Chapter 15 - Investment implementation and review

Question 1

What is the primary strategic objective of a commercial company in the long-term?

Answer 1

Maximisation of the wealth of the shareholders

Question 2

Who are stakeholders?

Answer 2

Those persons and entities that have an interest in the strategy of an entity. Stakeholders normally include shareholders, customers, staff and local community.

Question 3

Define equity investors

Answer 3

Within any economic system, the equity investors provide the risk finance. There is a very strong argument for maximising the wealth of equity investors. In order to attract funds, the company has to compete with other risk-free investment opportunities, e.g. government securities. The shareholders require returns from the company in terms of dividends and increase in share prices.

Question 4

Explain community at large as stakeholders

Answer 4

The goals of the community will be broad but will include such aspects as legal and social responsibilities, pollution control and employee welfare.

Question 5

Explain company employees as stakeholders

Answer 5

Returns = wages or salaries. However, maximising the returns to employees does assume that risk finance can be raised purely on the basis of satisfying the returns to finance providers. The employees’ other interests also include job security and good conditions of employment.

Question 6

Explain company managers/directors as stakeholders

Answer 6

Such senior employees are in an ideal position to follow their own aims at the expense of other stakeholders. Their goal will be both long-term (defending against takeovers, sales maximisation) and short-term (profit margin leading to increased bonuses).

Question 7

Customers as stakeholders?

Answer 7

Satisfaction of customer needs will be achieved through the provision of value for money products and services.

Question 8

Suppliers as stakeholders

Answer 8

Suppliers to the organisation will have short-term goals such as prompt payment terms alongside long-term requirements including contracts and regular business. The importance of the needs of suppliers will depend upon both their relative size and the number of suppliers

Question 9

Finance providers as stakeholders

Answer 9

Providers of loan finance (banks, loan creditors) will primarily be interested in the ability of the firm to repay the finance including interest. As a result it will be the firm’s ability to generate cash both long and short term that will be the basis of the goals of these providers

Question 10

The government as stakeholders

Answer 10

The government will have political and financial interests in the firm. Politically it will wish to increase exports and decrease imports whilst monitoring companies via the Competition Commission. Financially it requires long-term profits to maximise taxation income.

Question 11

Managing stakeholder interests

Answer 11

Part of managing any company involves dealing with any groups interested in the company. Dealing with customers and suppliers might be dealt with by lower level management, whereas dealing with shareholders and the bank are more likely to be dealt with by the Board. Customers and suppliers will need to be dealt with on a daily basis and there will be probably specialist departments within the company to do this, such as accounts receivable and accounts payable. Any marketing or public relations departments may also be involved with customers.

Question 12

Interest rate increase affects spending (falls). Explain

Answer 12

Expenditure by consumers, both individual and business, will be reduced. This occurs because the higher interest rates raise the cost of credit and deter spending. If we take incomes as fairly stable in the short term, higher interest payments on credit cards/mortgages, etc., leave less income for spending on consumer goods and services. This fall in spending means less aggregate demand in the economy and thus unemployment results.

Question 13

Interest rate increase affects asset value (falls). Explain

Answer 13

The market value of financial assets will drop, because of the inverse relationship (between bonds and the rate of interest). This in term, will reduce many people’s wealth. It is likely that they will react to maintain the value of their total wealth and so may save, thereby further reducing expenditure in the economy. This phenomenon seems to fit the UK recession of the early 1990s when the house-price slump deepened the economic gloom. For many consumers today a house, rather than bonds, is their main asset.

Question 14

Increase in interest rates affects The exchange rates (rise), inflation (falls). Explain

Answer 14

Exchange rates rise - the inflow of foreign funds raises demand for the domestic currency and so pushes up the exchange rate. This has the benefit of lowering import prices and thereby bearing down on domestic inflation. However, it makes exports more expensive and possibly harder to sell. The longer-term effect on the balance of payments could be beneficial or harmful depending on the elasticity of demand and supply for traded goods.

Inflation falls - higher interest rates affect the rate of inflation in three ways. First, less demand in the economy may encourage producers to lower prices in order to sell. This could be achieved by squeezing profit margins and/or wage levels. Second, new borrowing is deferred by high interest rates and so demand will fall. Third, the higher exchange rate will raise export prices and thereby threaten sales which in turn pressurises producers to cut costs, particularly wages. If workers are laid off then again total demand is reduced and inflation is likely to fall.

Question 15

What are the effects of high inflation rates?

Answer 15

Distorts consumer behaviour - people may bring forward purchases because they fear higher prices later. This can cause hoarding and so destabilise markets, creating unnecessary shortages.

Redistributes income - people on fixed incomes or those lacking bargaining power will become relatively worse off, as their purchasing power falls. This is unfair.

Affects wage bargainers - trades unionists on behalf of labour may submit higher claims at times of high inflation, particularly if previously they had underestimated the future rise in prices. If employers accept such claims this may precipitate a wage - price spiral which exacerbates the inflation problem.

Undermines business confidence.wide fluctuations in the inflation rate make it difficult for entrepreneurs to predict the economic future and accurately calculate prices and investment returns. This uncertainty handicaps planning and production.

Weakens the county’s competitive position - if inflation in a country exceeds that in a competitor country, then it makes exports less attractive and imports more competitive. This could mean fewer sales of that country’s goods at home and abroad and thus a bigger trade deficit. For example, the decline of Britain’s manufacturing industry can be partly attributed to the growth of cheap imports when they were experiencing high inflation in the period 1978-1983.

Redistributes wealth - if the rate of interest is below the rate of inflation, then borrowers are gaining at the expense of lenders. The real value of savings is being eroded. This wealth is being redistributed from savers to borrowers and from payables to receivables. As the government is the largest borrower, via the national debt, it gains most during inflationary times.

Question 16

What are the internal constraints on setting up the financial strategy?

Answer 16

Key internal constraints on strategy include:

• a shortage of key skills;
• limited production capacity

Question 17

What are the external constraints on setting up the financial strategy?

Answer 17

Major external constraints are:

• The need to maintain good investor relations and provide a satisfactory return on investment
• Limited access to sources of finance either due to weak creditworthiness or lack of liquidity in the banking sector and capital markets.
• Gearing level - The main argument in favour of gearing is that introducing borrowings into the capital structure attracts tax relief on interest payments. The argument against borrowing is that it introduces financial risk into the entity. Financial managers have to formulate a policy that balances the effects of these opposing features.
• Debt covenants - these are clauses written into debt agreements which protect the lender’s interests by requiring the borrower to satisfy certain criteria (e.g. a minimum level of interest cover)
• Government influence
• Regulatory influence
• Major economic influences such as interest rates, growth in GDP, inflation rates and exchange rates.
• Accounting concepts

Question 18

What is agency theory?

Answer 18

Agency theory: hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationship between principals (such as shareholders) and agents (such as company managers and accountants). A conflict may exist between the actions undertaken by agents in furtherance of their own self-interest, and those required to promote the interests of the principals.

Question 19

In which cases the view of shareholders and managers may not be similar?

