effects of Porter’s Five Forces – a good website may decrease
the need for investment in a branch network, which is a barrier to entry
 IT can enhance a cost leadership, differentiation or focus strategy (discussed later)
 IT can impact the value chain (discussed later)

4.1 Economics of digitisation

E-business is the transformation of business processes via the application of information technology. It
is broken down into stages of development:
 Web presence – no transactions are carried out
 E-commerce – buying and selling
 Integrated e-commerce – use of more IT to carry out ‘extras’ such as collecting customer data
 E-business – ‘fully fledged’
 Web 1.0 – web as a source of information
 Web 2.0 – participatory web ”facilitates interaction, communication, information sharing,
collaboration, via Facebook, YouTube, twitter, blogs etc. Also software as a service (Saas) where
a third party provides specific applications that can be accessed from anywhere

4.1.1 WWW techniques

 Mashups – mix, match, morph web content
 Competence syndication – different organisations benefit from each other’s competencies
 Network effects – effect that one user has on the value of the product to other users

4.2 Data and metrics

4.2.1 Data warehousing and mining
Data warehousing involves integrating data from a variety of sources to allow that information to be
combined flexibly for quick and easy analysis and reporting.
 Security
 What kind of information to keep
 How long to keep information
 Data to be transferred to warehouse only when it requires no further modification
 Information must be compatible
18 3: Digital strategy CIMA E3 Topic Reviews

Data mining is the process of finding trends, patterns and connections in data in order to improve
competitive performance:
 Associations – one event can be linked with another
 Sequences – one event follows another
 Classification – organisations of data
 Clustering – finding new groups of facts
 Forecasting – patterns that lead to new predictions

4.2.2 Metrics
Key issues:
 Scale
 Active usage
 Engagement
Measures:
 CVC
 LVC
 19

The impact of the ecosystem

on organisational strategy

1 The impact of strategic networks and platforms on organisational

strategy
1.1 Networks
 A group/system of interconnected members
 Technology has revolutionised networking (communication/systems)
 Rise of virtual networks (e-procurement/e-commerce)
 United face presented to customer

1.2 Platforms
 Where networks interface
 (In computing) where software is executed
 Where members of the ecosystem relate to one another
 Traditional: financial statements, catalogues, mailings, phone-calls, letters
 New: websites, emails, direct advertising, mobile technology, electronic returns

1.3 Technology enablers

Various developments have contributed to proliferation of ‘platforms’, such as:
 Cloud computing
 Social media
 Mobile technology
 Data analytics
20 4: The impact of the ecosystem on organisational strategy CIMA E3 Topic Reviews

2 Supply chains
SCM is co-ordination of operations from supplier of raw materials at one end of the chain to customers
at the other, to achieve synergies to benefit all parties along the chain, by acting as partners.
Upstream supply chain = raw materials
Downstream supply chain = eventual customer
Common practices include:
 Consolidating the supplier base (Have few suppliers. Be in long term relationships)
 Linking IT systems (e.g. EPOS)
 Participation in product development by all members of the chain
 Embedded representation (invite component supplier to place employee at manufacturing
plant)

Advantages of SCM
 Reduced transaction costs
 Improved communication
 Economies of scale (supplier consolidation)

Weaknesses of SCM
 Only as strong as weakest link
 Involves power relationships, money migrates to talent and the powerful

2.1 Relationship marketing

Relationship marketing focuses on long-term customer retention and contact.
 Important to manage relationship with customers (unhappy ones switch rather than complain)
 Existing customers are more profitable than new ones
 Existing customers are advocates
 If switching costs are high, business may lose customers for a long time if they leave
 Regular customers complaints indicate problems
 Long-term relationships are good for morale and motivation

2.1.1 Six Markets Model (Payne)

 Internal markets
 Supplier markets
 Recruitment markets
 Referral markets
 Influence markets
 Customer markets
CIMA E3 Topic Reviews 4: The impact of the ecosystem on organisational strategy 21

3 Impact on corporate social responsibility

How organisations exceed the minimum obligations to stakeholders specified through regulation and
corporate governance. CSR has internal aspects (treatment of employees) and external aspects
(attitudes to customers, suppliers, markets, community, human rights, ethics)
 Legal – minimum obligation
 Economic – costs and benefits
 Ethical – doing the right thing
 Philanthropic – what we give away

3.1 Sustainability
The use of resources in such a way that the needs of future generations are not compromised. Being
seen to pursue sustainability can add value to a brand and improve the bottom-line.
 Strategy and oversight – understanding the key drivers
 Execution and alignment – training and involvement for all staff
 Performance and reporting – setting targets and monitoring performance

Triple bottom line reporting (TBL)

 Profit – economic prosperity
 People – social justice
 Planet – environmental quality

3.2 Technology aspects

3.2.1 Fair communication
 The ethics of what companies communicate.
 Openness and transparency
 Legal restrictions eg advertising
 Developing area?

3.2.2 Fair expectations

 Technology makes work accessible 24/7
 Globalisation may erode traditional working hours
 What should employers expect?

3.2.3 Fair collaboration

 Increased risk of IT threats such as hacking and viruses
 Certification of security to reassure users that they are not at risk of fraud
22 4: The impact of the ecosystem on organisational strategy CIMA E3 Topic Reviews
 23

Generating strategic options

1 The role of governance and ethics in strategy

1.1 Corporate governance
Corporate governance is the system by which companies are directed and controlled.
 Increased disclosure to stakeholders
 Run the company legally and ethically
 Provide confidence for investors to invest
 Increased transparency at board level

1.1.1 Commonly accepted principles of corporate governance

 Leadership – role of Chairman and CEO not to be held by same person
 Effectiveness – appropriate balance of skills and experience
 Accountability – present a balanced and understandable assessment of the company position
 Remuneration – formal and transparent procedures
 Relations with shareholders – ensuring satisfactory communication

1.2 Ethics as an aspect of corporate governance

1.2.1 Johnson, Scholes and Whittington ethical stances
 Short term shareholder – maximise profits this year, comply with the law as it stands
 Long term shareholder – as above, also recognise that investing makes money in the future
 Multiple stakeholder obligation – acknowledge role to play in society
 Shaper of society – fulfil political role, doing good is more important than profit
24 5: Generating strategic options CIMA E3 Topic Reviews

1.2.2 Incorporating ethical behaviour into organisations

Organisations can adopt a rules-based approach to ethics with a focus on achieving minimum
standards, supervision and disciplinary procedures. This should ensure clear guidance and consistency,
but allows little discretion and it may be possible to work round it.
A conceptual framework or principles-based approach emphasises values and employees thinking for
themselves, considering situations on an individual basis and making judgements about threats and
safeguards. It is more difficult to circumvent than a rules-based approach and can be applied to a
wider range of situations.

1.3 Fundamental principles of CIMA Code of Ethics

 Confidentiality – do not disclose information unless legally obliged to do so
 Integrity – being straightforward and honest in all business relationships
 Professional competence and due care
 Objectivity – not allowing bias, conflict of interest or outside influence to override judgement
 Professional behaviour – comply with laws and regulations, do not disparage others

1.3.1 Threats to compliance with fundamental principles

 Self-interest, e.g. having shares in supplier to the company
 Self-review e.g. prepare and audit financial statements or prepare and sign off on report
 Advocacy, e.g. recommending son for job in company
 Familiarity, e.g. not appointing family member as a NED
 Intimidation, e.g. not threatening whistleblowers or staff who raise ethical concerns internally

1.3.2 Safeguards
(a) Internal safeguards
 Organisation reporting guidelines
 Fostering an ethical, open culture
 ‘Tone from the top’ – directors expect high ethical standards
 Disciplinary procedures if staff behave unethically
 Monitoring by internal audit department
(b) External safeguards
 Education, training and experience requirements for entry to CIMA membership
 CPD requirements for CIMA members
 Corporate governance regulations
 Professional standards for accountants and directors (eg Nolan principles)
 Professional monitoring/regulatory monitoring
 External review of published information by external auditors

1.4 Conflict resolution (ethical dilemmas)

 4As:
(STEP 1) Awareness - Consider everything you are involved with might have ethical implications
(STEP 2) Application – Analyse the issues in the context of the fundamental principles
(STEP 3) Ask – use any established internal procedures such as reporting mechanisms/mentors
(STEP 4) Alternatives (5Cs) –
(1) CONSULT with line manager, or board, or audit committee
(2) CIMA (If unresolved, obtain advice)
CIMA E3 Topic Reviews 5: Generating strategic options 25

(3) COUNSEL (if unresolved, seek legal advice)

(4) CUT OFF (withdraw from the assignment)
(5) CEASE WORK (resign – remember greatest duty is to CIMA: this may also be
CONSTRUCTIVE dismissal – another C to help you remember…)

2 Purpose, vision and values and impact on strategy

2.1 Mission and objectives
The mission says why you do what you do. Drucker suggested four questions:
 What is our business?
 What is valued by our customers?
 What will our business be?
 What should our business be?
A business also need to determine the means by which it implements its mission, which means setting
detailed objectives and targets:
 There must be congruence between objectives and strategy
 Conflicting objectives can arise
 Objectives might be hard to quantify
 Financial and non-financial objectives will both be relevant
 Different stakeholders have different interests

2.1.1 Campbell and Goold: mission statements

Mission statements should contain the following four elements:
 Purpose – why do we exist and who for?
 Strategy – how and where are we going to compete?
 Behavioural standards – guide the actions of employees
 Values – what does the organisation believe in?

2.2 Objectives
Objectives are statements of specific outcomes that are to be achieved. Objectives may be financial,
e.g. profit, sales growth or market based, e.g. market share, customer service, reduced churn.
 Specific
 Measurable
 Agreed
 Realistic
 Time bound

2.2.1 Objectives in not for profit organisations

Should focus on the three E’s:
 Efficiency
 Effectiveness
 Economy
26 5: Generating strategic options CIMA E3 Topic Reviews
 27

Generate and develop

options

1 Diagnose organisation’s starting position

Where are we now? (Back to chapter 2 – SWOT analysis)
What do we have to work with?

1.1 Resource audit

A resource audit reveals strengths and weaknesses, helps understand core competences and the
organisation’s competitive position, and provides an analysis of how it creates value. A business must
ensure that it has the right “strategic fit”(the right resources to take advantage of opportunities that
exist in the external environment):
 Core competences
 Products, trademarks, brands
 Operating systems
 Stakeholder relationships
 Returns to shareholders

1.1.1 Strategic fit

Johnson and Scholes: Businesses must concentrate on ensuring they have the right “strategic fit”.
(Having the right resources to take advantage of opportunities that exist in the external environment.)
Strategic capability
The ability to perform at a level that achieves objectives and fulfils the mission of the organisation.
The abilities required will change over time.
28 6: Generate and develop options CIMA E3 Topic Reviews

1.1.2 The 9M’s model

 Manpower
 Money
 Management, its quality
 Machinery
 Markets, operated in, and relative strength in them
 Materials
 Methods and processes used e.g. JIT, TQM, outsourcing, virtual organisation
 Management information (relevant, timely)
 Make-up, culture, structure, intangibles

1.1.3 Competences
The activities and processes through which an organisation deploys its resources effectively.
 Threshold competencies – those capabilities necessary for the organisation to compete in a market
 Unique resources – resources that cannot be easily imitated or obtained by competitors
 Core competencies – activities and processes through which resources are deployed so as to
gain a competitive advantage in ways that others cannot imitate or obtain

2 Forecast potential
2.1 Foresight
Foresight is about rehearsing alternative futures for the organisation.
All foresight techniques assume that actions taken today will shape the future. Foresight helps:
 Overcome vested interests
 Expand mindsets
 Employees form new strategic views
 Participants buy into or develop the organisation’s strategic vision
Futurists say that we should look at:
 Events – sudden developments
 Trends – long term shifts in for example, population, land use and technology
The challenge for managers is developing a deep understanding of the discontinuities that, if managed
properly, could be the foundation of new opportunities.
Irvine & Martin refer to the 5Cs of foresight:
 Communication – brings people together and provides a structure
 Concentration – on longer–term
 Co-ordination – allows different groups to harmonise research activities
 Consensus – around direction for research activities
 Commitment – to making results of research lead to action

2.2 Forecasting
The process of estimation in unknown situations, for example by correlation, regression analysis or
time series analysis.
CIMA E3 Topic Reviews 6: Generate and develop options 29

2.3 Trend analysis

Trend analysis involves collecting information and attempting to spot a pattern, or trend, in the
information.
Trend extrapolation is the assumption that the past will repeat itself.

2.4 The Delphi method

 The Delphi method is a systematic method for obtaining forecasts from a panel of independent
experts.
 Experts answer questionnaires in two or more rounds.
 After each round, a facilitator provides an anonymous summary of the experts’ forecasts from
the previous round as well as the reasons they provided for their judgements.
 Participants revise earlier answers in the light of what others say. In some groups, participants
tend to stick to opinions and conform to the group leader, the Delphi method prevents this.
 The range of answers decreases and the group will converge towards the "correct" answer.
 Participants comment on their own forecasts, the responses of others and overall progress.

3 Use frameworks to generate options

3.1 Scenario planning or scenario thinking
Scenario planning does not try to predict the future, but tries instead to describe a range of plausible
scenarios and the action plans required if they do occur. It tries to minimise surprises by rehearsing
the future.
It combines known facts about the future, including demographics, geography, military, political, industrial
information, mineral reserves, with plausible alternative PEST trends which are key driving forces.
Scenario planning is most beneficial when the environment is complex and dynamic.

3.1.1 Approach
 Define scope of activity, e.g. timescale, region, products etc.
 Identify key stakeholders (those likely to drive change)
 Identify main trends
 Identify key uncertainties (factors about which we cannot make reliable forecasts)
 Identify key causes of disruption
 Construct initial scenarios
 Check for consistency and plausibility
 Reduce to two or three scenarios
 Use scenario to formulate strategy
 Identify resource needs arising, e.g. increased monitoring

3.1.2 Advantages of scenario planning

 Provides a deeper understanding of the environment
 Indicates what needs to be monitored
 Encourages environmental scanning
 Encourages creative thought
30 6: Generate and develop options CIMA E3 Topic Reviews

3.1.3 Disadvantages of scenario planning

 Expensive
 May be a distraction from main business
 May be difficult to take action due to vested interests
 Many scenarios won’t come true

3.2 Visioning
 Visioning is seeing an image of the future which may be vague or out of focus. The goal is to
come up with a plan that gets the organisation to this future.
 The vision may start vaguely as a dream but should be firmed up into a concrete statement of
where the organisation wants to be.
 The vision should articulate a view of a credible and attractive future for the organisation, a
vision that is better in some important ways than its current state.

3.3 Morphological analysis

Morphological analysis is systematic investigation of all the components of large scale problems,
products or processes.
A matrix used to identify new combinations that could result in plausible new outcomes.
 The columns represent the attributes of a product or service
 The rows represent the variations of each attribute
It may also be used to determine the products competitors may be considering.

3.4 Relevance trees

A relevance tree is a systemised approach that starts with a clear goal.
The desired outcome is traced back through the trends and events on which it depends so that the
organisation can determine what needs to change or be developed for the desired outcome to be
achieved.

3.5 Game theory

Game theory involves the study of models of conflict and cooperation between rational decision
makers.
The idea is that my strategy depends to some extent on your strategy and vice versa, and that we take
a rational and informed view of what our competitors will do in a particular situation.
 Price wars, e.g. start, or join in with, one
 Marketing spend
 Product upgrades, R&D spend
Players must try to avoid being on the wrong side of a “win lose” scenario but in doing so may fall into
a “lose lose” situation.
An element of collaboration and/or a deep understanding of the market and competitors may be
needed.
CIMA E3 Topic Reviews 6: Generate and develop options 31

3.6 Real options

This project may open doors for
future investments (i.e. this
OPTION TO project develops key skills,
MAKE technology and intangibles that
FOLLOW ON help in future projects)
INVESTMENT

By delaying a project it may give

the opportunity to assemble If given a chance to cut
better information or to avoid a short a project you may be
capital rationing situation able to take advantage of
unforeseen opportunities
REAL and it gives extra flexibility

OPTIONS

OPTION TO OPTION TO
WAIT ABANDON
32 6: Generate and develop options CIMA E3 Topic Reviews
 33

Making strategic choices

1 Frame key strategic questions

What do we want to do?

1.1 The three generic strategies (Porter)

 Cost leadership – gain competitive advantage by producing at the lowest cost, emphasis on
efficiency, low-frills product, requires market share advantages and cheap resources
 Differentiation – being or appearing to be different in something that the customer values,
satisfying customers through sustainable advantage. Requires strong R and D, creativity and
marketing
 Focus – on narrow, defined section, may be best for smaller firms
Porter argues that if you select more than one approach, and then fail to achieve them, that your
organisation gets stuck in the middle without a competitive advantage.
34 7: Making strategic choices CIMA E3 Topic Reviews

1.2 Strategic direction (Ansoff’s product market matrix)

Existing Products New
Existing Protect/build Product development
 Consolidate  Easier to sell more to existing
 Penetrate, e.g. loyalty schemes customers than to find new customers

 Withdraw

Markets
Market development Diversification
 New segments  Related or unrelated
 New territories  Vertical or horizontal
 New uses  Most risky of the four boxes
New

1.3 Portfolio analysis

1.3.1 Product life cycle

 Maximise the value of products

 Maximise the use of resources through identifying where best to allocate marketing effort,
research and development etc.
 Make product strategy decisions, identifying which products to sell to which markets etc.
 Protect the company against possible downturns in one sector through diversification

1.3.2 The BCG matrix

The business portfolio is the collection of businesses and products that make up the company.
The best business portfolio fits the company's strengths and helps exploit the most attractive
opportunities.
 Analyse current portfolio and decide which businesses (or products) should receive more or less
investment
CIMA E3 Topic Reviews 7: Making strategic choices 35

 Develop growth strategies for adding new products and businesses to the portfolio, whilst at
the same time deciding when products and businesses should no longer be retained
 Compare results over time and against competitors

Relative Market Share

High Low
High
Market Growth Rate

Stars Question marks

$
Low

Cash Cows Dogs

>1 1 <1

1.3.3 Criticisms of the model

 Average growth is difficult to define
 Many very successful products or business units would be classified as dogs
 Calculating market share is difficult
 BCG makes no attempt to measure cash flows or profit
 Difficult to know how to deal with declining markets

1.3.4 Using the BCG model to determine strategy

 Build share – invest to increase market share
 Hold – invest just enough to keep the SBU in its present position
 Harvest – the amount of investment in order to maximise the short-term cash flows and profits from
the SBU
 Divest – divest the SBU by phasing it out or selling
36 7: Making strategic choices CIMA E3 Topic Reviews

2 How to achieve strategic options

2.1 Methods of strategy development (Johnson and Scholes)
2.1.1 Internal (organic) development
Strategies developed by building on and developing an organisation’s own capabilities. For many
organisations this is the primary method of development.
Advantages Disadvantages
Cost is spread over a longer period of time Slow
Requires a slower rate of change than acquisition We may lack expertise
Possibly more acceptable to stakeholders May be expensive

There may be no competitor to buy, leaving no choice but Risk of distraction from core operations
to develop internally
Offers development opportunities to middle managers Spreads management thinly
Difficult to acquire overseas companies, e.g. Japan
Avoids the political and cultural problems of merging two
separate organisations
We get exactly what we want

2.1.2 Mergers and acquisitions

Advantages Disadvantages
Quick Cultural differences
Takes out a competitor Difficult to control speed of acquisition
May be cheaper than internal development Buy “warts and all”
(Target may have a lower P/E)
Acquire core competences, R&D, people etc. May cause staff anxiety
Cost efficiency Risk of paying too much (e.g. hostile or contested
takeover)
Institutional stakeholders expect growth

2.1.3 Strategic alliances

Two or more organisations share resources and activities to pursue a strategy. Partners may provide
the strategic alliance with products, distribution channels, manufacturing capability, funding,
equipment, knowledge, expertise, or intellectual property.
Collaborative leadership describes leadership across functional and organisational boundaries. It
particularly applies in strategic alliances and in public-private partnership contracts. Increasingly
common in technological age.
The alliance may fail due to failure to understand cultural differences between the organisations, goal
divergence, insufficient trust or unrealistic expectations.
CIMA E3 Topic Reviews 7: Making strategic choices 37

Benefits Drawbacks
Creates critical mass, useful for competing in a global Shared returns
market
Co-specialisation, e.g. manufacturer working with Compromise
distributor to enter a market
Learning opportunity Surrender unique knowledge
Shared resources Fallout if things go wrong
Shared risk Reputation risk if partner fails to deliver

2.1.4 Joint venture

The parties agree to create a new entity by both contributing equity, and share in the revenues,
expenses, and control of the enterprise. The venture can be for one specific project only, or a
continuing business relationship. Reasons for failure include lack of communication and disputes over
distribution of power.

2.1.5 Franchising
The franchisee uses name, food, supplies, logo and even building design in exchange for a fee. The
franchisor provides advertising, training, and other support services.
Benefits Drawbacks
Quick way to start a business for franchisee Franchisee has to follow franchisor’s system
Turnkey business Franchisee requires franchisor’s approval for
changes
Franchisee can obtain training in all aspects of Franchisee’s costs dictated by franchisor
franchisor’s business
Franchisor can quickly propagate brand and formula Level of franchise fee/royalties/contributions may
be high
Shared risk Conflict if lack of good faith

2.1.6 Licensing
This arrangement involves giving the right to use a resource in return for a share of the proceeds.

2.1.7 Outsourcing
Contracting out aspects of the work of an organisation to a specialist provider, such as payroll or IT.

2.1.8 Divestment (could be a sale or de-merger)

 Make a profit
 Raise cash for another venture
 Rationalise a diversified business
 Satisfy market fashion
 Allow managers to concentrate on the remaining portfolio
 Swap for a more desirable asset
 Reduce debt
 As a result of a strategic review
 As a result of competition law requirements
38 7: Making strategic choices CIMA E3 Topic Reviews

2.1.9 Overseas expansion

The business may simply export, it may manufacture overseas or it may conduct business on a
multinational or transnational basis.

3 Value analysis
3.1 Value chain
Value drivers are those activities that enhance the perceived value or service by the customer

 Identify costs and benefits of each activity

 Understand what factors drive costs and generate benefits behind each activity
 Benchmark processes of competitors in relation to each activity
 Understand linkages in the chain

Firm Infrastructure

Human Resource Management

Technology Development

Procurement Profit
Margin
Marketing &
Operations

Outbound
Logistics
Inbound

Logistics

Service
Sales

3.2 The value network

The value network is the set of inter-relationships that are necessary to create a product or service.

Suppliers Our value Customer's

value chain chain value chain

3.3 The value shop

The value shop schedules activities and applies resources in a manner appropriate to the client’s
needs.

4 Criteria for evaluation (Suitable, Acceptable, Feasible)

 Is the plan suitable (Does it fit in with our mission and objectives?)
 Will it be acceptable to our stakeholders? (Consider Mendelow matrix.)
 Is the plan feasible, do we have the resources available to carry out the plan? (Use 5Ms or the
4Ps maybe?)
 39

Strategic control

1 Strategic performance management systems

 Establish expectations
 Provide yardstick for measurement
 Determine progress
 Decide when corrective action is needed
Influences are environment, strategy and business type
 Financial performance measures – widely understood and enable comparisons but can be
manipulated, lead to short-term thinking and focus on past events rather than what is required
to create future value
 Non-financial performance measures – take wider view, but may be subjective and difficult to
establish

1.1 Strategic management accounting (Keith Ward)

Strategic management accounting is where accountant focuses on external as well as internal
information and works as part of a team with other senior managers, aiming to provide multi-
dimensional performance measurement and strategic evaluation of projects.
 Competitor analysis
 Customer profitability analysis
 Support for pricing and other strategic decisions
 Portfolio analysis

2 Critical success factors

“Those components of strategy where the organisation must excel to outperform competition”
(Johnson, Scholes and Whittington).
Examples include product quality, delivery time, brand awareness, positive staff attitude.
40 8: Strategic control CIMA E3 Topic Reviews

Sources of critical success factors

 The industry
 The company and its situation in that industry
 The wider environment
 Temporal organisational factors

2.1 Key performance indicators

Business strategy (for

example, differentiation)

CSF (for example,

customer service) there
would be serveral for
each strategy

KPI (for example,

customer feedback)
there would be several
for each CSF

3 The balanced scorecard

The balanced scorecard adds strategic non-financial performance measures to traditional financial
metrics to give managers and executives a more 'balanced' view of organisational performance.

Customer perspective
Financial perspective
Delivery time
Cashflows
Maintenance response time
Profits
Call waiting
Margins
Rank in customer surveys
Sales growth
Market share
Cost ratios
Churn rate
Working capital
Complaints

Internal perspective Innovation and learning perspective

Percentage reduction in cycle time Speed to market
Capacity utilisation Speed of imitation
Order response time (JIT, TQM etc) % of revenue from new products
Staff satisfaction Training days per employee
R&D spend, absolute and % of turnover
CIMA E3 Topic Reviews 8: Strategic control 41

3.1 Disadvantages of balanced scorecard

 If the number of different measures is large, it may be difficult to see a clear picture of what’s
happening.
 It may be difficult for managers to understand some of the measures being used.
 Some of the measures (investment expenditure vs cost limitation) may conflict.
 Other measures may take too much attention away from maximisation of profit.

3.2 Strategy mapping

Strategy mapping is an extension of the balanced scorecard:
 Identify the key objective
 Determine how organisation creates value
 Identify objectives to help achieve this under the four BSC perspectives
 Identify cause and effect relationships between them
The strategy map identifies what is needed in terms of human, information and organisational capital
(culture, leadership, alignment, teamwork). The map needs to be updated continually for changes and
events in the environment.

4 Performance Pyramid (McNair, Lynch & Cross)

The organisation consists of interdependent levels that support each other but each has its own concerns.

 Commercial organisations
Tend to focus on s/h & customers &
ignore other stakeholders but need
Corporate vision
measures for staff, suppliers, govt etc

 Business units

Market Financial Measures

Objectives
share profit

 Business operating
Flexibility, eg
Customer systems & internal systems
response to Productivity
satisfaction processes to meet
customer demands
customer needs

 Departments and work

Quality Delivery Cycle time Waste centres. Day to day
operational measures to
monitor the status of
level 3 measures
Operations

External effectiveness Internal effectiveness

Measures are predominantly Measures are predominantly

non-financial financial
42 8: Strategic control CIMA E3 Topic Reviews

5 Fitzgerald and Moon’s models

5.1 Results and Determinants framework
 Determinants – flexibility, innovation, reliability of service and efficiency
 Results – financial and competitive performance

5.2 Building blocks model

 Dimensions – profit, competitiveness, quality, resource utilisation, flexibility and innovation
 Standards – ownership, achievability and equity
 Rewards – clarity, motivation and controllability

6 Benchmarking
Benchmarking is making comparisons to measure relative levels of performance and hence identify
how best practice can improve performance.
 Internal – comparison against another department of the same organisation
 Competitor – comparison against competitor with similar processes
 Process or activity – comparison against a similar process in a non-competitor company
 Industry/sector – profitability, cost ratios, customer satisfaction, branding, strategy
 Best-in-class – comparison against the best performer, internally or externally

6.1 Benefits of benchmarking

 Challenges assumptions
 Changes behaviour
 Helps break resistance to change by demonstrating other methods of solving problems
 Helps cut costs
 Improves service
 Helps simplify processes
 Improves quality

6.2 Gap analysis

Gap analysis enables a company to compare its actual performance with its potential performance. It
is a formal study of what a business is doing currently and where it wants to go in the future.
The process involves determining, documenting and approving the variance between business
requirements and current capabilities. The analysis can be performed at the strategic or operational
level.
Gap analysis helps provide the company with insight into areas that require improvement.
 Identify the future expected gap
 Come up with a strategy, or strategies, to close it
CIMA E3 Topic Reviews 8: Strategic control 43

Goal

Gap

Forecast

T0 T1

Where we The future

are now

 Demand gap – the difference between total market potential and current demand from users.
 Distribution gap – loss of product demand due to lack of access to, or utilisation of, distribution
channels.
 Product gap – demand lost through product failure or deliberate product positioning decisions.
 Competitive gap - loss in sales due to failures in pricing or promotion.

6.3 Transfer pricing

Transfer pricing arrangements need to be transparent and clear. Their impact on internal reward
systems, motivation and behaviour needs to be carefully assessed. The tax implications (tax planning
but also avoidance of problems with tax authorities) may influence arrangements.

7 Divisional performance measures

The measures used will depend on whether the division is a cost centre, investment centre or profit
centre.
Examples:
 Cost centre – total cost, cost variances, quality measures
 Profit centre – as above, plus sales, profits, margins, market share
 Investment centre – all the above plus ROI, RI, EVA, SVA
See also triple bottom line reporting (Chapter 4).
44 8: Strategic control CIMA E3 Topic Reviews

7.1 Return on investment (ROI)

Should use profit before head office allocations,

usually before interest and tax, if assessing the
manager’s performance. If looking at the
performance of the division it may be better to
include centrally allocated costs as well.

Divisional profit
ROI = × 100
Divisional investment

May use capital employed (TALCL) or

net assets (total assets – total liabilities)

7.2 Residual income (RI)

$
Divisional profit (same definition as for ROI) X
Notional (imputed) interest (divisional investment × cost of capital) (X)
RESIDUAL INCOME X

A positive RI suggests that the division has generated a profit over and above that required by the
capital providers.

7.3 ROI & RI comparison

Technically residual income is the better method because it is linked to cost of capital and should
result in fewer dysfunctional decisions being made.
ROI is still preferred in the majority of businesses:
 It gives a % answer and people understand % returns such as ROCE.
 Interdivision comparisons are easier to make since ROI is a relative measure, not an absolute
one like RI. This makes it simpler to compare divisions of differing sizes.
 It is not felt that dysfunctional decision making happens often enough to be a real problem.
 RI needs an estimate of cost of capital to be made.
Problems with both measures:

Which profit figure to use?

 Identifying what is controllable and what is not
 Pre or post tax figures?
 Attributable and non-attributable costs (including central spreading of overheads)

Which investment figure to use?

 Do we use opening, closing or average net assets?
 Use of statement of financial position values based on historic cost and NBV will make
comparing divisions of differing ages hard. Use replacement cost for asset values.
CIMA E3 Topic Reviews 8: Strategic control 45

 How to include those assets that are not reflected on the SOFP such as intangible assets (for
example in a service or people orientated business)?

7.4 Economic value added (EVA®)

EVA ® is based on the same principles as residual income but aims to make adjustments to both the
profit figure used and the asset figure used in order to better reflect the economic reality of the
performance and decision making.

Benefits of EVA
 Linked to cost of capital and hence will be consistent with trying to improve shareholders’
wealth
 NOPAT will be a closer reflection of cash flow than accounting profit because of the adjustments
made
 Adjustments reflect the economic reality of the costs and revenues rather than accounting
prudence

Limitations of EVA
 By looking at a single period at a time rather than all cash flows over a long time span, a short-
term view may be taken by some managers
 Involves potentially many adjustments
 It is difficult to compare divisions of differing sizes using EVA

7.5 Shareholder value added

Maximise future cash flows via a set of ‘value drivers’ for cash generation:
 Sales growth rate
 Life of the project
 Operating profit margin
 Working capital
 Cost of capital
 Asset investment
 Taxation
46 8: Strategic control CIMA E3 Topic Reviews

8 Communication of performance targets

Targets should be difficult to achieve but not impossible and should promote goal congruence
(behaviour in line with organisational objectives). They should be communicated clearly, particularly if
they are stretch targets (only achievable by redesigning processes).

8.1 Problems with target setting

Tunnel vision Focus only on a specific performance target, not the whole performance
Sub optimisation Focus on some targets to the neglect of others
Myopia Short term achievement of targets favoured over working towards longer-term
goals
Misrepresentation Manipulation of results
Misinterpretation Failure to see where targets fit into the whole picture
Gaming Fixing the results of a measure for an inappropriate reason
Ossification A measure continues to be used even if it is found to be inappropriate
Measure fixation Wrong indicators are used but resources are absorbed into achieving them

9 Resource audit
Link back to whether the organisation has the appropriate resources/competencies and using them
well. (Chapter 5).
 47

Change management I

1 Impact of strategies on the organisation

Implementing strategy might lead to change. The following might cause change:
 Challenges of growth, especially global markets
 Changes in strategy
 Technological changes
 Competitive pressures, including mergers and acquisitions
 Customer pressure, particularly shifting markets
 To learn new organisation behaviour and skills
 Government legislation/initiatives.

1.1 Triggers for change

Internal External
CEO introduces new management practices and Political and legal pressures (new laws, regulations
initiatives and tax rules)
Changes in organisational performance and results Changes in the economic cycle (recession)
Changes in senior management (personnel and / or Social changes, e.g. demographics (age, income and
opinions) gender)
High staff turnover may be as a result of relocations Technological changes, (for example internet and
outsourcing, new practices mobile technologies)
Outdated working processes and methods Changes in customer tastes and buying behaviour
Changes in competitors and / or the amount of
competition (think Porter’s five forces)
48 9: Change management I CIMA E3 Topic Reviews

1.2 Change-adept organisation

 The imagination to innovate – new concepts
 The professionalism to perform – competence
 The openness to collaborate – connection with external partners

1.3 Lewin’s model of staged change

1.3.1 Model of change
 Unfreeze – create a level of dissatisfaction with the status quo which creates conditions for
change to be implemented
 Change – organise and mobilise the resources required to bring about the change
 Re-freeze – embed the new ways of working into the organisation

1.3.2 Force Field Analysis

OBJECTIVE OF THE CHANGE PROCESS

DRIVING FORCES RESTRAINING FORCES

Ideal state

Current state
 Investigate the balance of power involved in an issue
 Identify the key stakeholders on the issue
 Identify opponents and allies
 Identify how to influence the target groups

1.3.3 The three C’s

 Communicate
 Consult
 Counsel
Managers should consider the pace, manner and scope of change carefully.

1.4 Balogun and Hope-Hailey

 Nature of change – speed and intensity of change
 Scope of change – extent of change and how much it challenges existing methods and
assumptions
CIMA E3 Topic Reviews 9: Change management I 49

Types of change

2 Change strategies and processes

2.1 Change strategies (Beer and Nohria)
 Theory E (economic) change strategies focus on shareholder value and often involve
downsizing, restructuring and incentives for staff. They can achieve short-term improvements
but ignore employees and therefore lack the commitment of employees to sustain competitive
advantage over the long-term.
 Theory O, organisation, change strategies take a softer approach, for example improving
capabilities through organisational learning or personal development. Theory O organisations
may fail to take tough decisions and thus fail to gain shareholder buy in.
Solution – try to combine the two.

2.2 The cultural web

Symbols &
Titles

Rituals & Power &

Routines Relationships

The
paradigm
Organisational Myths &
Structure Stories
Control
Systems
50 9: Change management I CIMA E3 Topic Reviews

 Symbols & Titles – visual representations of the company including logos, how plush the offices
are, and the formal or informal dress codes
 Power & Relationships – people that have the greatest amount of influence on decisions,
operations, and strategic direction
 Myths & Stories – past events and people talked about inside and outside the company
 Control Systems – financial systems, quality systems and rewards
 Organisational Structure – structure defined by the organisation chart and the unwritten lines of
power and influence
 Rituals & Routines – daily behaviour and actions of people that signal acceptable behaviour

2.3 McKinsey 7S model

This looks at the components of corporate culture, which must be aligned for change to work:
 Hard – strategy, structure and systems
 Soft – skills, staff, styles, shared values
 51

10

Change management II

1 The role of the leader in managing change

1.1 Change leadership
 Establish a sense of urgency
 Create a coalition – topics around teams and team building are relevant here – see Section 4
 Develop a vision
 Communicate the vision
 Empower action
 Generate short term wins
 Maintain the process
 Incorporate changes into the culture
According to Reardon and Rowe, different leadership styles are needed at different times in the
change process to successfully steer an organisation through steps of radical change:
 Logical – seeks new information, identifies obstacles, generates alternatives, evaluates options
 Inspirational – inspires other team members to maximise their contribution and increase
creativity
 Supportive – provides the reassurance to help employees cope with change
 Commanding – goal orientated management – ensuring that plans are adhered to

1.2 Change agents

A change agent facilitates and manages change, defining problems associated with change and
recommending solutions. They require the ability to think flexibly and personal skills including
networking, teambuilding, communication and negotiation skills.
52 10: Change management II CIMA E3 Topic Reviews

1.3 Five styles of change management (Johnson, Scholes & Whittington)

Style Context Benefits Problems Circumstances of
effectiveness
Education and Group briefings Overcoming lack of Time consuming
communication assume (or mis) information Direction or
(Meet and internalisation of progress may be
explain) strategic logic and unclear
trust of top
management Incremental change or
long-term horizontal
Collaboration/ Involvement in Increasing ownership Time consuming
transformational
participation setting the of a decision or Solutions/outcome change
(Joins) strategy agenda process within existing
and/or resolving May improve quality paradigm
strategic issues by of decisions Potentially very
taskforces or Need good, conservative
groups motivated people approach
Intervention Change agent Process is Risk of perceived Incremental or non-
(Considered retains co- guided/controlled manipulation crisis transformational
change) ordination/ but involvement change
control: delegates takes place Time needs to be
elements of available
change
Direction Use of authority Clarity and speed Risk of lack of Transformational
(Do it) to set direction acceptance and ill- change
and means of conceived strategy
change
Coercion/edict Explicit use of May be successful in Least successful Crisis, rapid
(Do it or else) power through crises or state of unless crisis transformational
edict confusion change or change in
Needs strong established autocratic
leadership cultures
May be illegal or
unethical

1.4 Forming teams (Tuckman)

 Forming – team meets and learns about the opportunity, challenges, agrees goals and begins to
tackle the tasks
 Storming – different ideas compete for consideration and team considers what problems they
are supposed to solve, how to function independently and together and their leadership model
 Norming – members adjust behaviour to each other as they develop work habits that make
teamwork seem more natural and fluid
 Performing – high-performing teams are able to function as a unit as they find ways to get the
job done smoothly and effectively without conflict or the need for external supervision

1.5 Team members (Belbin)

 Plant – creative, imaginative, unorthodox team-member who solves difficult problems
 Resource Investigator – networker for the group, has the contacts to supply resources
 CIMA E3 Topic Reviews 10: Change management II 53

 Chairman/Co-ordinator – ensures all members of the team are able to contribute to discussions
and decisions of the team
 Shaper – dynamic team-member who loves challenges and thrives on pressure, with drive and
courage required to overcome obstacles
 Monitor-Evaluator – tries to see all options and judge accurately.
 Team Worker – ensures interpersonal relationships are maintained
 Company Worker / Implementer – practical thinker who creates systems and processes that
will produce what the team wants and who works out how to solve problems
 Completer Finisher – detail person, ensures the quality and timeliness of the output of the
team.
 Specialist – brings 'specialist' knowledge to the team

2 Resistance
Overcoming resistance to change (Kotter and Schlesinger)
 Education and communication
 Participation and involvement
 Facilitation and support
 Negotiation and agreement
 Manipulation and co-option
 Explicit and implicit coercion

2.1 Success of change programmes

 Understandable goals
 Realistic time frames
 Clear guidance for individual participants
 Clear and unified leadership
 Management support
Mentoring and coaching are key elements of management support:
 Mentoring – more experienced person serves as a role model offering practical support and
advice to develop the skills an individual needs in order to be more effective
 Coaching – over a shorter timescale and is targeted to help a more junior person to gain specific
skills in a key work area

2.2 Failure of change programmes

 Individual change initiatives are not always undertaken as part of a wider coherent change plan
 Lack of effective project management
 Insufficient training, e.g. in project management, change management skills, leadership skills
 Poor communication of reasons for, and benefits of, change
 Imposed change can lead to greater employee resistance
 Lack of effective leadership
 Excessive focus on costs
 Managers fear of impact of change on them
54 10: Change management II CIMA E3 Topic Reviews

2.3 Managing decline

 Retrenchment – radical cost cutting
 Turnaround – repositioning in the market
 Divestment – sale of part of the business
 Liquidation – sale of the whole organisation
CIMA P3 Topic Reviews Approach to the Strategic Case Study 55

Paper P3
Risk Management
56 Approach to the Strategic Case Study CIMA P3 Topic Reviews
 57

Identifying risk

1 Types of risk
There are two main categories of risk that organisations can face:
 Strategic risk – arises from overall strategic positioning of the company in its environment,
long-term business risk
 Operational risk – refers to potential losses arising from normal day-to-day business operations
Other important risk types include:
 Downside – risk of negative outcomes
 Upside – risk of possible benefits
 Pure risk – loss is the only possible outcome, often related to events that are beyond the risk-
taker's control such as natural disasters
 Gross risk – inherent risk that exists if management take no action
 Net risk – residual risk which still exists after management’s actions

2 Specific risks
Common risks include:
 Product risk  Fraud risk
 Political risk  Reputation risk
 Macro-economic risk  Ethical risk
 Social trends risk  Business probity risk
 Technological risk  Environmental risk
 Industry-specific risks  Information systems risks
 Risk from competitor strategies  Compliance risk
 Financial risk  Business risk
 Event risk  Supply risk
 Financing risk
58 1: Identifying risk CIMA P3 Topic Reviews

3 Risks in IS/IT systems

 Physical threats
 Virus infection/hacking
 Technical failure
 Infrastructure failure
 Human error
 Theft of hardware or software
 Business interruption through fire or flood

4 Risk of international operations

Companies who operate overseas face additional risks:
 Currency – changes in foreign exchange rates
 Cultural – differences in income levels, language and taste mean that companies may have to
adapt products
 Transit – more goods in transit between countries
 Credit – overseas customers may take longer to pay their debts
 Political – risks faced by businesses due to the exercise of political power or instability in a
country, including tax rules, expropriation, nationalisation, remittance or ownership restrictions

5 Tools for quantifying risk

5.1 Expected values
Expected value is a weighted average calculation involving assignment of probabilities to possible
outcomes and multiplying by estimated value of outcomes.

5.2 Value at Risk (VaR)

Value at Risk (VaR) quantifies the maximum loss that is acceptable to a company over a period of time,
given normal market movements and a given level of probability.
Value at Risk = confidence interval value × standard deviation
Confidence interval value is the Z score derived from the area under a normal curve formula sheet
given in the exam.
 59

Risk management strategy

1 CIMA’s Risk Management Cycle

1 Establish risk management group and set goals
2 Identify risk areas
3 Understand and assess the scale of risk
4 Develop risk response strategy
5 Implement strategy and allocate responsibilities
6 Implement and monitor suggested controls
7 Review and refine the process and do it again
(1) Establish a risk management group and set goals.
Risk management group has the following roles:
 Facilitate and co-ordinate the overall risk management process
 Set out approach to risk management
 Establish and communicate risk appetite (risk v returns)
 Set out responsibilities:
– Risk manager – maintains effective risk management throughout the organisation, instills
culture of risk awareness and implements risk strategy
– Risk management function – comprising managers throughout the business
– Risk committee – board committee promoting understanding and assessment of risk,
and facilitating development of risk management strategy
(2) Identify risk areas
A risk audit is a review of all of the risks that a business faces now or may face in the future. It
involves assessing the competitive environment in which the company operates (perhaps using
PEST/SWOT analysis), relevant economic conditions and surveying key stakeholders such as
customers and staff.
60 2: Risk management strategy CIMA P3 Topic Reviews

The main risks facing the company should be recorded in a risk register.
IDENTIFY ANALYSE RESPOND
ID Description Likelihood Consequence Action

(3) Understand and assess the scale of risk

Evaluate:
 Seriousness of risk
 Controllability of risk (can it be managed)
Risks can be quantified by applying probabilities, expected values or by performing cost-benefit
analyses.
Risks can be evaluated using a risk map or likelihood/consequences matrix.
Consequence of risk

Low probability/high impact = High probability/high impact =

Medium risk : High risk

Transfer Avoid

Likelihood of
occurrence
Low impact/low probability = Low impact/high probability =

Low Risk Medium risk

Accept Reduce

High risk items threaten the business objectives of an organisation and MUST be controlled as a
matter of urgency.
Low risk items shouldn’t have any significant impact on the organisation and can be accepted.
Medium risk items (either high probability/low impact or low probability/high impact) should
firstly be monitored, with subsequent actions determined by the matrix: (see below)
(4) Develop a risk response strategy
 Transfer the risk – e.g. by insuring against the risk or forming a joint venture
 Accept the risk (i.e. do nothing) – particularly if the risk is deemed immaterial (cost vs
benefit)
 Reduce/Control the risk – limit likelihood of occurrence and/or impact
 Avoid the risk – by abandoning the actions causing the risk to arise
CIMA P3 Topic Reviews 2: Risk management strategy 61

Portfolio theory suggests that it is less risky to have diverse sources of income rather than a
single stream. Spreading investments reduces risk. This can be achieved through market
expansion or diversification.
(5) Implement the strategy and allocate responsibilities
The risk can then be assigned to a director or manager, who is given the responsibility for
managing that risk.
(6) Implement and monitor the suggested controls
The board should inform the whole organisation about the key risks it faces and its responses to
them, and what is expected in terms of managing that risk and implementing controls.
Internal audit could be used at this stage to monitor the effectiveness of the implementation
process and the effectiveness of the controls themselves.
(7) Review and refine the process and do it again
It is prudent for an organisation to see its risk management strategy as a continual process – an
embedded system.

2 Enterprise Risk Management (ERM)

Another model for managing risk in an entity is set out by the Commission of Sponsoring Organisations
of the Treadway Commission (COSO).

2.1 2004 framework

The Framework that COSO published has eight Components and four Objectives categories.

2.2 2017 framework

COSO updated its framework in 2017 with its publication Enterprise Risk Management – Integrating
with Strategy and Performance. The emphasis in this update is on the use of ERM in strategic planning
and embedding it throughout the organisation.
62 2: Risk management strategy CIMA P3 Topic Reviews

ERM framework
Governance and culture Exercises board oversight
Establishes operating structures
Defines desired culture
Demonstrates commitment to core values
Attracts, develops and retains capable individuals
Strategy and objective setting Analyses business context
Defines risk appetite
Evaluates alternative strategies
Formulates business objectives
Performance Identifies risk
Assesses severity of risk
Prioritizes risk
Implements risk responses
Develops portfolio view
Review and revision Assesses substantial change
Reviews risk and performance
Pursues improvement in enterprise risk
management
Information, communication and reporting Leverages information and technology
Communicates risk information
Reports on risk, culture and performance

2.3 ISO 31000

CIMA P3 Topic Reviews 2: Risk management strategy 63

ISO (the International Organisation for Standardisation) updated ISO 31000 in 2018 to provide risk
management guidelines. The standard describes risk as an iterative process that is part of the
organisation’s governance and leadership, and considers external and internal factors.

3 The risk cube

Risk can be presented visually in the form of a risk cube, determined by three dimensions:
 Seriousness of threat itself
 Extent to which organisation is vulnerable to threat
 Impact of threat if it materialises (referred to as the asset)

4 Assurance maps
An assurance map provides a structured approach to identifying the main sources and types of
assurance in an organisation. The ICAEW recommends the following ten-point map:
(6) Identify who will champion the process (the sponsor)
(7) Determine scope of the map (e.g. strategic / operational level)
(8) Assess level of assurance required (based on risk, complexity, past experience)
(9) Map each assurance provider to the four lines of defence
(10) Identify your assurance activities (i.e. what actions the providers perform)
(11) Reassess your scope (2) in the light of the activities (5)
(12) Assess the quality of your assurance activities (e.g. breadth/depth of scope)
(13) Assess how much assurance is being provided by the providers at each line of defence
(14) Analyse any gaps or overlaps in assurance being provided
(15) Determine course of action in the light of (9)
64 2: Risk management strategy CIMA P3 Topic Reviews
 65

Corporate governance

1 Evaluate governance and ethical issues facing an organisation

Corporate governance is the system by which organisations are directed and controlled.
The objective of good corporate governance is to ensure the management and reduction of risk, and
to create clear lines of accountability to all stakeholders (not just shareholders).

2 Non-executive Directors (NEDs)

NEDs have no executive involvement in the running of the business. They scrutinise the actions of the
executive directors, providing reassurance to shareholders that management is acting in the best
interests of the organisation.
Independent non-executives should make up the majority of the three main committees – the audit
committee, nomination committee and remuneration committee.

2.1 Main advantages of independent NEDs

 They can be more objective than executive directors.
 They may have external experience that the executive directors don’t have.
 They should challenge and help to develop proposals on strategy.
 They should conduct performance monitoring of both the company and the board, providing a
comfort factor to shareholders.
66 3: Corporate governance CIMA P3 Topic Reviews

3 Audit committees
Audit Committee

Internal control aspects External audit

Review internal control system and risk Monitor integrity of financial statements
management system
Monitor and review effectiveness of internal Recommend to the board appointment and
audit department remuneration of the external auditor
Review results of internal auditors’ work Review the auditor’s independence and
quality
Review the auditor’s “letter of weakness”

3.1 Whistle-blowing
Whistle-blowing is when someone who works for a company raises a concern about a possible fraud,
crime or other serious risk that could threaten customers, colleagues, shareholders, the public or the
company’s own reputation.
The audit committee (or, for smaller companies, the Board of Directors) should oversee how an
entity’s whistle-blowing procedures operate.

4 The UK Corporate Governance Code

The UK Corporate Governance Code is considered best practice both in the UK and abroad. Aimed
primarily at companies on the London Stock Exchange, the UK Corporate Governance Code is not law
but there are requirements to ensure that any non-compliance is disclosed.
There are five key sections which companies need to focus on:

4.1 Leadership
 Every company should be headed by an effective board.
 The roles of Chairman (the person overseeing the Board) and Chief Executive (the person
running the company’s business on a day-to-day basis) should be held by different people.

4.2 Effectiveness
 The board and its committees should have the appropriate balance of skills, experience,
independence and knowledge of the company.
 The board should include a balance of executive and non-executive directors such that no
individual or small group of individuals can dominate the board’s decision-making.
 There should be a formal, rigorous and transparent procedure for the appointment of new
directors to the board, carried out by the nominations committee.
 All directors should be able to allocate sufficient time to the company to discharge their
responsibilities effectively.
 The board should be supplied in a timely manner with information in a form and of a quality
appropriate to enable it to discharge its duties.
CIMA P3 Topic Reviews 3: Corporate governance 67

 All directors should receive induction on joining the board and should regularly update and
refresh their skills and knowledge.
 The board should undertake a formal and rigorous annual evaluation of its own performance
and that of its committees and individual directors.
 All directors should be submitted for re-election regularly. Non-executive directors who have
served longer than nine years should be subject to re-election annually.

4.3 Accountability
 The board should present a balanced and understandable assessment of the company’s
position and prospects.
 The board is responsible for determining the nature and extent of the significant risks it is
willing to take in achieving its strategic objectives.
 The board should maintain sound risk management and internal control systems.
 The board should maintain an appropriate relationship with the company’s external auditor.
This should be done using the audit committee.
 The directors should, at least annually, conduct a review of the effectiveness of the company’s
system of internal control and should report to shareholders that they have done so.

4.4 Directors’ remuneration

 Levels of remuneration should be designed to promote the long term success of a company,
but a company should avoid paying more than is necessary for the purpose.
 There should be a formal and transparent procedure for developing policy on executive
remuneration and for fixing the remuneration packages of individual directors.
 No director should be involved in deciding his or her own remuneration. Executive director
remuneration should be set by the remuneration committee made up of NEDs. The executive
directors determine the fee levels paid to NEDs.

1.4.1 The design of performance-related remuneration for executive directors

 There should be appropriate balance between fixed/performance related and
immediate/future remuneration.
 Performance conditions should be relevant, should stretch the individual and be designed to
promote the long term success of the company.
 Incentives should be compatible with the company’s risk policies and systems.
 Upper limits should be set/disclosed.
In terms of share-based remuneration:
 New long term incentive schemes should be approved by shareholders.
 Total rewards available should not be potentially excessive.
 Remuneration committee should consider requirements attaching to shareholdings, such as
minimum shares to hold and length of time to hold them.

4.5 Relations with shareholders

There should be a dialogue with shareholders based on a mutual understanding of objectives. The
board should use the AGM to communicate with investors and to encourage their participation.
68 3: Corporate governance CIMA P3 Topic Reviews

5 The US approach to corporate governance

The Sarbanes-Oxley Act (“SARBOX”) applies to all US public corporations:
 The audit committee should consist of independent directors, one of whom should be a
financial expert.
 The CEO and CFO of each company prepare a statement to certify the appropriateness of the
financial statements and that they fairly present, in all material respects, the operations and
financial condition of the issuer.
 The financial statements should contain an internal control report, which contains an
assessment, as of the end of the issuer's fiscal year, of the effectiveness of the internal control
structure and procedures of the company.

6 The CIMA Code of Ethics for Professional Accountants

6.1 Fundamental principles
A professional accountant is required to comply with the following fundamental principles:
 Confidentiality – should not be breached
 Objectivity – independence
 Professional competence and due care – using the relevant professional standards
 Professional behaviour – don’t bring the reputation of the profession into disrepute
 Integrity – being straightforward and honest

6.2 Ethical conflicts

Accountants and auditors may find their compliance with the above principles threatened:
 Self-interest – having shares in the company
 Self-review – preparing and auditing financial statements
 Advocacy – promoting a supplier company run by family member
 Familiarity – appointing family member as a NED
 Intimidation – threatening external auditor with the sack
 69

Risks associated with

formulation of strategy

1 Analysis of strategic choice

A strategy is the plan an organisation puts together in order to achieve its goals, set with consideration
to internal strengths and weaknesses, as well as external opportunities and threats.
To formulate a strategy, it is necessary to make assumptions about the future based on the
information available. There is a risk that these assumptions prove to be inaccurate and the strategy is
inappropriate.
Models can be used to analyse specific aspects of strategy and can therefore be used to identify and
manage risk:

1.1 Porter’s Competitive strategies

Cost leader Stuck in the middle Differentiator

Costs Profit
70 4: Risks associated with formulation of strategy CIMA P3 Topic Reviews

Cost leaders and differentiators are able to secure high profits, either by keeping costs low or offering
a differentiated service respectively.

1.2 Ansoff’s and Lynch growth matrices

Ansoff Existing products New products

Existing markets Market penetration Product development

New markets Market development Diversification

Market penetration is the lowest risk option as it continues with existing products in existing markets,
although it also has the lowest potential for growth. Diversification is the highest risk option and
offers a correspondingly high potential for growth.
Lynch Internal development External development

Joint venture, merger,

Home country Internal development
acquisition, alliance, franchise

Exporting, overseas Joint venture, merger,

Abroad
office/manufacturing acquisition, alliance, franchise

1.3 Suitability, Acceptability, Feasibility (SAF)

Suitability Does the strategy fit with the organisation’s strategic vision?
Acceptability Will this meet stakeholders’ expectations?
Feasibility Can the strategy be implemented with the resources available?

2 Managing disruptions to strategy

2.1 Scenario planning
Scenario planning prepares a number of strategies based on a variety of plausible situations.
Scenario planning is most appropriate where the environment is complex and at risk of sudden and
significant change.

2.2 Stress testing strategy

Stress testing involves scrutinising and critically appraising an existing strategy. It is designed to
challenge the status quo and is particularly appropriate where there is a risk of complacency or
stagnation.
CIMA P3 Topic Reviews 4: Risks associated with formulation of strategy 71

3 Reputational risk
An organisation’s reputation can be damaged in the following ways:
 Unethical behaviour
 Absence of suitable Corporate Social Responsibility policies
 Customer service failures
 Demotivated staff
 Data breaches

4 Disruption
The rate of change in the modern business environment makes innovative disruption increasingly
common. This is when a new product, often driven by technology, fundamentally disrupts the existing
market.
72 4: Risks associated with formulation of strategy CIMA P3 Topic Reviews
 73

Responses to strategic risk

1 Management control systems

1.1 Costing systems
 Activity-based costing (ABC) – identifying the main drivers of costs in an attempt to control
those costs
 Standard costing – determining the planned cost of a product, based on materials, labour and
overhead costs
 Target costing – designing a product meeting customer needs, determining what the customer
would be willing to pay and deducting required profit margin to get to a target cost
 Life cycle costing – seeing whether total revenue arising from the product exceeds total costs,
whether these costs are incurred before, during or after the product is produced.

1.2 Human Resource Management

 Recruitment policy
 Contracts of employment
 Adequate policies and procedures
 Discipline and reward
 Performance appraisal and feedback
74 5: Responses to strategic risk CIMA P3 Topic Reviews

1.2.1 Performance-related pay (e.g. profit-related pay)

Advantages Disadvantages
Profit is a known, tangible measure which is Profits can be manipulated through accounting
understood by employees and shareholders alike estimates such a depreciation
Using profit aligns the interests of managers and Can lead to short-term behaviour such as lowering
most shareholders as their main goal is likely to be expenditure on advertising or R&D
maximisation of wealth
There may be important, non-financial factors which
should be considered, such as pollution or quality

1.3 Organisational structure

The organisational structure can also act as a control system. For example, the company may need to
determine whether a centralised or decentralised structure is appropriate.
When the company becomes more geographically dispersed, then each division will be accountable
for its own data.

1.3.1 Outsourcing
Advantages Disadvantages
Allows company to focus on its core strengths Quality of the supplier needs to be vouched
Gives access to experts/specialist skills Company loses skills in-house
Saves company time and money Probable redundancies
Risk of high staff turnover borne by outsourced entity Potential confidentiality issues
Improved independence for certain areas Supplier is in good bargaining position at the end of
the contract

2 Divisional performance
2.1 Transfer pricing system
If a business has a divisional structure one division may transfer goods or services to another division.
The question is ‘at what price do the divisions agree to transfer at?’
 Cost centre – transfer at cost
 Profit/investment centre – decide on/negotiate price
For profit/investment centres, a good transfer pricing system should demonstrate:
 Goal congruence – managers of individual divisions should make decisions that are consistent
with optimising group overall profitability and usage of resources
 Autonomy – managers should be able to negotiate the transfer price between themselves with
minimal interference from head office, to keep them motivated
 Performance evaluation – system should allow a fair appraisal of the performance on the
divisions and their managers
 Minimise the tax liability
Goal congruence and autonomy can conflict however.
CIMA P3 Topic Reviews 5: Responses to strategic risk 75

2.2 Approaches to setting a transfer price

2.2.1 Market price
Selling division makes the same return as they would selling to third parties outside the group and the
receiving division would pay a fair price based on market conditions. This should ensure goal-congruent
behaviour.

2.2.2 Cost based transfer pricing (excluding opportunity cost)

 Actual cost or standard cost? (Standard cost means seller has incentive to control costs.)
 Full cost (i.e. FC + VC) or marginal cost? (Seller will cover costs if full cost is used, but buyer may
buy from cheaper external supplier.)
 Add a mark-up onto the cost? (Allows seller to make profit, but buyer may buy from cheaper
external supplier.)
 Use a dual pricing system where the selling division gets credited with the market price for the
transferred item and the receiving division only gets charged with variable cost.

2.3 Divisional performance measures

2.3.1 Return on investment (ROI) for an investment centre

Should use profit before interest and tax, if you are

assessing the managers’ performance. If looking at
the performance of the division it may be better to
include centrally allocated costs as well.

Divisional profit
ROI = × 100
Capital Employed

Use capital employed (TALCL) or net

assets (total assets – total liabilities)

2.3.2 Residual Income (RI)

$
Divisional profit (same definition as for ROI) X
Notional (imputed) interest (“divisional investment” × cost of capital) (X)
RESIDUAL INCOME X

A positive RI suggests that the division has generated a profit over and above that required by the
capital providers.

2.3.3 ROI & RI comparison

Technically residual income is the better method because it is linked to cost of capital and should
result in fewer dysfunctional decisions being made. ROI is still preferred in the majority of businesses:
 It takes figures from the statement of profit or loss and statement of financial position -
statements which are generally known and understood.
 It gives a % answer.
76 5: Responses to strategic risk CIMA P3 Topic Reviews

 Interdivision comparisons are easier to make since ROI is a relative measure, not an absolute
one like RI. This makes it simpler to compare divisions of differing sizes.
 RI needs an estimate of cost of capital to be made.

1.3.4 Divisional performance

In comparing divisional performance, like must be compared with like:
 When was the division established (age of assets etc)?
 How long has the current divisional manager been in place?
 What are the market conditions for the division’s goods or services?
 How old are the assets used by the division?

2.3.5 Economic Value Added®

CAPITAL CHARGE

Net operating profit after tax (NOPAT) X The net assets figure used will normally
Less capital charge (WACC × net assets) (X) be based on replacement cost (and
adjusted for R&D, advertising, lease costs
EVA X
etc as noted below).

NOPAT
Use the profit figure from the accounts and make adjustments for:
 Depreciation
 R&D, advertising etc.
 Lease costs
 Interest

3 Other aspects of performance measurement

3.1 Behavioural aspects of traditional control mechanisms
When people know that their performance is being controlled and monitored their behaviour can
change.
Positive change Negative change
Improved efficiency and motivation Become stressed and ill, lose confidence
Achievement of targets Unite and oppose targets

People are more concerned to avoid failure rather than achieve success. Employees will do what they
can to ensure their performance achieves the minimum level, including possibly setting easy targets
and manipulating their actual results.
CIMA P3 Topic Reviews 5: Responses to strategic risk 77

3.1.1 Benefits and difficulties of participation of employees in the negotiation of targets

Benefits Difficulties
Improved motivation Time consuming
Improved budget quality as set by more informed staff Slack is included
Greater commitment to achieving the budget Fits local objectives rather than corporate goals

3.2 Non-financial performance indicators (NFPIs)

 Customer satisfaction
 Market share
 Quality – level of service, reliability, number of complaints
 Delivery – on time, waiting times

3.3 Performance analysis in not-for-profit organisations and the public

sector
Organisations such as councils, charities and universities will have multiple stakeholders with a range
of non-quantifiable, conflicting objectives and therefore need different methods of control.

3.3.1 Value for Money

Performance could be measured in this sector by:
 Comparing actual performance to non-financial targets
 Questioning users
 Appointing regulators/experts to monitor performance
The National Audit Office (NAO) assesses value for money (VFM) according to three criteria:
 Economy – cost of resources used (are you spending more on resources than you should?)
 Efficiency – outputs vs. inputs (is there more wastage than expected?)
 Effectiveness – achieving targets (even if you are being economical and efficient, is what you’re
doing helping the organisation achieve its overall goals?)

4 The balanced scorecard (Kaplan and Norton)

The balanced scorecard approach to appraising performance was put forward by Kaplan & Norton as a
way of giving managers a comprehensive view of business performance.
The principle is that to achieve long term financial success you need to meet or exceed customer
expectations. To meet or exceed customer expectations, your internal business processes must be
very good and you will need to keep innovating, learning and improving.
78 5: Responses to strategic risk CIMA P3 Topic Reviews

4.1 Four perspectives of the balanced scorecard

Customer perspective
Financial perspective
Delivery time
Cashflows
Customer satisfaction
Profits
Call waiting
Margins
Rank in customer surveys
Sales growth
Market share
Cost reduction
Churn rate (% of customers who don't renew contracts)
Working capital
Complaints

Internal perspective
Innovation and learning perspective
Percentage reduction in cycle time
Speed to market
Capacity utilisation
Speed of imitation
Order response time (JIT, TQM etc)
% of revenue from new products
Staff satisfaction
Training days per employee
Staff turnover
R&D spend, absolute and % of turnover
Hours per unit produced
Number of patents registered

5 Modern management accounting techniques

5.1 Lean manufacturing
The emphasis in Lean manufacturing is on the elimination of waste and unnecessary activities.

5.2 Just in time (JIT)

A two-step process:
 Resources (material, labour etc) should be acquired just as you need them to use in the
production process (JIT Purchasing)
 The finished goods should roll off the production line just as the customer arrives to purchase
them (JIT Production).
Good supplier relationships and well trained flexible staff will be needed to operate JIT.

5.3 TQM
TQM refers to an overall philosophy within organisations of ‘getting it right first time’ and ‘continuous
improvement’ - everyone throughout the organisation striving for excellence in all products and
systems. The target should be zero errors.
Costs associated with quality are:
 Prevention costs
 Appraisal costs
 Costs of internal failure
 Costs of external failure
 79

Control systems and

information systems

1 Internal control systems

To manage risks, businesses set up internal control systems, covering all financial and non-financial
activities. CIMA defines an internal control system as including “all the policies and procedures
adopted by the management of an entity to assist in achieving their objectives of ensuring the orderly
and efficient conduct of a business”.
 Control environment – the management’s attitude and philosophy regarding controls.
 Control procedures/activities – the actual policies and procedures in place which ensure that
risks and errors are minimised

1.1 Control procedures

 Organisation – the way a company is structured, the level of autonomy given to divisions
 Authorisation – of purchase orders or overtime
 Personnel – from recruitment through to training and motivation
 Supervision – of subordinates
 Physical – lock and key and password controls
 Segregation of duties – not giving too much power to one person
 Arithmetical and accounting – bank reconciliations and VAT returns
Control activities can also be categorised into preventive and detective:
 Preventive controls seek to minimise the risk from materialising in the first place
 Detective controls seek to identify the risk when it materialises
80 6: Control systems and information systems CIMA P3 Topic Reviews

2 Fraud
Fraud is deliberate deception, usually for personal gain.
 Ghost employees – imaginary employees on the payroll (often the boss’ spouse as a tax dodge)
 Inflated expense claims
 Misappropriation of assets – e.g. theft of inventory
 Collusion with external parties
 Teeming and lading – where an employee has the opportunity to steal payments from
customers
 Pyramid fraud
The management of a business should implement an effective system of internal controls designed to
take account of the risk of fraud:
 Fraud policy statements
 Recruitment procedures
 People in the business being alert to unusual activity which might indicate fraud
 Whistleblowing – directly reporting suspicion of fraud to senior management/audit committee
As with any control system, the primary aim of any business should be the prevention of fraud rather
than the detection after the event.

2.1 Fraud response plan

 Who will lead the investigation – internal staff or an external consultant
 The investigation method to be used – e.g. interviews
 How to deal with suspects
 How/when to inform the police
 The systems needed to reduce fraud in future

3 Information systems
Information Systems are any systems which provide information for use in the decision making at all
levels within an organisation.

3.1 Information systems strategies

 Information Systems (IS) strategy refers to the long-term plan to exploit an entity’s information
systems in order to support its business strategy. It needs to ensure that the appropriate
information is acquired, retained and shared in all areas of the entity’s activities.
 Information Technology (IT) strategy defines the specific systems that are required to satisfy
the information needs of the organisation, including hardware, software and operating systems.
 Information Management (IM) strategy is concerned with methods by which information is
stored and how the information collected is provided to users. It also considers how the
information is protected or backed up securely.
CIMA P3 Topic Reviews 6: Control systems and information systems 81

3.2 Types of Management Information System

A management information system (MIS) is wherein data (from within and outside the entity) is
converted into information. This data is recorded, stored, processed and retrieved for managerial
decision-making.

Supplier Relevant IT systems:

Corporate Executive Information Systems (EIS)
Strategy

Enterprise Resource Strategic Enterprise Management (SEM)

Planning System system
Business Strategy Decision Support Systems (DSS)
(ERPS)

Transaction Processing System (TPS)

Customer
Operational Strategy

3.3 Operational strategy level

 Transaction Processing System (TPS) capture all the day-to-day routine transactions within a
business. Although they cope with large volumes of data, their output is not usually summarised
in any useful way.
 Expert systems e.g. price comparison websites.

3.4 Business strategy level

 Strategic Enterprise Management Systems (SEMS) provide data in formats that assist managers
in setting strategic goals.
 Decision Support Systems (DSS) (e.g. data analysis models) allow managers to simulate
different scenarios and then form conclusions on the results, using e.g. sensitivity analysis.

3.5 Corporate strategy level

 Executive Information Systems (EIS) provide high level overviews of an organisation by
aggregating data from various sources from within the organisation and from external sources.

3.6 Whole organisation

 Enterprise Resource Planning (ERPS) systems are integrated computer-based systems used to
manage internal and external resources. They integrate the various business functions into one
system and are usually undertaken centrally by information management specialists.

3.7 Open and Closed systems

Open systems refer to systems that interact with other systems or the outside environment.
82 6: Control systems and information systems CIMA P3 Topic Reviews

Closed systems refer to systems having relatively little or no interaction with other systems or the
outside environment. In businesses truly closed systems are rare since survival in business will to a
great extent depend on reaction to external factors.

3.8 Sources of management information

3.8.1 Internal sources
The main internal sources of management accounting information include the accounts, budget
supplier and customer databases, inventory management and payroll department.

3.8.2 External sources

The main external sources of information for a business include trade journals, government data,
internet, market research and trading partners

3.8.3 Costs of information

 Direct data capture costs (money spent on scanning, bar code systems)
 Processing costs such as the costs of data input, personnel and costs of staff who
check/summarise input data
 Indirect costs of producing information, including loss of other opportunities through lack of
budget or time
 Information overload costs
 Costs of collecting external data (survey, staff, equipment costs)
 Costs of time spent analysing data

3.9 Information system controls

3.9.1 Systems development and implementation
 Establish steering committee – to ensure system meets strategic and operational needs.
Committee should include project sponsor, project manager, IT staff, Finance Director and users
 Planning/Feasibility study – identify the needs and objectives of the system by identifying
current problems and the feasibility of the proposed solution
 Systems analysis – rank the available systems and ultimately determine whether the company
produces the new system in-house or outsources its design
 Systems design – describe desired features and operations in detail, including screen layouts,
business rules, process diagrams and other documentation
 Systems development – build and document the new system, IT staff and users test it, and
training is given to users
 Implementation – introduce the new system by parallel running or direct changeover
 Maintenance – correct or enhance the system once in operation. A post-implementation
review checks that all users feel that their needs are being met and the system is performing in
accordance with the system specification

3.9.2 General controls

 Password controls
 Physical controls such as swipe cards restricting entry to computers and fire alarms
CIMA P3 Topic Reviews 6: Control systems and information systems 83

 Personnel controls – ensuring that staff are aware of the importance of good computer security
 Environmental controls – fire detectors
 Contingency (disaster recovery) plan
 Regular backups of key data
 Virus protection
 Firewalls
 Spyware software

3.9.3 Application controls

Application controls are those controls within the system which help to ensure the validity of data
input into the system, processed within the system and output from it.
 Data verification controls e.g. having mandatory fields on an application form
 Data validation e.g. credit card number validity
 Exception reports – where any values over a certain value are highlighted in a separate report

3.10 Disaster recovery plan

 Assess risks of a disaster occurring that might pose a serious threat to the organisation
 Develop contingency plan to address those risks

Contents
 Responsibilities – who will take control in a crisis
 Priorities – which areas/tasks should be tackled first – these should be established in advance
 Back-up and standby arrangements – internal or involve the use of outside contractors
 Recovery procedures – implemented once the cause of the disaster has been investigated and
resolved, and the impact is known
 Communication and PR – how to deal with the internal impact on staff and any external impact

4 Big Data
Big Data involves capturing and processing data on a vast scale and converting it into information that
is able to be utilised by the organisation.
Big Data is often too large or changes too rapidly to be handled using traditional database or software
techniques, so it also includes the storage facilities, processes and techniques that an organisation
requires.
 Source of competitive advantage
 Used to identify or analyse opportunities for revenue increases and cost decreases, and build a
better picture of customers

4.1 Characteristics of Big Data

 Volume – more data than ever before is being collected, driven by social media and
transactional-based data
 Velocity – speed at which data is being streamed into the organisation, in real time, may be
continuous for multinational organisations
 Variety – inclusion of data from many different systems, including structured and unstructured
data
 Veracity – trustworthiness of the data
84 6: Control systems and information systems CIMA P3 Topic Reviews

4.2 Big Data analytics

Big Data analytics is the process of collecting, organising and analysing large sets of data to discover
patterns and other useful information.
 Understand the information contained within the data
 Extract knowledge (data mining)
 Identify the data that is most important to the business and future business decisions
 Use data to reduce time taken to answer questions and take decisions

4.3 Challenges of Big Data

 Sheer volume of data and the many different formats
 Breaking down data silos to access all the data organisation stores in different places and often
in different systems.
 Creating platforms that can pull in unstructured data as easily as structured data
 Determining which data is relevant
 Security and data protection
 Requires information to be made available and acted upon quickly
 85

Internal audit

1 The purpose of audit in the context of internal control systems

1.1 Role of internal audit
Audit is the process of checking transactions, records and systems in order to vouch their
reasonableness or accuracy.
Internal audit is an independent and objective function which may be a department of an organisation
or an outsourced function which exists to evaluate the activities of the entity as a service to the entity.
The need for an internal audit department or 'function' will vary according to organisation-specific
factors, such as the scale, diversity and complexity of its operations and the number of employees.

1.2 Forms of internal audit

 Compliance – assessment of specific activities in order to determine whether performance is in
conformity with predetermined contractual, regulatory or statutory requirements
 Fraud investigation – investigation of whether a fraud is being carried out against the company
by employees or management
 Value For Money (VFM) – assessment of whether proper arrangements have been made for
securing economy, efficiency and effectiveness in the use of resources by the company
 Management – review of the structure and effectiveness of the management of a company in
the achievement of entity policies and objectives
 Environmental – review of how well an entity is safeguarding the environment by management
control of environmental practices, and compliance with entity policies and external regulations
 Social – review of whether an entity has complied with policies and objectives relating to social
objectives, for example health and safety, working conditions, equal opportunities
86 7: Internal audit CIMA P3 Topic Reviews

1.3 Internal audit and risk management functions

 Risk management is concerned with the identification, measurement and control of risks. The
role of a risk management functions is to act as an advisory service to management, helping
them to identify risks and design controls by which to control them.
 Internal audit is involved in the testing and evaluation of the risk controls. Good governance
practice suggests that those that design the controls should not be involved in testing them.

2 The audit process

 Audit planning and strategy – focus on the key risk areas of the organisation to prioritise the
work of the auditor
 Audit planning – individual assignments – auditors should understand the objectives of the
work, risks involved and any issues which might need greater time devoted to them
 Ascertaining and documenting systems/policies/regulations
 Audit testing – test controls or carry out substantive tests on transactions or events. Consider use of
sampling, analytical review, benchmarking. Consider source and reliability of available data
 Documentation and review

2.1 Computer-assisted audit techniques

 Audit software – auditors use own computer programmes to substantively test a balance or
transaction. Audit software enables large data volumes to be processed quickly and accurately.
 Test data – auditors test the integrity of the client’s system by posting data onto the client’s
computer system to see if the transactions are posted as they should be, and controls such as
passwords are operating correctly.

3 Effective internal audit

 Internal auditors should be independent.
 The internal audit department should have the appropriate status within the organisation. This
can be achieved by reporting its findings to the audit committee.
 Internal auditors should also be appropriately qualified.
 Internal auditors need appropriate knowledge and understanding of the client’s business and
processes.
 Internal audit work should be subject to appropriate quality control processes.
 The Head of internal audit should develop an internal audit plan based on risk assessments,
submit it to the audit committee for approval and implement the approved plan.

4 The internal audit report

Reports should be submitted to the audit committee and contain details of the conclusions and
recommendations made, and an action plan detailing the deadlines and individual responsibilities.
 87

Cybersecurity risk

1 Cybersecurity risks
1.1 Cybersecurity issues
 All organisations and individuals rely on technology to manage their information.
 For this information to be used, it needs to be made available.
 Software programs are made up of billions of lines of code, making the existence of bugs (flaws
in the coding) inevitable.
 The rapid evolution of technology means that society lacks an understanding of how online
information may be exploited.

1.1.1 Organisations’ information responsibilities

Organisations are responsible for creating, collecting, transmitting, using and storing many types of
information.
The information an organisation holds is often commercially sensitive and a source of competitive
advantage. In addition, the organisation has a legal duty to protect information it holds (General Data
Protection Regulations (GDPR) in the UK)

1.2 Cybersecurity objectives

 Availability – available to users in a timely, reliable and user-friendly manner
 Confidentiality – access to data needs to be protected from unauthorised access or disclosure
 Integrity of data – data needs to be accurate, consistent and from a valid source
 Integrity of processing – data needs to be protected from improper use or modification
88 8: Cybersecurity risk CIMA P3 Topic Reviews

1.3 Factors that impact on cybersecurity risks

1.3.1 Technologies
 Outsourcing of IT services (e.g. cloud computing)
 Use of mobile devices and platforms
 Network structure
 Service providers that store, process or transmit the organisation’s data (e.g. website host)
 Nature of software applications – both external and in-house
 Systems that would be difficult to repair in the event of failure
 Dependence on emerging technologies

1.3.2 Organisational factors

 Structure and size of IT department (e.g. centralised / decentralised, insourced / outsourced)
 Types of user groups (customers, suppliers, employees, business partners)
 Geographic location and associated legal issues
 Organisational structure
 The department or individuals with responsibility for cybersecurity (e.g. IT, operational
departments or a separate security department)

1.3.3 Changes to the organisation

Organisational changes should be considered in the context of cybersecurity risk.

2 Types of cybersecurity risks

2.1 Malware
Malware is software which is specifically designed to disrupt, damage or gain unauthorised access to a
computer system.
The main types are virus, worm, trojan, spyware and ransomware.

2.1.1 Defences against malware

Antivirus software checks any newly downloaded data for malware and also performs a regular scan
of the user’s system in case any malware has got through.
New malware is being developed all the time, so antivirus software must be updated regularly. Users
should also be vigilant, especially when using email.

2.2 Application attacks

Application attacks target web applications (e.g. websites) to alter their functionality and presentation
or extract sensitive information.
 CIMA P3 Topic Reviews 8: Cybersecurity risk 89

Type of attack Description

Bot Software applications that run automated tasks over the internet such as sending
spam messages.
Need to maintain anti-bot software and have awareness of system users and
patterns of use.
Distributed denial of Overwhelming application with excessive traffic so it crashes.
service Firewalls, denial of service mitigation from service providers and filtering hardware
and software can offer protection.
Cross-site scripting Reprogramming of buttons on the victim’s website. A user clicking on a corrupted
button is diverted to a different destination.
Main protection measure is ensuring changes to program code are only allowed
from authorised sources.
SQL injection Submission of malicious software code into the organisation’s database.
Where data can be input online, the fields should be locked down for valid types
only.

2.3 Hackers
A hacker is a skilled computer programmer who circumvents an organisation’s security systems to
access sensitive information.

2.4 Problems with social media

The increased use of social media exposes both individuals and companies to risks of identity fraud
(being impersonated by a fraudster), damage to reputation and trolling (comments designed to
provoke offence or upset). Furthermore, social media posts can be very difficult to remove.

3 Cybersecurity organisational characteristics

A cybersecurity policy needs to:
 Protect the organisation’s system from cyberattack
 Detect any attacks as they happen and target defences accordingly
 Respond promptly when a breach occurs

3.1 Governance structure

3.1.1 Establishing, maintaining and communicating integrity and ethical values
 Culture of cybersecurity
 Clear standards of behaviour set for all staff
 Controls to identify and address any breaches in these standards

3.1.2 Board oversight

 Sufficient expertise in IT and cybersecurity or can call on it
 Board cybersecurity committee
 Review of cybersecurity issues
 Oversight of specific security incidents that have taken place
90 8: Cybersecurity risk CIMA P3 Topic Reviews

3.1.3 Establishing accountability

 Responsible individual for the review and oversight of cybersecurity (e.g. Chief Information
Officer)
 Roles and duties of staff with cybersecurity responsibilities

3.1.4 Hiring and developing qualified personnel

 Clear criteria used to recruit personnel with cybersecurity responsibilities
 Tailored cybersecurity training for staff
 Resources available to meet cybersecurity obligations
 Accountability for adherence to cybersecurity standards

3.2 Suppliers and business partners

 Suppliers or business partners having potential to affect organisation’s cybersecurity position
 Types, likelihood and impact of risks to information assets arising from the use of external
parties
 Adherence by suppliers to the organisation’s standards with regard to cybersecurity
 Periodic review of performance of suppliers to ensure compliance

3.3 Communication of cybersecurity objectives

 Training and awareness programmes
 Policy and procedures manual
 Job descriptions
 Code of conduct (including signed acknowledgement by staff)
 Promotion of whistle-blower hotlines

4 Security controls
4.1 Methods of protection
 Policies and procedures – carefully developed and clearly communicated
 Software updates – ensure that the latest security patches have been implemented
 Specialist software – firewalls and anti-virus software
 Configuration controls – restrict users’ access to specific parts of the system
 Application controls – input, processing and output controls

4.2 System monitoring

Once controls have been put in place, the organisation should monitor the system to:
 Detect attacks
 React to attacks
 Review system activity to see how it is being used
 CIMA P3 Topic Reviews 8: Cybersecurity risk 91

The monitoring process should cover the following areas:

 Establish a monitoring strategy based on business need and assessment of risk
 Monitor all systems across the network (especially any wireless networks)
 Monitor network traffic for unusual activity or trends that could indicate attacks
 Monitor user activity to identify unauthorised or accidental misuse of systems or data
 Establish a centralised capability to collect and analyse information
 Ensure that policies and processes are in place to manage and respond to incidents
 Conduct a lessons learned review after any security incident

4.3 Business continuity planning

Business continuity planning is a proactive approach that allows the organisation to continue to
operate while the cybersecurity threat is resolved.
Disaster recovery planning is a reactive approach that focuses solely on taking action to restore the
organisation to its original position.
Back-up sites help to minimise the impact of a cybersecurity attack:
 Mirror – duplicate website hosted on a different server
 Hot back-up – separate location with all the necessary hardware and software live and ready
 Warm back-up – separate location with key hardware on hand which can be configured with
the latest software and information
 Cold back-up – separate location with no pre-installed hardware or software that would be
available in an emergency

4.4 Blockchain
The traditional approach to data security is to hold a single master set of data securely. However, if
the master copy is hacked, it is relatively easy for unauthorised alterations to be made.
Blockchain contradicts this approach by requiring each party to a transaction to maintain their own
independent record or ledger. Changes can only be made with the agreement of all parties involved.
When a new transaction (or block) is added, it is inextricably chained to the previous transaction. This
makes it impossible to alter or remove any historic transactions without breaking the chain.
Blockchain technology is used in cryptocurrencies such as bitcoin.

5 Cybersecurity tools and techniques

5.1 Forensic analysis
Forensic analysis involves a detailed examination of systems relating to a particular breach or
attempted breach:
 System-level analysis – retracing attacker’s footsteps, looking at system components,
configuration, accounts and authorisation
 Storage analysis – analysis of data stored
 Network analysis – collecting and analysing data traffic across the network
92 8: Cybersecurity risk CIMA P3 Topic Reviews

5.2 Malware analysis

If malware has infected a system, it is necessary to study the software in detail:
 Reverse engineering – the analyst breaks down the malware into its component parts
 Decompilation and disassembly – once the malware has been deconstructed, each component
is analysed at a forensic level

5.3 Penetration testing

Penetration testing seeks out potential weaknesses in a system:
 Network discovery – identifying all the components of a network
 Vulnerability probing – each component is tested for any potential weakness
 Exploiting vulnerabilities – one of the vulnerabilities is used to access the system

5.4 Software security

Three levels of software can be written in order to make a system more resilient to attack:
 Tier 1 software blocks an attack from succeeding
 Tier 2 software alerts security to an attempted attack and logs relevant information
 Tier 3 software takes evasive action to protect sensitive data in the case of an attempted attack

6 Cybersecurity risk reporting

6.1 AICPA System & Organisational Control (SOC) for Cybersecurity
6.1.1 Cybersecurity Risk Management Program (CRMP)
 Nature of the business and its operations
 Nature of information at risk
 Cybersecurity objectives
 Factors that have a significant effect on inherent cybersecurity risks
 Cybersecurity risk governance structure
 Cybersecurity risk assessment process
 Cybersecurity communications and the quality of cybersecurity information
 Monitoring of the CRMP
 Cybersecurity control processes

6.1.2 Cybersecurity risk management report

 Assertion by organisation’s management that its CRMP is in accordance with the AICPA
description criteria and an assessment of the effectiveness of its controls
 Independent opinion of a practitioner of management’s assertions
 Copy of the CRMP itself
CIMA F3 Topic Reviews Approach to the Strategic Case Study 93

Paper F3
Financial Strategy
94 Approach to the Strategic Case Study CIMA F3 Topic Reviews
 95

Business objectives

1 Objectives of organisations
1.1 Types of organisation and their goals
Private Public
Goals Maximise shareholder wealth Value for money (VFM)
Shareholders are the principal A wider range of stakeholders to consider
stakeholders
Key measures Share price increases and dividends 3 Es
Economy (cheap acquisition of resources)
Efficiency (minimum wastage of resources)
Effectiveness (operating in line with
organisation’s objectives)
Typical internal NPV of free cash flows, ROCE, EPS, gearing Ability to keep within budget and whether
indicators a surplus or deficit is made

1.2 Financial objectives

These can include:
 Profit maximisation
 Achievement of target return on capital employed

1.3 Non-financial objectives

Non-financial objectives should involve seeking to satisfy wider stakeholder groups.
96 1: Business objectives CIMA F3 Topic Reviews

 Stakeholder relationships – maintaining good relationships with stakeholders

 Intellectual – protection of intellectual property, brand and reputation
 Human – improving staff capabilities, ensuring staff turnover does not go above a certain level
 Social – how the organisation wishes to conduct its relations with the local community
 Environmental/Natural – the organisation aiming to limit its impact on the natural environment
This list of objectives corresponds closely to the list of capitals that make up integrated reporting.

2 Ratio analysis
2.1 Profitability ratios
Ratio Calculation Description & Notes
Return on Capital PBIT Efficiency in generating profits from all capital
Employed (ROCE) TALCL employed (by both lenders + shareholders)
TALCL = total assets less current liabilities
Return on Equity Earnings Efficiency in generating earnings for shareholders
(ROE) Shareholder Funds from capital they have contributed
Gross profit margin Gross Profit Ability to sell goods for more than they cost to make
Revenue
Operating profit PBIT Ability to make operating profit on goods sold
margin Revenue
Net profit margin PAT Ability to make profit after tax on goods sold
Revenue
Asset turnover Revenue Efficiency in use of assets to generate sales
TALCL

2.2 Liquidity
Ratio Calculation Description & Notes
Current ratio Current assets Liquidity of the organisation and ability to meet its
Current liabilities short term debts using current assets
Quick ratio Current assets − inventories A better measure of an organisation’s liquidity if
Current liabilities inventory cannot be turned into cash very quickly
Inventory turnover Cost of sales How many times a business gets through its
Inventory inventory balance each year
Inventory days Inventory The number of days inventory is held for (on
× 365
Cost of sales average)
Receivables days Trade receivables The number of days it takes credit customers to pay
× 365
Credit sales (on average)
Payables days Trade payables The number of days taken to pay suppliers (on
× 365
Credit purchases average). Cost of sales can be used if credit
purchases are unknown
Working capital Inventory days + receivables The number of days between a business paying its
cycle days – payables days suppliers and receiving cash from its customers
CIMA F3 Topic Reviews 1: Business objectives 97

2.3 Lender ratios

Ratio Calculation Description & Notes
Debt:Equity ratio Long term debt Proportion of assets are funded by lenders vs
Equity shareholders (use market values if available)
Gearing Long term debt Proportion of assets are funded by lenders vs
Equity + long term debt shareholders (use market values if available)
Debt ratio Long term debt Proportion of assets that might have a prior claim
Total assets on them (affecting a lender’s willingness to offer
further lending)
Interest cover PBIT How many times could the annual interest bill be
Interest payable paid with profits before interest and tax

2.4 Investor ratios

Ratio Calculation Description & Notes
Total shareholder Dividend + change in price Total return on investment (based on income and
return Price at start of year capital growth) for shareholders
Earnings per share Earnings Amount of earnings the company has generated for
(EPS) Number of shares the shareholders on each share they hold
Earnings yield Earnings per share If you purchased a share today, what % return does
Share Price your EPS represent
Dividend yield Dividends per share If you purchased a share today, what % return does
Share Price your dividend represent
Dividend payout Dividends per share Proportion of earnings that are paid out as
ratio Earnings per share dividends
P/E Ratio Share Price The market’s view of future growth. A high P/E ratio
EPS suggests high predicted growth (or perhaps low risk)

2.5 Impact of economic forces on financial plans

Important external economic factors include:
 Rising interest rates mean borrowing becomes more expensive, demand and inflation fall,
exchange rate strengthens
 Rising inflation rates mean increased costs (passed onto customers), uncertainty, exports
becoming relatively more expensive and imports relatively cheaper, exchange rate weakens
 Strengthening exchange rates mean revenues and costs denominated in foreign currencies will
be worth less in domestic currency, exports less competitive and imports more attractive
98 1: Business objectives CIMA F3 Topic Reviews
 99

Sustainability and integrated

reporting

1 The GRI and Sustainability Reporting

Disclosures made in environmental reports are voluntary, although companies may base their
environmental reports on guidelines such as those set out by the Global Reporting Initiative (GRI) as
part of sustainability reporting.

1.1 GRI reporting principles

1.1.1 Principles for defining sustainability report content
Principle Description
Stakeholder Identify stakeholders and show response to their expectations and interests
inclusiveness
Sustainability Report on organisation’s performance in the context of limits and demands placed on
context environmental and social resources
Materiality Report on significant impacts (economic, environmental, social) and aspects
substantively influencing assessments and decisions of stakeholders
Completeness Cover significant activities, events and impacts during the reporting period

1.1.2 Principles for defining sustainability report quality

Principle Description
Balance Reflect both positive and negative aspects of performance
Comparability Consistency of reporting to compare historic performance and other organisations
Accuracy Sufficient accuracy and detail for stakeholder review (qualitative and quantitative)
100 2: Sustainability and integrated reporting CIMA F3 Topic Reviews

Timeliness Reporting on a regular schedule and in good time for stakeholders to make decisions
Clarity Information understandable and accessible
Reliability Recording and disclosure of information and processes used in preparing the report

1.2 Disclosures
Under sustainability reporting, there are two different types of disclosure:
 General standard – strategy and analysis, organisational profile, material aspects/boundaries,
stakeholder engagement, governance, ethics and Integrity
 Specific standard – management approach, economic, environmental and social indicators

2 Integrated reporting
Integrated reporting aims to explain how businesses create value over time. It demonstrates the link
between strategy, governance and financial performance and the social, environmental and economic
contexts within which they operate.

2.1 Capitals
Capitals are the resources and relationships used by businesses and which businesses affect.
Capital Description
Financial Sources of finance - debt, equity (including retained earnings)
Manufactured Objects used in production / service provision – e.g. buildings, equipment,
infrastructure
Intellectual Intellectual property – patents, copyrights, software and accumulated
knowledge, systems, procedures
Human Skill, experience, understanding, motivation, loyalty and ethics of staff
Social and relationship Internal norms, stakeholder relationships, brand and reputational value
Natural Environmental resources (water, mineral, land)

2.2 Enhancing the value of non-financial capitals

Capital Actions to enhance the capital
Manufacturing  Buildings maintenance programme
 Security measures
 Inspection of machinery
 Replacement cycle for assets
Intellectual  Investment in research and development
 Use of new technology
 Expenditure on organisational change/process development
 Software development for internal systems
 Programme for enhancement of brand awareness
Human  Investment in training
 Reducing injuries and absenteeism
 Improving minimum pay levels
CIMA F3 Topic Reviews 2: Sustainability and integrated reporting 101

Capital Actions to enhance the capital

Social and relationship  Enhancing customer satisfaction
 Using staff surveys as basis of improving working conditions
 Involvement in local community
 Charitable contributions
 Allowing staff time off for voluntary work
Natural  Reduction of energy consumption programme
 Waste avoidance
 Recycling of waste
 Effective management of risk of negative environmental impacts

2.3 Principles of reporting

Principle Description
Strategic focus and future Planned use of the capitals in future
orientation Impact on the capitals
Risks and opportunities
Balance of short and long term performance
Connectivity of information Links between performance and resource allocation, strategy and
changes in the external environment and between different capitals
Stakeholder responsiveness Identifying, taking into account and responding to needs of
stakeholders
Materiality Focus on matters which substantively affect ability to create value over
short/medium/long term
Conciseness Providing sufficient, but not excessive, information
Reliability and completeness Balance, free from material error, complete and future-oriented
Consistency and comparability Comparison vs. historic performance and vs. other companies

2.4 Content of integrated reports

This is based on the guiding principles.
Principle Description
Organisation overview and Who we are, what we do, how big we are
external environment PESTLE factors which affect ability to create value
Governance structure and Leadership structure, governance bodies (board, committees), how they
value creation set strategy, create value and manage risk
Business model Inputs and outputs, business activities, marketing, innovation, outcomes
Impact of opportunities and Impact of past events or possible future events, evaluation of likelihoods,
risks on value creation how risks are managed or mitigated
Strategy and resource Strategy over short-long term and planned resource allocation
allocation
Performance Quantitative and qualitative indicators, KPIs, stakeholder relationships
Outlook Expectations for external environment, how changes may affect us, how
we will cope
Basis of preparation and How materiality and boundary are set and assessed
presentation
102 2: Sustainability and integrated reporting CIMA F3 Topic Reviews

3 Pros and cons of non-financial reporting

3.1 Benefits of environmental reporting
 Demonstrates commitment to issues which becoming more important to consumers
 Willingness to identify and manage corporate risk, which may lead to reduced financing costs
and a broader range of investors
 Improved profitability (through increased sales and possibly reduced costs)
 Better employee morale

3.2 Arguments against voluntary disclosure of environmental information

 Lack of comparability – disclosures are voluntary and there is no prescriptive format
 Lack of reliability - statements unaudited
 Only positive aspects of their policies presented
 Hiding of damaging aspects
 Danger of information overload for users of the accounts
 103

Financial strategy

1 Key decisions of financial management

 Financing – funding existing operations and new projects
 Investment – deciding which new projects to invest in
 Dividend – how much and when
 Risk management – investments, financing and foreign exchange)
These decisions are inter-related.

2 Internal constraints on performance

2.1 Stakeholders (external factor as well)
Failure to meet the needs of stakeholders can significantly affect long run profitability.
Stakeholder Objectives
Shareholder Share price maximisation, dividend maximisation, earnings growth,
maintenance of control
Lenders Certainty of payment, security of capital, further loans
Directors/Senior Maximise remuneration, security of tenure, maximisation of power and
managers influence
Employees Maximise remuneration, security of tenure, career development , training
Customers VFM, high quality, reliable service, innovation
Suppliers Certainty of payment, further business
Government Creation of employment, payment of taxes
Community Environmental improvements, creation of wealth
104 3: Financial strategy CIMA F3 Topic Reviews

2.1.1 Agency issues

Shareholders are the owners of a company. However, they do not also have to be the managers and so
they appoint directors to manage the company for them as agents.
The agency problem refers to the situation where the directors may act in their own best interests
rather than the shareholders. It may be addressed by using a mixture of appropriate managerial
reward schemes, corporate governance and audits.

2.2 Funding issues

Internal funding restrictions (soft capital rationing) may reduce the ability of managers to pursue all
available profitable projects.

2.3 Strategic factors

The currently most profitable strategy may not be implemented because of the need to follow a more
careful strategic path to ensure long term survival.

3 External constraints on performance

3.1 Funding
It may not be possible to raise external funds to pursue the desired strategy (hard capital rationing):
 Investors (lenders / shareholders) not being convinced by the business plans of the company
 The company having a poor credit rating / history
 The credit market drying up due to macro-economic factors

3.2 Regulatory
Industry regulators can place pricing, quality or service level controls or targets on businesses.

3.3 Government
Legislation can impact profit maximisation, for example minimum wage, environmental regulations.

3.4 Taxation
Taxation levels and rules may impact:
 Tax allowable depreciation
 Tax-deductibility of interest on debt
 Relative level of taxes on capital gains and dividends impacting on dividend decision
 Minimisation of global tax liabilities (tax authorities may intervene to prevent manipulation)

3.5 Economic
Inflation, interest rates and foreign exchange rates affect the results of businesses by changing the
value of revenue and costs, and hence their ability to achieve their short and long-term goals.

3.6 Investor relations

The organisation may face investor pressure to behave in a certain way.
 105

Overview of finance sources

and Equity finance

1 Overview of sources of finance and financial markets

1.1 Sources of debt finance
Term Type of debt finance Description
Overdrafts / revolving credit Flexible borrowing facility where a company only
facilities pays interest on the outstanding balance
Short-term bank loans Fixed amount borrowed for a fixed term with fixed
Short term (≤ 1 year) or variable interest charged
Commercial paper Issued at a discount and redeemed at par
Eurocurrency loans Borrowing from banks in foreign currencies
Bank loans As for short-term bank loans
Medium-term notes (MTNs) Paying a set coupon until redeemed at a fixed
maturity date for a set amount
Medium term (1-5 Floating-rate notes (FRNs) As for MTNs, but paying a variable rate of coupon
years) Mezzanine finance High coupon debt that is subordinated (has a lower
ranking than other more senior debt)
Leasing / hire purchase / sale The same in substance as borrowing to buy an asset
and lease back
106 4: Overview of finance sources and Equity finance CIMA F3 Topic Reviews

Term Type of debt finance Description

Bonds / loan stock / As for MTNs, but longer maturity
debentures
Convertible bonds Give holder option to convert the debt to equity at
Long-term (> 5 years) or sometimes before maturity
Bonds with warrants Issued with attached call options on ordinary shares
Eurobonds Issued on international markets in a currency other
than the domestic currency of the issuer

1.2 Sources of equity / other finance

Source of finance Description
Ordinary shares Business owners, receiving dividends and benefitting from share price rises
Face greatest risk as dividends paid out of profits remaining after other
investors paid and out-ranked by other investors / creditors on liquidation
Preference shares Paid a fixed dividend before any dividend is paid to the ordinary shareholders
No voting rights unless the preference dividend is in arrears
Retained cash Easiest and cheapest to access source of finance for a company
Venture capital (VC) VC firms look to provide equity (and mezzanine debt) investments in
potential growth businesses
Want board representation and returns in excess of 30%
Business angels Wealthy individual or business providing finance, usually in return for equity
Government assistance Schemes targeted at smaller companies operating in specific regions, or
undertaking research and development

1.3 Money and capital markets

Money markets Capital markets

<12mths >12mths

Stock market Bond market

raise new finance disintermediation

investors realise investment investors realise investment
assist share based assist funding acquisitions
acquisitions with debt

Both money and capital markets consist of:

 Primary market through which initial issues take place
 Secondary market where the securities are traded once they have been issued
CIMA F3 Topic Reviews 4: Overview of finance sources and Equity finance 107

2 Issuing equity finance

2.1 Share prices
In an efficient market the share price should represent the present value of the future cash flows likely
to be generated by the company and returned to shareholders. Share prices may change due to the
following factors:
 Economic – interest rates, exchange rates, legislation, inflation
 Industry – actions of competitors, regulator actions, changes in technology
 Company – announcements, management changes, projects undertaken, financing used

2.2 Summary of different methods of issuing shares

Share Issuance

Rights Public Private

Issue Offer Placing

Invitation to existing
shareholders to purchase Issue to a select group of
additional shares in Shares offered to the public at a investors (often
proportion to current holding fixed price or by tender offer institutional)

2.3 Rights issues

Rights issue are referred to as e.g. a ‘1 for n’ issue – meaning that you are offered one new share for
every n shares held.
New shares in a rights issue are issued at a discount in order to make the offer attractive to
shareholders.
When a rights issue is announced investors can:
 Do nothing – the value of their shareholding and their % shareholding will fall
 Sell the rights – they will receive cash but their percentage holding will fall
 Subscribe for the shares – maintain their existing percentage holding in the company

2.3.1 Theoretical ex-rights price

Theoretical ex-rights price (TERP) is the price at which the shares will theoretically settle immediately
after the rights issue has been made.
1
TERP= [(N ×cum rights price)+issue price]
(N+1)
108 4: Overview of finance sources and Equity finance CIMA F3 Topic Reviews

This can also be expressed as:

Market capitalisation pre-rights issue + rights proceeds
TERP=
Total number of shares after the rights issue
With NPV of the project which will be funded by the rights issue proceeds:
Market capitalisation pre-rights issue + rights proceeds + project NPV
TERP=
Total number of shares after the rights issue
 Cum rights price = the share price immediately before the rights issue
 Market capitalisation = number of issued ordinary shares x the share price
 Value of one right = TERP – the issue price
2.3.2 Yield-adjusted theoretical ex-rights price
Calculated if you’re given the annual return that the proceeds will generate.
1 new yield
Yield-adjusted TERP= (N+1)
�(N ×cum rights price)+issue price× old yield
�

 New yield = the return generated on the rights proceeds

 Old yield = return on existing funds (e.g. the current WACC)

2.4 Terms of new share issue

If a company wishes to invest in a project that generates a positive net present value, and wishes to
finance it by a share issue (other than a rights issue), the issue price of the shares will determine how
much of the gain from the new project goes to existing shareholders.

3 Cost of equity
3.1 Dividend valuation model
𝑫𝑫𝒐𝒐 (𝟏𝟏 + 𝒈𝒈)
𝑷𝑷𝟎𝟎 = (𝒌𝒌𝒆𝒆 − 𝒈𝒈)

Where:
Po = Current ex-div share price
Do = Current dividend
g = Constant growth in dividends
ke = Return on equity or the cost of equity
𝑫𝑫𝒐𝒐 (𝟏𝟏+𝒈𝒈)
𝒌𝒌𝒆𝒆 = 𝑷𝑷𝒐𝒐
+ 𝒈𝒈

If there is zero growth in dividends or profits:

PAT EPS
𝑘𝑘𝑒𝑒 = Market Capitalisation
or Share Price

3.1.1 Estimating growth

 Use information on dividend payout ratio (and hence proportion of retained funds) in the
Gordon growth model to estimate growth as:
g=r×b
Where:
r= return on capital employed or return on assets
b = proportion of funds reinvested in the business
 Use historic dividend growth rates as a basis for estimating future growth.
CIMA F3 Topic Reviews 4: Overview of finance sources and Equity finance 109

3.2 Risk and the Capital Asset Pricing Model (CAPM)

Risk represents the likelihood and impact of returns being either higher or lower than expected

Business Risk
 Variability of profits before interest and tax
 Comprises systematic and specific risks

Systematic Business Risk

Specific (unsystematic) Business Risk
 Variability in PBIT due to macro-economic
 Variability in PBIT due to factors factors
specific to a company
 Impacted by business sector of the company
 Investor exposure to these risks and its level of operational gearing
may be diversified away
 β measures a company’s exposure to
systematic business risk

3.2.1 Capital Asset Pricing Model (CAPM)

CAPM links risk with investors’ required return (the higher the risk, the higher the return: required).

k = R + R − R  β
f  m f 
Where:
k = cost of equity (shareholders’ required return)
Rf = risk free rate (i.e. rate that could be obtained from a government bond)
Rm = return on the market as a whole (i.e. average return on the FTSE 100 index)
β = beta factor (the relative riskiness of the company compared to the market as a whole)
Rm- Rf may also be referred to as the ‘market risk premium’ (premium required over the risk
free rate if investing in a portfolio of all investments on the stock market)

3.3 Cost of irredeemable preference shares

Preference shares are similar to ordinary shares except the dividend is constant and so there is no
growth.
d
k pref =
P0
110 4: Overview of finance sources and Equity finance CIMA F3 Topic Reviews
 111

Debt finance

1 Debt finance – borrower’s perspective

When deciding which type of debt finance to choose, consider:
 Timescale – short or long-term
 Cost – interest
 Liquidity – timing of repayments
 Currency – domestic / foreign currency
 Interest type – fixed or variable rate

2 Debt finance - lender’s perspective

2.1 Factors considered by lenders
Factors determining whether to lend and at what rates of interest is linked to perception of risk:
 Security offered – what assets or other assurances can the loan be secured against
 Timeframe – longer-term loans usually carry higher interest rates
 Repayment profile – regular repayments of capital will justify a lower interest rate
 Amount requested – larger amounts leave the lender more exposed
 Purpose – speculative project likely to carry higher rates

2.2 Credit ratings

The credit rating of businesses focuses on the probability of default and the possibility of eventual
recovery of the debit.
112 5: Debt finance CIMA F3 Topic Reviews

The better the credit rating, the greater the likelihood of the lender lending and the lower the interest
rate.
Credit rating agencies such as Standard and Poor and Moody’s use financial and other information to
assign a rating reflecting credit risk and expected loss.
 A from AAA at best to A) – high quality debt
 BBB and BB – medium quality debt
 B – speculative debt
 C – poor quality and highly speculative debt

2.3 Security offered

Security will be some of the assets of the business. If the borrower then defaults on the terms of the
loan, the lender will then be able to take control of the assets to realise the debt.
Security can be offered as a fixed or floating charge on assets of the borrower.

2.4 Covenants
A loan covenant is part of a loan agreement that:
 Requires the borrower to fulfil certain conditions
 Forbids the borrower from undertaking certain actions
 Restricts certain activities to circumstances when other conditions are met
If there is a breach of a covenant, the lender may terminate the debt agreement and/or demand
immediate repayment, impose a penalty payment, or increase the interest rate on the loan.

3 Market issue of bonds

3.1 Market value of bond
The market value of a bond can be calculated as the sum of future interest payments and redemption
proceeds of the bond, discounted at the yield to maturity (cost of debt) for similar bonds.

4 Cost of debt
The required return for a lender is the effective interest rate they require in order to lend to a
particular company.
The post-tax cost of debt for the borrower is the effective interest rate that they pay (after tax savings)
on the money they borrow.
Debt holders face lower risk than shareholders and hence require a lower return – hence the cost of
debt for a company will always be lower than the cost of equity.
CIMA F3 Topic Reviews 5: Debt finance 113

Leasing
A lease is effectively a means of medium-term financing aimed at specific assets such as vehicles and
technological equipment such as computers/photocopier. Leasing has several benefits:
 Avoids the need to obtain financing in advance of acquiring the asset
 Provides a means of acquiring assets if traditional funding is not available (e.g. if capital is rationed).

4.1 Features of leases

 Avoid the need to obtain financing in advance of acquiring the asset
 Business cannot claim tax allowances (capital allowances, tax-allowable depreciation) but tax
relief is available for the lease rental payments
 Provide a means of acquiring assets if traditional funding is not available (e.g. if capital is
rationed)

4.2 Lease vs buy decisions

4.2.1 Leasing decisions
 Include annual lease payments
 Include tax relief arising on these lease payments
 Lease payments will include capital and revenue elements. They can be allocated between the
two by using sum of digits or actuarial method

Sum of digits method

 Calculate the total interest charge relating to the lease:
$
Total repayments (deposit and instalments) X
Less: Fair value of asset (X)
Total interest charge X
𝒏𝒏(𝒏𝒏+𝟏𝟏)
 Sum of digits = where n = number of interest-bearing payments.
𝟐𝟐

 Sum of digits then allocates the finance charge across the interest bearing lease payments:
n
– The interest allocated to the 1st year of the lease will then be Sum of Digits × Total interest
n-1
– The interest allocated to the 2nd year of the lease will be × Total interest
Sum of Digits

Actuarial method
 Calculate the interest rate implicit in the lease (IRR calculation making the PV of lease payments
equal to the fair value of the asset)
 Prepare a loan repayment schedule to work out the finance charge for each of the interest
bearing lease payments
4.2.2 Buying decisions
 Include initial capital cost
 Include tax saved as a result of being able to claim capital allowances on legal ownership of the
asset
 Include disposal proceeds
 Do not include any cash flows associated with any loan used to make the purchase
114 5: Debt finance CIMA F3 Topic Reviews
 115

Capital structure

1 Practical considerations
1.1 Matching
 Duration – long-term funds used to fund long-term acquisitions and shorter-term funds used to
finance shorter-term items
 Currency – investment in a foreign asset (e.g. merger or acquisition) could be funded by a
foreign source, hedging exchange risk
 Risk of cash flows – high risk projects where the potential returns are high but not certain are
more suited to being financed with equity where returns are not obligatory

1.2 Cost
 Issue costs – arrangement fees, underwriting fees, prospectus printing costs and advisers’ fees
 On-going servicing cost – dividends expected by investor vs interest required by lender, also
tax issues for financial providers and costs of supplying information to finance providers

1.3 Capital providers’ considerations

 Impact on gearing (covenants, future borrowing capacity etc.)
 Impact on control (new share issue will dilute control unless it’s a fully subscribed rights issue)
 Impact on EPS
 How much is needed
 Appropriateness of raising finance
 State of the market
 Type of company
116 6: Capital structure CIMA F3 Topic Reviews

1.4 Group issues

Issues with groups of companies include arranging borrowings in countries with the highest tax rate, to
obtain maximum tax relief.
Thin capitalisation rules aim to stop companies getting excessive tax relief on interest on inter-group
loans. The tax authorities will consider gearing and interest cover to judge whether a company is thinly
capitalised. If it is, then only the interest on the part of a loan that an independent party would be
prepared to lend is allowable.

2 Weighted Average Cost of Capital (WACC)

2.1 Use of WACC
WACC can be used as the hurdle rate (cost of capital/discount rate) for appraising projects.
A project offering a return that is higher than the WACC is worth undertaking (it will have a positive
NPV), as it generates an amount in excess of what’s necessary to repay finance providers.
VE VD
WACC = k eg �V � + k d [1 − t] �V �
E +VD E +VD

Where:
keg = cost of equity in a geared company
kd = cost of debt (pre tax)
VE = market (book) value of equity
VD = market (book) value of debt
t = tax rate
The cost of debt is only multiplied by (1-t) if the cost of debt is pre-tax (if you already have a post-tax
cost of debt, then you don’t need to multiply by (1-t)).

2.2 Conditions for use of the WACC

 New project has same business risk as existing operations
 No change in the long term capital structure of the company (financial risk stays the same)
 New project is relatively small (so that the cost of any additional finance raised will be similar to
the current costs of finance)
 Project specific finance is not being used (e.g. an interest-free government grant which is tied to
this specific project)

3 Business and financial risk

3.1 Business risk
Use CAPM to derive the cost of equity for a business (assuming that their shareholders are diversified)
using the following formula:

k = R + R − R  β
f  m f 
Hence, as exposure to systematic risk increases, the cost of equity of the company will increase.
If a debt beta is inserted into the CAPM formula it will find a pre-tax cost of debt.
CIMA F3 Topic Reviews 6: Capital structure 117

3.2 Impact of debt on β factors and ke

Risk facing shareholders in a geared company > Risk facing shareholders in an ungeared company
β for a geared company (equity beta) �βeg � > β for an ungeared company (asset beta) (βeu )

3.3 Calculating βeu and βeg

(1) Ungear β (find βeu from βeg):
𝑉𝑉𝐸𝐸 𝑉𝑉𝐷𝐷 [1−𝑡𝑡]
𝛽𝛽𝑒𝑒𝑒𝑒 = 𝛽𝛽𝑒𝑒𝑒𝑒 �𝑉𝑉 � + 𝛽𝛽𝑑𝑑 �𝑉𝑉 �
𝐸𝐸 +𝑉𝑉𝐷𝐷 [1−𝑡𝑡] 𝐸𝐸 +𝑉𝑉𝐷𝐷 [1−𝑡𝑡]

(2) Regear β (find βeg from βeu):

𝑉𝑉𝐷𝐷 [1−𝑡𝑡]
𝛽𝛽𝑒𝑒𝑒𝑒 = 𝛽𝛽𝑒𝑒𝑒𝑒 + [𝛽𝛽𝑒𝑒𝑒𝑒 − 𝛽𝛽𝑑𝑑 ] 𝑉𝑉𝐸𝐸

Where VE = market value of equity and VD = market value of debt

Unless otherwise stated, debt betas are assumed to be zero. With debt beta set to equal zero, the
formulae above become:
(1) Ungear β (find βeu from βeg):
𝑉𝑉𝐸𝐸
𝛽𝛽𝑒𝑒𝑒𝑒 = 𝛽𝛽𝑒𝑒𝑒𝑒 � �
𝑉𝑉 𝐸𝐸 +𝑉𝑉𝐷𝐷 [1−𝑡𝑡]

(2) Regear β (find βeg from βeu):

𝑉𝑉𝐷𝐷 [1−𝑡𝑡]
𝛽𝛽𝑒𝑒𝑒𝑒 = 𝛽𝛽𝑒𝑒𝑒𝑒 + 𝛽𝛽𝑒𝑒𝑒𝑒 × 𝑉𝑉𝐸𝐸

4 Dealing with a change of business risk

(1) Determine the geared beta of a typical company operating in the new sector, along with their
gearing and tax rates
(2) Un-gear the geared beta from the new sector to obtain an ungeared beta for the new sector :
𝑉𝑉𝐸𝐸
𝛽𝛽𝑒𝑒𝑒𝑒 = 𝛽𝛽𝑒𝑒𝑒𝑒 �𝑉𝑉 �
𝐸𝐸 +𝑉𝑉𝐷𝐷 [1−𝑡𝑡]

(3) Re-gear the ungeared beta using the gearing of our company:
𝑉𝑉𝐷𝐷 [1 − 𝑡𝑡]
𝛽𝛽𝑒𝑒𝑒𝑒 = 𝛽𝛽𝑒𝑒𝑒𝑒 + 𝛽𝛽𝑒𝑒𝑒𝑒 ×
𝑉𝑉𝐸𝐸
(4) Use CAPM to calculate a project specific cost of equity using the new βeg
(5) Use this cost of equity to calculate a new project specific WACC
(6) Use this new project specific WACC to evaluate new project
118 6: Capital structure CIMA F3 Topic Reviews

5 Dealing with a change of gearing

.

Increase the
level of debt

Debt is cheaper than Shareholders'

equity (less risk to financial risk
the investor). increases (↑ Ke).
WACC ↓ WACC ↑

Suggests it Suggests it
would be a good
idea to use
? would be a good
idea to use less
more debt debt

5.1 Traditional theory

Adding debt initially reduces the WACC (benefit
of cheap debt outweighs increase in cost of %
equity) keg

Eventually, increase in the cost of equity WACC

outweighs benefit of more cheap debt and
WACC starts to rise. keu
Cost of
Ultimately, at high levels of gearing even the cost debt
of debt rises
Gearing
Conclusion – find optimum WACC (where
project and hence company value will be
maximised)

5.2 Modigliani and & Miller (no tax)

As the level of debt increases, the benefit of
debt (cheaper than equity) is exactly offset by
the fact that the cost of equity (keg) increases, %
keg
such that overall the WACC remains constant.
Conclusion – WACC is not affected by gearing.
keu WACC

Cost of debt

Gearing
CIMA F3 Topic Reviews 6: Capital structure 119

5.3 Modigliani and & Miller (with tax)

Tax saving is an added benefit to using debt
since it is made even cheaper due to the tax
relief on the interest payments. The lower cost %
keg
of debt outweighs the increasing keg
Conclusion – WACC reduces as debt levels ↑.
keu
kadj (WACC)
Cost of debt
(post tax)

Gearing

5.3.1 M&M’s assumptions

 Debt is always risk free and hence the cost of debt remains at the risk free rate
 Perfect capital markets (perfect information, rational risk averse investors, no transaction costs)
 Individuals and companies can borrow and invest at the same rate
 Investors are indifferent between personal and corporate gearing

5.4 M&M’s formulae

5.4.1 Direct calculation of keg from keu

𝑽𝑽𝑫𝑫 [𝟏𝟏−𝑻𝑻]
𝒌𝒌𝒆𝒆𝒆𝒆 = 𝒌𝒌𝒆𝒆𝒆𝒆 + [(𝒌𝒌𝒆𝒆𝒆𝒆 − 𝒌𝒌𝒅𝒅 ) � 𝑽𝑽𝑬𝑬
�]

Kd here will be the pre-tax risk-free rate of return

5.4.2 Direct calculation of WACC from keu

𝑽𝑽𝑫𝑫 𝒕𝒕
𝑾𝑾𝑾𝑾𝑾𝑾𝑾𝑾 = 𝒌𝒌𝒆𝒆𝒆𝒆 (𝟏𝟏 − � �)
𝑽𝑽𝑬𝑬 +𝑽𝑽𝑫𝑫
120 6: Capital structure CIMA F3 Topic Reviews

6 Impact of capital structure on company value

Value of a company = value of debt and equity in the company.
MVDebt + MVEquity = Future cash flows to the investor(s) discounted at the WACC
The lower the WACC, the higher the PV of future cash flows and the higher the company value.

6.1 Traditional theory

Since WACC falls to a minimum and then starts to rise as gearing increases, the MV of the company
must rise to a maximum and then fall such that there is an optimum MV.

6.2 M&M (no tax)

As the WACC is unaffected by level of gearing, the MV of the company must also be unaffected.

6.3 M&M (with tax)

M&M’s 1963 proposition implied that a geared company will have a lower WACC and hence a higher
value than an ungeared company because it will pay less tax (due to the tax saving on interest).
Vg = Vu + TB
Where:
Vg = the value of a geared company (MV of debt + MV of equity)
Vu = the value of an identical company that is 100% equity financed (un-geared)
TB = the value of the ‘tax shield’ = the PV of the tax savings (from the interest in a geared company)
 The tax shield is calculated by discounting the interest savings at the pre-tax cost of debt,
Annual interest ×tax rate
TB = = MV of debt ×tax rate
pre-tax Kd

 If the company is investing in a new project:

Vu = Ungeared value before project + Capital invested in project + NPV of project

7 Practical considerations
There are many practical reasons why the company may not gear up:
 In reality, lenders do face risk of not being repaid, hence they may be unwilling to lend to the
company if its gearing is considered too high
 Even if lenders are willing to lend, they will charge an increasing rate of interest
 Covenants on existing debt may prevent additional debt being added
 Shareholders / directors may be concerned by the financial risk of additional debt and may
prevent further borrowing
 Tax deductibility of interest is only beneficial to the extent you have profits to deduct the
interest from
 121

Dividend policy

1 Dividend policy
Surplus funds
generated
from projects

Retain within Return to

business? shareholders?

To fund future Share

Dividends
projects? buybacks

1.1 Practical considerations

 Shareholders’ wishes – whether they will sell their shares if dividend policy isn’t what they want
 Market perceptions of dividend announcement
 Availability of cash – if cash is short, consider borrowing to fund payment or scrip dividend
 Tax implications – relative levels of income and capital gains taxes
 Availability and conditions surrounding debt financing for investment
 Expected profit levels – whether they are sufficient to maintain dividend policy
 Level of cash needed to sustain future investment
 Dividend policy of competitors/industry norms
122 7: Dividend policy CIMA F3 Topic Reviews

1.2 Common dividend policies

 Growth year on year – linked to inflation, industry growth rates or a sustainable level that is in
line with growth in profits
 Constant dividend payout % – best for companies with stable profits, leads to dividend
instability if profits are volatile
 Zero dividend – surplus funds invested in business to fund growth in business value and capital
gains for investors

1.3 Dividend theories

Residual theory
 Dividends are paid out only after all value enhancing projects have been financed.
 Whatever cash is left (i.e. the residual amounts) is returned to shareholders as a dividend.
 This can lead to an erratic dividend policy if investment in projects is not consistent each year.

Irrelevancy theory
Modigliani & Miller proposed that the pattern of dividend payments is irrelevant:
 The return on shares is split into the capital gain and the dividend. The dividend decision
determines how the return is delivered, but it does not affect the total return.
 All that matters is that the company invests in positive NPV projects.
 Investors have the ability to manufacture their own desired dividend policies by selling or
buying shares.
In reality, tax and transaction cost implications means this logic is flawed.

1.4 Share buybacks (share repurchase)

Arguments for share repurchase Arguments against share repurchase
Doesn’t lead to future dividend expectations Increased dividends are seen as a stronger
expression of confidence in the company
May be favourable from a tax perspective as Frequently only the big institutions benefit from
investors may realise a capital gain rather than being being involved in the repurchase of shares
subject to income tax
Fewer shares remaining with consistent earnings
should give rise to increased EPS and share prices

1.5 Scrip dividends

If a company wishes to retain money within the business, it may offer a scrip dividend instead of a cash
dividend. Shareholders will be offered additional shares free of charge, reducing retained profits and
increasing share capital. However share price and earnings per share may well fall.
 123

Business valuations

1 Valuing a business
1.1 Reasons for valuing a business
 Company is seeking a stock market floatation and therefore an assessment of the issue price of
the shares is necessary
 Business is considering buying another business (acquisition)
 Owners may be looking to sell all or part of the business
 Bank purposes when making a lending decision
 Tax purposes

1.2 Methods of valuation

Asset based Earnings based Cash flow based

• Historic cost • P/E ratio • Discounted cashflows
• Replacement cost • Earnings yield • Dividend yield
• Realisable value • Dividend growth
model

In addition, the quickest way to value a listed business’s equity is if given its share price:
Value (market capitalisation) = Share price × number of shares
124 8: Business valuations CIMA F3 Topic Reviews

2 Asset based valuations

Net Assets

Minimum Cost of starting

acceptable price up like for like
to sell business

Replacement
Book value Realisable value
cost

Net assets value = Non-current assets + Net current assets – Long-term liabilities = Total assets – Total
liabilities
 Statement of financial position book values are likely to be stated at historic cost and therefore
are not representative of current market values
 A realisable value would give a better indication of price if there was a sell off or asset stripping
intention, but realisable value would generally be lower than market value
 Using the replacement cost of the assets may be more appropriate if you are trying to duplicate
an existing business

2.1 Advantages and disadvantages

Advantages Disadvantages
Quick and simple to estimate Not as good at valuing the on-going earnings/profit
potential of the business
Gives a starting point/benchmark, minimum Does not consider valuation of assets not shown on the
valuation statement of financial position such as intangible assets
Reliant on the accounting conventions which may not
give valuations that reflect current market values

3 Earnings based valuations

3.1 PE valuations
Total market value of equity Share price
P/E ratio for a company =
Earnings
= Earnings per share

3.1.1 Using PE ratios in valuations

 Total market value of equity = P/E ratio x current earnings
Where earnings = PAT less preference dividends
 Value of one share = P/E ratio x EPS
CIMA F3 Topic Reviews 8: Business valuations 125

3.1.2 PE ratio valuation scenarios

 If valuing an unquoted (non-listed) business, a P/E ratio for a similar quoted business must be
used and adjusted downwards if necessary.
 P/E ratio can be applied to new expected earnings in times of growth.
 Earnings should be sustainable earnings available to the ordinary shareholders, usually profit
after tax (PAT) but with adjustments if current earnings figure are distorted by one-off factors.

3.1.3 Advantages and disadvantages

Advantages Disadvantages
Quick to calculate Adjustments may be necessary to the P/E and
Considers future potential earnings figure
Useful for valuing unquoted companies Calculations are based on profits rather than cash
Good for valuing a controlling interest flows
Which P/E to use in a takeover situation (target co’s,
predator co’s or an average)?

3.2 Earnings yield

Earnings EPS
Earnings yield = or (ie the inverse of the P/E ratio).
MV of shares Share price
Earnings
MV of all shares =
Earnings yield
EPS
Value of one share=
Earnings yield

or
EPS
Share price = Shareholders′ required return

The same caveats (adjusting the valuation, using a suitable earnings yield, using sustainable earnings)
that applied to the PE ratio method also apply here.

4 Cash flow based valuations

Cash based methods are also useful for valuing the on-going business:
 Present value of future cashflows is appropriate for controlling interests in a company
 Dividend based methods are more suitable for smaller shareholdings (as they are only valuing
entitlement to a future stream of dividends)

4.1 Discounted cash flow (present value of future cashflows)

COMPANY
VALUE

Future cashflows Cost of capital

126 8: Business valuations CIMA F3 Topic Reviews

Cost of equity approach WACC approach

Cashflows to use Free cashflow to shareholders Free cashflow to all investors
Discount rate to use Cost of equity WACC
Result MV of equity MV of equity + MV of debt

4.1.1 Free cashflows – how to derive from profits

Free cashflow to equity Free cashflow to all investors

Start with PBIT Start with PBIT
+ Depreciation / amortisation + Depreciation / amortisation
+ Proceeds from capital disposals + Proceeds from capital disposals
– Cost of capital expenditure – Cost of capital expenditure
+ Decrease / deduct increase in working capital + Decrease / deduct increase in working capital
– Interest
+ New debt raised / deduct debt repaid
– Tax – either: – Tax – either:
(PBIT – interest) x tax rate PBIT x tax rate
OR: OR:
(PBIT – interest + depreciation - tax allowable (PBIT + depreciation – tax allowable depreciation)
depreciation) x tax rate x tax rate
 If the examiner simply refers to ‘free cashflow’, they mean the free cashflow to equity
 Once the annual free cashflows have been determined, they can be valued as a growing
perpetuity using an appropriate cost of capital and growth rate, so:
Free cashflow to equity × (1+g)
– MV of equity =
Ke - g
Free cashflow to all investors × (1+g)
– MV of equity + debt =
WACC - g

4.1.2 Advantages and disadvantages

Advantages Disadvantages
Considers future potential of the business Future cash flows will be estimates only
Can be used to value any business Requires a cost of capital to be estimated
Considers the time value of money

4.2 Dividend yield

Total dividend Dividend per share
Dividend yield for a company = or
Market capitalisation Share price
Total dividend
MV of all shares =
Dividend yield

Dividend per share

Value of one share =
Dividend yield

If valuing a non-listed company use dividend yield of a similar listed company and scale down your
valuation (similar to P/E adjustments in the P/E valuation).
CIMA F3 Topic Reviews 8: Business valuations 127

4.3 Dividend growth model

For an ordinary (equity) share, paying an annual dividend, D0, growing in perpetuity at a constant rate,
g where P0 is the ex-dividend value:
𝑫𝑫𝒐𝒐 (𝟏𝟏 + 𝒈𝒈) 𝑫𝑫𝟏𝟏 (𝟏𝟏 + 𝒈𝒈)
𝑷𝑷𝟎𝟎 = (𝒌𝒌𝒆𝒆 − 𝒈𝒈)
or 𝑷𝑷𝟎𝟎 = (𝒌𝒌𝒆𝒆 − 𝒈𝒈)

4.3.1 Advantages and disadvantages

Advantages Disadvantages
Considers future cash flows to shareholder Assumes dividends grow at a constant rate forever
Relevant for minority interests Requires a cost of equity to be estimated
Spurious results arise for businesses that don’t pay
dividends (zero value) or where growth (g) > cost of
equity (ke) (negative value)

5 Valuation of intangible assets

5.1 Types of intangible assets
 Intellectual capital
 Digital assets
 Brands
 Customer loyalty

Intellectual capital
 Human – knowledge, skills, qualifications, experience of staff
 Intellectual assets – assets developed within the business such as reports, drawings, developed
computer software
 Intellectual property – assets that can be legally protected, patents, copyrights, trademarks

Digital assets
 Digital assets include websites, domain names, apps, branding and other forms of digital data
 Value of these assets is heavily dependent on:
– Usage rights of (especially if digital asset was developed in partnership with a 3rd party)
– The impact of regulation changes over e.g. a company’s ability to use data (e.g. GDPR)

5.2 Valuing intangible assets

 Market – comparison to similar assets sold recently at arms’ length, but may be difficult to find
examples
 Cost – valued by costs of development, but that ignores ability to generate revenue
 Income – present value of cash flows, relief from royalties, CIV
128 8: Business valuations CIMA F3 Topic Reviews

5.2.1 Calculated intangible value (CIV)

Step 1 - Estimate average excess return expected on tangible assets
$000
Actual return/profit The profit before tax A
Average industry return with (Industry return on assets % × our year end tangible assets) (B)
our tangible assets
Excess pre-tax return attributable to intangible factors C

Step 2 - Estimate PV of excess pre-tax return (CIV value of intangibles) by valuing it as a perpetuity
using the company’s cost of capital
1
PV=Excess return (C) × (1 - tax rate) ×
r

Step 3 – Estimate total value of business

Total value of business = Value of tangible assets + CIV value of the intangibles

6 Efficient market hypothesis (EMH)

6.1 Market efficiency
 Share prices are fair (shares can’t be bought cheap and immediately sold at a profit)
 No individual dominates the market
 Transaction costs are not significant
 Share prices follow a random walk (rise on good news, fall on bad news)
 Share prices change ‘quickly’ to reflect information about a company

6.2 The efficient market hypothesis (EMH)

How to beat the When a positive NPV project
Method Share prices reflect:
market is reflected in the share price
Information about past
Analysis of forecasts When its value has been
Weak form price moves and past
and the actions of the evidenced (e.g. reflected in
efficiency information which has
company published accounts)
become fact
Semi-strong All publically available When the project is
Insider trading (illegal)
efficiency information announced
Strong form All information about a When the board agree to
Luck
efficiency company undertake the project
 129

Mergers and acquisitions

1 Mergers and acquisitions (M&A)

1.1 Types of M&A
Transaction Description
Takeover/Acquisition One company buys another company / business
Merger Two companies make a mutual decision to combine
Vertical integration A company buys one of its suppliers / distributors
Reverse takeover A private company buys a public company
Horizontal integration Two companies in the same business sector combine
Diversification One company buys another company in a different sector

1.2 Reasons for M&A

Reason Description
Improved market reach / Reach new markets and grow revenues and earnings, expansion of two
visibility / power companies' marketing and distribution

Eliminate a competitor / Increase market power, leading to greater control over (e.g.) pricing
increase market power
Asset strip an undervalued Identifying a unsuccessful company with certain valuable assets and
target buying the company purely to get those assets

Use surplus cash Generate a return for shareholder – if there is a lack of internal projects

Use big data Acquiring useful data / knowledge / expertise (e.g. customer data)

Gain synergies Avoiding duplicating expenditure or achieving economies of scale

130 9: Mergers and acquisitions CIMA F3 Topic Reviews

1.3 Synergies
Synergy Category Synergy Description
Economies of scale Greater ability to negotiate reduced costs with suppliers
Avoiding duplication Combined entity only needs one finance / HR department
Operating Elimination of
synergies If the target company is poorly run, make it more efficient
inefficiencies
Acquiring another company with strengths elsewhere in the
Vertical integration
value chain
Bigger firms (with larger earnings and asset bases) have easier
Financial time raising capital (increased sources of finance and cheaper
Financial finance)
synergies Group loss relief but may face withholding tax on payments
Tax
between group companies
Reduced risk Diversification effect as a result of acquisition
Speed Acquisition is often faster than organic growth
Market power Horizontal integration will improve market power
Other synergies
Improved knowledge
Using expertise / technology / data from another company
/ technology

Synergies are not automatically realised once two companies merge. This may be due to clashing
cultures or inability to merge systems.

1.4 Forms of consideration and their impact on buyer and seller

Consideration Pros/cons For buyer For seller
Cash Pros More attractive to seller – get a better Certain amount received
price?
Cons Causes liquidity problems for buyer Immediate tax issues (capital gains)
Additional finance may be required No ongoing stake in the business

Shares Pros Preserves liquidity and reduces No immediate tax issues (gain
gearing deferred)
Ensures cooperation of seller in
ongoing business
Cons Dilution of control + EPS for current Uncertain value received
shareholders
Transaction costs to sell shares
Debt Pros Avoids dilution of control Lower risk than shares (more
Preserves immediate liquidity certainty over return)
Cons Increases gearing + interest payments May prefer higher return of equity
Earn-out Pros Ensures continued cooperation and Give the seller the ability to maximise
arrangements motivation of seller the amount they receive
(price Reduces risk as some of the price is
contingent on contingent on future performance
future
Cons If future performance is good, may Less certainty than the other methods
performance)
end up paying more than a fixed price
CIMA F3 Topic Reviews 9: Mergers and acquisitions 131

1.5 Approach to acquisition questions

1.5.1 Cash acquisitions

(1) Value the business

(2) Suggest an initial offer above the current share price but below the maximum the business
would be prepared to pay
(3) Consider the likelihood of acceptance by other party and other factors (e.g. strategic factors)

1.5.2 Acquisitions with share exchanges

 Predator company acquiring shares of target company by issuing shares to target shareholders
in proportion to their existing shareholdings

PREDATOR (Co A) 2 for 1 TARGET (Co B) NEW (Co A)

offer
100m issued shares 40m for 20m issued shares = 140m issued shares
20m (100m + 40m)

Issues
(1) Evaluating / suggesting the terms of share exchange
(2) Assessing post-acquisition value of joint entity (to determine the max. price to be paid)
Max to pay for B = MVA+B - MVA
Where:
MVA is the current value of company A
MVA+B is the value of the combined entity (including the value of any synergies)
(3) Quantifying impact of acquisition on shareholders in each company
(4) Quantifying impact of acquisition on key ratios for buying company

2 Share exchanges
2.1 Evaluating the terms of a share exchange
 Calculate the value of one share in each of the companies (likely using the existing PE ratios and
EPS for each of the companies)
 Use those values to value each side of the exchange (the value of the shares given up vs. the
value of the shares received)

2.2 Assessing the post-acquisition value of the joint entity

Max price for the buyer = MVA+B - MVA (where company A is the buyer)

METHOD 1 – separately valuing synergies

MVA+B = MVA + MVB + PV of synergies
132 9: Mergers and acquisitions CIMA F3 Topic Reviews

MVA and MVB can be calculated as:

 Share price × number of shares, OR
 P/E ratio × existing earnings (PAT), OR
 PV of future cash flows

METHOD 2 – PE valuation of combined earnings

MVA+B = PE ratio × Combined sustainable earnings
 The predator’s P/E is most likely if the companies are in the same industry (this is referred to as
‘bootstrapping’)
 A combination of the P/E ratios of the two businesses is also a possibility
Combined sustainable earnings, as well as PATA + PATB, may also include any synergies that are
expected to last forever (e.g. “savings in salaries for the foreseeable future”)

METHOD 3 – Finding the present value of the combined cashflows

MVA+B = PV of future combined free cash flows
Cost of capital could be WACC of buyer, or seller or combined WACC

2.3 Quantifying the gains for the shareholders

 Choice of price will determine how two sets of shareholders share in synergies
MV Before MV After Change in wealth
$m $m
A X ? ?
B Y ? ?
X+Y Method1/2/3

 Calculate share price of combined company MVAB/New number of shares

 Calculate new MV of shares held (Combined company share price × New number of shares)
 Compare MV of new holding in combined company with MV of old holding in old company to
find gain

2.4 Quantifying the impact on key ratios for the buyer

Depending on how the purchase is financed, there could be significant impact on key ratios for the
buying company (e.g. gearing, EPS).

3 Regulation of takeovers
Regulation around takeovers can be relevant in two main areas:
 Potential market power of the combined entity if market dominance is too great and against
the public interest
 Behaviour during a bid/acquisition process –fair treatment, meaning enough information is
given for informed decisions, directors of target allowing shareholders to make own decisions,
and if ‘control’ (30% voting rights) is acquired then general offer is made to all remaining
shareholders
CIMA F3 Topic Reviews 9: Mergers and acquisitions 133

4 Defensive tactics
Directors should only undertake defensive strategies if they believe they are in the best interests of
shareholders and other key stakeholders.

4.1 Before the bid

 Effective communication – keep shareholders fully informed
 Poison pill – granting of rights to shareholders, other than the potential acquirer, to purchase
shares at a deep discount, diluting the ownership interest of the potential acquirer
 Shark repellent – altering the ‘constitution’ of the business to require a ‘super majority’ to
accept a takeover
 Asset revaluation – to make the statement of financial position look healthier

4.2 After the bid

 Prompt response – issue rejection letter within 14 days
 Revised financial forecasts – highlight the better potential performance of your business to
your shareholders
 Find ‘white knight’ – friendlier bidder who you are happy to deal with
 Regulator – try to get bid referred to the competition authorities
 Brief against bidder – issue negative statements about the bidder’s style, culture, investment
strategy etc.
 Pacman defence – counterbid for the predator company

5 Post-acquisition integration
5.1 Drucker’s five golden rules for post-acquisition integration.
(1) Both acquirer and the acquired should share a “common core of unity” including shared
technology and markets, not just financial links.
(2) The acquirer should ask “What can we offer them?” as well as “What’s in it for us?”
(3) The acquirer should treat the products, customers etc, of the acquired company with respect,
not disparagingly.
(4) The acquirer should provide top management with relevant skills for the acquired company
within a year.
(5) Cross-company promotions of staff should happen within one year.

5.2 Post-acquisition value enhancement strategies

 Review business units for cost cuttings and potential synergies
 Consider staffing and possible redundancies and the likely cost of the redundancies
 Good communication of post-acquisition intentions to key stakeholders
 Identify economies of scale
 Review of redundant assets and resource audit
 Strong marketing campaign implemented
 Align corporate objectives
134 9: Mergers and acquisitions CIMA F3 Topic Reviews

6 Impact on stakeholders
 Shareholders in the predator company will want to make sure they are getting value for
money.
 Shareholders in the target company will want to make sure they are offered a decent price (i.e.
above the current share price) and are going to be paid in a form that they would like.
 Stock market will want to make sure that the acquisition and the behaviour of the directors
conforms to the relevant rules and regulations (e.g. City Code).
 Suppliers to either of the businesses will want to ensure continuance of a trading relationship.
 Customers will be keen on guaranteed quality of product and after-sales service.
 Regulators will want to ensure that in an acquisition the merged entity does not breach market
rules on monopolies and the public interest.
 Employees of either company will want to guarantee continued employment and prospects.
 Bankers and other financiers will want to make sure that there are no covenants breached and
how they are affected by the new business structure.
 Management teams of the two businesses will be concerned with being able to work
effectively together.
 135

10

Business reorganisations

1 Reasons to divest
There are several reasons why owners of a business may want to divest of some or all of it, including
shift in strategic emphasis, poor results and need for cash.

2 Methods of divestment
2.1 Demerger/spin off
A company spins off some business it owns into a completely separate company, generally also owned
by the current shareholders. Demergers allow the management of demerged companies to
concentrate on their core business and make companies easier for investors to analyse.

2.2 Sell off

Part or all of a business is sold to a third party for cash. The shareholders retain no further investment
in the business that is sold off.

2.3 Liquidation
The business ceases to exist and assets are sold. This may be the best way to obtain some value for
shareholders.

2.4 Initial public offering (IPO)

An IPO is a sale of the shares of the company to the public to be traded on a stock exchange.
Advantages may be that there is some realisation of cash for investors, major shareholders usually
maintain control and it can offer a high potential return. Disadvantages are that it is a costly process
with an uncertain outcome.
136 10: Business reorganisations CIMA F3 Topic Reviews

2.5 Franchise
The business concept is sold to others to replicate. There will usually be an upfront cash receipt with an
on-going franchise fee.

2.6 Management buyout (MBO)

A team of managers from inside the organisation buy out the business or a part of it. The management
team will need to have the relevant skills and expertise on board (particularly in IT, HR and other head
office functions that they can no longer utilise from the original business).

2.6.1 Motivation for the managers

 Own and run their own business
 Benefit from potential large equity gains

2.6.2 Motivation for the existing owners of the company

 Allows them to dispose of non-core operations
 Allows them to raise cash
 Quicker than a sale to a third party (as the buyers already know the business)

2.6.3 Financing MBO

A typical financing structure will often be driven by the fact that the MBO team want a good share of
the equity but can only personally afford a small fraction of the amount payable.
Party % of funding
Management team 1-5%
Banks – Senior (secured) debt and subordinated (less secured) debt 30-40%

Banks/Investors – Mezzanine debt (unsecured, higher interest rate, shorter term) 20-30%
possibly with equity warrants
Venture capital 20-30%

2.6.4 The venture capitalist

Venture capital firms look to invest in businesses with high potential growth where the management
has a proven track record.
A VC firm may want:
 25%-30% average annual return ( dividends + capital gain)
 Board presence and decision making input
 Clear exit plan for a three to seven year timescale
 137

11

Risk management and

currency risk

1 Financial risks facing an organisation

1.1 Types of financial risk
Financial risk is the risk of future financial conditions being different to those expected:
 Currency risk – fluctuations in exchange rates
 Interest rate risk – fluctuations in interest rates
 Credit risk – non-payment by customers, managed by credit control policies, debt factoring,
insurance
 Political risk – action by a foreign government will affect position of company

1.2 Political risk

Governments may take various actions:
Measure Description
Quotas Limits on quantities of goods a subsidiary may buy from its parent
Tariffs Extra tax or duty applied to imports to make domestic goods more competitive
Non-tariff barriers Extra quality or safety checks applied to imported goods
Foreign companies prevented from buying domestic companies in certain industries
Restrictions
(e.g. defence, energy)
Nationalisation of foreign owned companies and their assets (without
Nationalisation
compensation)
Minimum shareholding Insistence of a minimum shareholding in companies by residents
138 11: Risk management and currency risk CIMA F3 Topic Reviews

1.2.1 Dealing with political risks

Measure Description
Negotiations Agree concessions with the host government
Contract out some production to local sources, or locate key parts of production
Production strategies
and distribution overseas
Management structure Use of joint ventures with domestic companies or ceding control to local investors

2 Foreign exchange rates and currency risk

2.1 Quoting exchange rates
E.g. the current price of US dollars in £ (the ‘spot’ price) might be displayed as $1.2543 - $1.2594
 Sell $ for £ – use rate of $1.2594 : £1 (need to sell more $ to obtain each £)
 Buy $ with £ – use rate of $1.2543 : £1 (obtain fewer $ with each £)

Ticks
 Foreign currencies are often quoted to 4 decimal places
 £/$ 0.0001 is the smallest possible movement in a foreign currency, referred to as a tick

Strengthening / Weakening
A currency (e.g. the £) is described as strengthening against another currency if the exchange rate
moves such that one £ can buy more of a foreign currency than it previously could.

2.2 Exchange cross rates

The exchange rate between two currencies can be calculated using the exchange rates between those
two currencies and a third currency. This is called the cross rate.

2.3 Currency risk

 Transaction – entering into a short term transaction involving credit in a foreign currency,
changes in the FX rates before settlement could lead to either a gain or a loss
 Economic – longer term risk by trading in a particular foreign country (changes in FX rate may
make it less able to compete against rivals)
 Translation – accounting losses when translating the value of a foreign asset or liability into the
functional currency of business at the end of the accounting period

3 Currency movements
3.1 Balance of payments
The balance of payments is the difference between a country’s overseas earnings and spending:
 A surplus implies the country is exporting more than it imports and so its currency will
strengthen (as demand for that currency will increase)
 A deficit implies it is importing more than it imports and so its currency will weaken
CIMA F3 Topic Reviews 11: Risk management and currency risk 139

3.2 Purchasing power parity theory (PPP)

FX rates between two countries will be influenced by the respective inflation rates in the two
countries.
 If price inflation (and hence the price of goods) is lower in one country (e.g. US) than another
(e.g. the UK), purchasers located in the UK will seek to buy their goods in the US.
 This will lead to UK purchasers buying $ in order to buy goods from the US.
 This will lead to the $ strengthening against the £
[1+𝑟𝑟 𝑣𝑣𝑣𝑣𝑣𝑣]
𝑆𝑆1 = 𝑆𝑆0 × [1+𝑟𝑟
𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏]
S1 = Predicted spot rate at the future date
S0 = Current spot rate
r var = the inflation rate of the variable currency (i.e. in the foreign country)
r base = the inflation rate of the base/fixed currency (i.e. in the home country)

3.3 Interest rate parity theory (IRP)

Interest rate parity argues that a fair forward exchange rate can be determined using the current spot
exchange rate and the nominal interest rates in the two countries.
[1+𝑟𝑟 𝑣𝑣𝑣𝑣𝑣𝑣]
𝐹𝐹0 = 𝑆𝑆0 × [1+𝑟𝑟
𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏]
F0 = Current forward rate
S0 = Current spot rate
r var = interest rate in the variable currency (i.e. in the foreign country)
r base = interest rate in the base/fixed currency (i.e. in the home country)

3.4 International Fisher effect

The international Fisher effect assumes that:
 Only reason that nominal interest rates in two different countries are different is due to
differing levels of inflation (the real interest rates in each country are equal)
 Forward rate (as found using interest rate parity) is an unbiased predictor of the future
expected spot rate (as calculated using purchasing power parity)

3.5 Other factors causing currency fluctuations

 The political stability of the respective countries
 The debt ratings of the respective countries
 Government policies in the respective countries
140 11: Risk management and currency risk CIMA F3 Topic Reviews

4 Internal hedging techniques

Internal techniques for hedging transaction risk are generally simpler and cheaper than using external
foreign currency markets (‘external hedging’).
Hedging method How it works
Invoice foreign customers in your domestic currency. This pushes the risk
Invoice currency
onto the customer and may prove unpopular
Match receipts and By setting up a foreign currency bank account, only need to hedge net
payments foreign currency position (net of foreign currency receipts and payments)
Match assets and Fund foreign assets generating revenues in foreign currency with foreign
liabilities borrowing, so that interest payments are also in foreign currency
Make an early payment (lead) to a foreign supplier if foreign currency is
likely to strengthen
Leading and lagging
Delay payment (lag) on payment to foreign supplier if foreign currency is
likely to weaken
Countertrade Payment in goods rather than foreign currency
Set up netting centre through which all intra-group transactions will be
settled
Multilateral netting A single net settlement from each company will be processed through the
netting centre periodically (reducing the number of foreign exchange
transactions and saving money)

5 External hedging techniques

5.1 Forward exchange contracts
Forward exchange contracts (FX forwards) are binding agreements to buy or sell an amount of one
currency in the future for a set price in another currency (agreed today).
This can be used to eliminate the transaction risk of a future foreign currency payment to a supplier or
receipt from a customer.
 FX forwards are either quoted as discounts or premiums on the spot price
 ADDIS (add a discount, deduct a premium)
Pros
 Lock in a price, hedging downside risk
 Tailored to the investor
Cons
 Investor loses any upside potential
 Difficult to unwind the hedge
 141

12

Advanced currency risk

management

1 Money market hedges

Instead of using forward exchange contracts, a company can achieve a similar result by:
 Borrowing and lending on money markets
 Using spot foreign exchange transactions
This will fix an effective forward exchange rate for the hedging company
To hedge future payment in Dollars To hedge future receipt in Dollars:
 Borrow in £ now  Borrow in $ now
 Convert to $ at spot  Convert to £ at spot
 Deposit $ and earn interest  Deposit £ and earn interest
 On payment date, settle payment out of $ deposit  On receipt date, use receipt to pay back $
account loan
 Pay back £ loan + interest  Withdraw £ from deposit
142 12: Advanced currency risk management CIMA F3 Topic Reviews

2 Currency futures (FX futures)

Currency futures are standardised (‘traded’) contracts to buy a set amount of currency at a set rate for
a standardised delivery date in the future. They are effectively standardised versions of forward
contracts and are available in most major currencies (e.g. £, $ and €).

2.1 Hedging steps

Setup of hedge
 Determine whether buy or sell futures
 Choose the first available futures maturity date after the expected settlement date
 Calculate the number of contracts
Outcome of hedge
 If sell futures initially, now buy and vice versa
 Calculate gain or loss on futures and convert to home currency at spot rate if necessary
 Convert the amount of the transaction at spot rate and adjust by futures gain/loss

2.2 Pros and cons of FX futures

Pros
 Lock in a price, hedging downside risk
 Close out a futures position at any time
Cons
 Investor loses any upside potential
 Standardised contracts, so may be under/over hedge
 Basis risk (difference between spot rate and futures rate before futures maturity date) may lead
to the hedge not being 100% efficient if futures maturity ≠ transaction date
 Need to post margin to the exchange

3 Currency options
A currency option is an agreement involving a right, but not an obligation, to buy or to sell a certain
amount of currency at a stated rate of exchange (the exercise price) at some time in the future.
 Protect against adverse movements in the exchange rate and
 Allow the investor to take advantage of favourable exchange rate movements
A premium is required to purchase a currency option.
CIMA F3 Topic Reviews 12: Advanced currency risk management 143

3.1 Over the counter (OTC) currency options

OTC currency options allow you to pay a premium now to buy a tailored option to:
 Buy (call), or sell (put) a set amount of currency
 At a set price (in another currency)
 At a future date
OTC options allow the exchange of currencies if exercised.

3.1.1 Hedging steps

Setup of the hedge
 Determine type of option
 Choose strike price (based on the minimum £ you want to receive)
 Pay premium

Outcome of the hedge

 Determine whether to exercise the option

3.2 Traded currency options

Traded exchange options in currencies other than $ have the following characteristics:
 Standardised with standard maturity dates and contract sizes
 Contract sizes quoted in underlying currency of option
 Premiums quoted in $

3.2.1 Hedging steps

Setup of hedge
 Determine whether put or call option needed
 Choose strike price and maturity date
 Calculate number of contracts needed
 Pay the premium in $
Outcome of hedge
 Convert amount of transaction at spot rate
 Determine whether there is a gain on the option and if there is, exercise it and convert to home
currency at spot rate if necessary
 Determine net outcome by taking converted amount of transaction and adding gain on option
and deducting premium

3.3 Pros and cons of FX options

Pros
 Protect from downside risk and allow buyer to benefit from upside
144 12: Advanced currency risk management CIMA F3 Topic Reviews

Cons
 Option premiums can be expensive and must be paid upfront
 If traded, may over/under hedge (due to standardised contracts)
 Traded options not available in all currencies

3.4 Intrinsic value and time premium of options

Intrinsic value is the value that would be generated by exercising the option today, calculated as the
difference between the spot price and the strike price of the option.
Time premium is the difference between the total value of the option (the premium) and the intrinsic
value. It depends on the standard deviation in the daily value of the underlying asset, the time to the
expiry of the option and the risk-free interest rate.

4 Arbitrage
Arbitrage profit arises when a trader takes advantage of price differences between two markets. The
law of supply and demand ensures that the undervalued item’s price rises and the overvalued item’s
price falls (as traders take advantage of the arbitrage), until equilibrium is regained.

5 Value at Risk (VaR)

Value at Risk is method used by companies to assess the maximum loss on given assets / investments
over a period of time, assuming:
 Normal market movements
 A given level of probability (confidence level)
VaR assumes that variations in the future value of a portfolio of assets are normally distributed in
order to calculate the maximum loss:
Value at Risk = Z score based on the confidence level × standard deviation
VaR for a period n times as long as follows:
𝒏𝒏 period VaR = single period VaR × √𝒏𝒏
 145

13

Interest rate risk

1 Interest rate risk

Interest rate risk is the risk to profitability/cash flow resulting from changes in interest rates:
 Borrowing at a fixed rate in times of falling interest rates / borrowing at a variable rate in times
of rising interest rates
 Being exposed to rising interest rates when re-financing
 Depositing at a variable rate in times of falling interest rates / borrowing at a fixed rate in times
of rising interest rates

2 Internal methods for hedging interest rate risk

Hedging method How it works
Investments and loans of a similar value which earn / pay a variable rate of
Matching
interest (reducing the net impact of rate movements)
Balancing mix of fixed and floating rate debt, providing a natural hedge
Smoothing
against movements in interest rates
Netting Aggregating all assets and liabilities to determine a net exposure

3 External methods of interest rate risk management

OTC instruments Exchange Traded Instruments
Forward Rate Agreements (FRAs) Interest Rate Futures
Interest Rate Guarantees (IRGs) Traded Interest Rate Options
Interest Rate Swaps
146 13: Interest rate risk CIMA F3 Topic Reviews

4 Forward Rate Agreements (FRA)

Forward Rate Agreements are OTC contracts which are used to fix the effective rate of interest to be
paid on future short-term borrowing.
 5.75 – 5.70 means you can fix the borrow rate at 5.75, deposit rate at 5.70
 A 3 – 6 FRA starts in 3 months, lasts 3 months

4.1 Hedging steps

Setup of the hedge
 Buy a FRA (if borrowing in the future)
Outcome of the hedge (when the borrowing starts)
 Net settlement on the FRA =
(Spot rate – FRA rate) × Nominal value × Number of months /12
 Borrow money from bank at spot rate

4.2 Pros and cons of FRAs

Pros
 Hedge away downside risk (e.g. of rates rising if borrowing)
 Tailored to the investor (so you won’t be under/over hedged)
Cons
 Usually only available on loans > £500k and for periods of < 1year
 Remove any upside potential (e.g. of rates falling if borrowing)
 Difficult to exit (e.g. if date or size of borrowing changes)

5 Interest rate futures

Interest rate futures are similar to FRAs (they attempt to set fixed rate for future borrowing, don’t
actually lead to any money being borrowed), but are standardised and traded on exchanges.
 Mature at set points (e.g. end of March / June / September / December)
 Standardised contract sizes
 Futures price = 100 – r (where r= fixed interest rate)
 Borrowers sell futures now & buy futures on date their borrowing starts
 Lenders buy futures now and sell futures on date their lending starts

5.1 Hedging steps

Setup of hedge
 Sell futures (if borrowing)
 Choose maturity date (as close to borrow start date as possible)
Borrowing notional value borrowing period
 Calculate no. of contracts = ×
Futures contract value 3

Outcome of hedge (when the borrowing starts)

 CIMA F3 Topic Reviews 13: Interest rate risk 147

 Close out futures by buying same number of contracts  gain/loss on futures =

(Sell price – Buy price) 3
 100
× No of contracts × futures contract value × 12

 Borrow money from bank at the spot rate

5.2 Pros and cons of interest rate futures

Pros
 Hedge away downside risk (e.g. of rates rising if borrowing)
 Close out a futures position at any time (they are more flexible than FRAs)
Cons
 Remove any upside potential
 Standardised contracts somay under / over hedge
 Basis risk (difference between spot rate and futures rate before the futures maturity date) – this
may lead to the hedge not being 100% efficient
 Need to post margin (collateral) to the exchange

6 Interest Rate Guarantees (IRGs)

Interest guarantees are options on forward rate agreements (FRAs)  hence they give the user the
option as to whether to fix the interest rate at the FRA rate at some point in the future.
This provides a capped (maximum) interest rate for borrowers and a floor (minimum interest rate) for
lenders.
Description Used by
Call option Gives the holder the right to BUY an FRA and pay interest at a Borrowers
fixed rate
Put option Gives the holder the right to SELL an FRA and receive interest at a Lenders / depositors
fixed rate
A premium must be paid upfront when buying the IRG.

6.1 Collars
A collar involves using a combination of options to set both a maximum and minimum rate that you’d
pay.
By limiting the upside hedge is cheaper due to receiving a premium.

6.1.1 Collar for a borrowing company

 Buy call option and therefore have the option to pay interest at no more than a certain interest
rate – an interest rate cap on payments
 Sell a put option and therefore limit to paying interest at no less than a certain amount – an
interest rate floor on payments
148 13: Interest rate risk CIMA F3 Topic Reviews

7 Exchange traded interest rate options

Exchange-traded interest rate options are available as options on interest rate futures, which give the
holder the right to:
 Buy (call option) or sell (put option) one futures contract
 On or before the expiry of the option at a specified price (strike price)
 Buyer must pay a premium now
 Borrowers buy puts
 Lenders buy calls

7.1 Hedging steps

Setup of the hedge
 Buy put options (if borrowing) or call options (if investing)
 Choose strike price (based on 1 - maximum rate you want to pay/receive)
 Choose maturity date (as close to start date as possible)
notional value period in months
 Calculate no. of contracts = ×
futures contract value 3

 Pay premium = No of contracts × Futures contract value × Premium % × 3/12

Outcome of the hedge (when the borrowing starts)
(1) If exercising options
 Exercise options and receive gain on futures
 Borrow/invest at spot rate
(2) If rates fall below rate implied by strike price, let option lapse:
 Borrow/invest at spot rate

7.2 Pros and cons of traded interest rate options

Pros
 Protect from downside risk and allow the buyer to benefit from upside
Cons
 Option premium can be expensive and must be paid now
 Over/under hedge (due to standardised contract sizes)
 Basis risk may lead to hedge not being 100% efficient if futures maturity ≠ borrowing start date

8 Interest rate swaps

An Interest rate swap is an Over the Counter (OTC) agreement whereby two parties agree to exchange
interest rate commitments.
 One party will effectively pay a variable rate of interest to the other
 The other party will effectively pay a fixed rate of interest to the other
 CIMA F3 Topic Reviews 13: Interest rate risk 149

8.1 Interest rate savings using swaps

(1) Set out rates each company would pay (with no swap) and could pay (if they did the opposite)
and work out the total rate in each case
(2) Calculate total potential benefit by finding the difference between the two totals in part (1)
(3) Split this potential saving between the two parties as instructed in the question
(4) Calculate overall effective rate with a swap for each party by deducting their share of the saving
from the rate they would pay with no swap
(5) Use this end result to calculate the two legs of the swap
Notes: in order for swaps to work, one company must want fixed interest rates and the other must
want floating/variable. A swap will not be possible if both companies want fixed or floating.
Exam questions sometimes refer to “basis points”:
 100 basis points = 1%
 50 basis points = 0.50%.

8.2 Pros and cons of interest rate swaps

Pros
 Transaction costs are low
 Flexibility, arranged in any size, and they can be reversed if necessary
 Companies with different credit ratings can borrow at the best cost in the market that is most
accessible to them and then swap this benefit with another company
 Allow capital restructuring without the need to redeem debt or to issue new debt, thus
reducing transaction costs
 The company taking on the fixed rate debt is immune to interest rate rises

Cons
 Counterparty risk – the risk that the other party will default on its interest payments
 If a company takes on floating rate debt, it is subject to adverse movements in interest rates
 It might be difficult to find a swap partner directly so the services of a bank may be required
(fees payable)

9 Currency swaps
Currency swaps allow companies to swap both the currency of their debt and the profile of their
interest payments.
A cross-currency swap involves both:
 A swap of principals (in different currencies)
 A swap of interest payments
As with an interest rate swap, the two ultimate counterparties will be companies with similar
borrowing requirements (albeit in different currencies), but they will be linked through a bank.
150 13: Interest rate risk CIMA F3 Topic Reviews
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Sample Assessment
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Preseen Extracts

Preseen extracts 2019 Prototype

You are the Senior Manager in Fizz which is a large company that manufactures soft drinks. Fizz has its
head office in Nortland and is quoted on the Nortland Stock Exchange. You report directly to the
Board. Nortland uses International Financial Reporting Standards. Nortland’s currency is the N$.

The soft drinks market

Retail sales of soft drinks in Nortland amounted to N$12.3 billion in the year to 31 December 2018.
Soft drinks can be split into two main categories: carbonated soft drinks (CSDs) and still drinks.
Manufacturers have two main distribution channels for their products:
The off-trade comprises bulk sales to major retailers and wholesalers.The final consumers consume
them off the vendor’s premises.
Off-trade products are packaged as cans and bottles.
Some major retailers sell their own-brand drinks. Own-brand products accounted for 23% of the off-
trade market by value in 2018.
The on-trade comprises sales to outlets where consumers consume the drinks on the premises. Major
ontrade outlets will buy directly from the manufacturer, but there are also wholesalers who service
the on-trade channel.
Off-trade sales are split 49% CSD and 51% still by value. On-trade are 72% CSD and 28% still.
Retail sales of soft drinks in Nortland totalled N$12.3 billion in the year to 31 December 2018, of which
N$8.2 billion was off-trade and N$4.1 billion was on-trade.
Retail prices are significantly higher for on-trade sales and so on-trade sales account for approximately
10% of soft drink sales by volume, despite being roughly 33% by value

Company background
Fizz was founded by the Clann family in 1890. The company manufactured 422 million litres of soft
drinks in the year to 31 December 2018. Fizz was listed on the Nortland Stock Exchange in 1962. The
Clann family still holds 18% of the company’s shares.
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Products:

Carbonated
Froot The company’s most popular drink is widely available from on-trade and off-trade outlets The
regular version is sweetened with corn syrup but there is also a sugar-free version. A 330ml can of
Froot contains about as much caffeine as a cup of coffee.
Fizz a range of carbonated drinks, including Fizz Cola, Fizz Orange and Fizz Cream Soda. These drinks
sell steadily through the off-trade sector, but they are not market leaders.
There are both regular and sugar free versions and they contain the same level of caffeine as Froot.
Funn a range of energy drinks that are marketed primarily at consumers in their teens and early 20s. A
can of Funn contains a significant quantity of sugar to give the consumer an energy boost and a
concentrated shot of caffeine, equivalent to drinking three cups of coffee.

Still
Clann cordial a concentrated drink that is mixed with water before consumption. It comes in a range of
fruit flavours. It is sold through the off-trade channel.
Joocy Juice a range of real fruit juices. This is a premium brand made by harvesting fruit and having it
pressed locally. Fizz’s competitors use concentrated juice. This process is far cheaper but the process
affects the flavour of the juice and removes some of its vitamin content.
In addition, Fizz sells Clann Spring Water in both carbonated and still versions.
Fizz is one of the largest manufacturers of soft drinks in Nortland.
Fizz’s main competitor is Qwench which manufactures its own range of CSDs and still drinks. Qwench
also has the franchise to bottle and sell a global-brand of cola drink. Qwench generates 45% of its
revenues from this franchising arrangement.

The manufacturing process

Carbonated drinks, including Froot, are largely water. The water used in the drinks must be very pure.
Fizz filters and sterilises all water.
There is a cooking process to create the syrup that provides colour and taste. The syrups are combined
with the water and the sugar or sweeteners to create the drink. Then CO2.is added.
Clann Cordial is made in a very similar manner, although there is a much higher concentration of syrup
and the product does not contain CO2. All of Fizz’s carbonated drinks and cordials are manufactured
at a single factory, with several production lines.
Joocy Juice is made by pressing fresh fruit, with the resulting juices filtered and packaged immediately
by third parties located close to the origin of the juice. Some of the juice is delivered directly to
customers, such as major supermarkets. The remainder is delivered to the distribution centre at Fizz’s
factory.

Administration and systems

Fizz relies heavily on an integrated suite of enterprise software to manage every aspect of its
operations. The information systems monitor inventory levels and schedule purchases and
manufacturing accordingly. Routine purchases are managed using Electronic Data Interchange.
The Board relies on the information from this system to inform budgeting and forecasting processes
and for inputs into the company’s enterprise risk management system.
The company’s servers are located in a secure building that is adjacent to the factory. All data is
backed up to a remote location that is managed by a specialist third-party cloud service provider.
CIMA E3/F3/P3 Sample Assessment 155

Internal audit
Fizz’s internal audit department comprises a team of 14 audit professional staff and 4 administrative
staff. 11 of the professional staff are qualified accountants and the remainder are trainees who are
registered as students.
The Chief Internal Auditor reports to Michelle Adams, one of Fizz’s non- executive directors. The CIA
attends all meetings of the Audit Committee but does not have a vote.

Fizz’s Board
There are currently 5 executive directors including Hong Li CEO and Mary Shannon FD. There are 5
non executive directors including Walter Clann Chairman.

Risk register extracts

Fizz’s risk factors include the following:

Problems with product safety
Supplies of raw materials may be interrupted
Failure of key IT systems
Disruption of deliveries
Intellectual property rights may be compromised
Legislation of tax penalties to discourage the sale of high calorie products
Changing consumer tastes may lead to declining sales
Financial risks including volatility in currency and commodity prices

Board committees
Fizz has the following board committees:
Audit committee, compensation committee and nomination committee.

Fizz strategy
The Board of Fizz is committed to pursuing the following strategies:
Maintain growth in core markets
Exploit global opportunities
Develop consumer trust

Highlights from financial statements

Fizz Qwench
Year ended Year ended Year ended Year ended
31 December 18 31 December 17 31 December 18 31 December 17
N$ million N$ million N$ million N$ million
Revenue 336.2 365.3 1690.1 1882.2
Operating profit 75.8 97.4 332.5 448.3
Cash and equivalents 10.4 7.0 316.3 184.3
156 Sample Assessment CIMA E3/F3/P3

Press highlights:
Fightback of soft drink manufacturers claiming parents must take some responsibility for obesity.
Fizz’s share price falls on publication of 2018 results (Qwench fall in profits is greater).
Rising cost to health service of obesity
Health warning on the consumption of energy drinks
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Sample Assessment Questions

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Sample answer proforma

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[END OF EXAM]
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Answers
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Sample Assessment Answers

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Marking Guide
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Marking guidance from CIMA

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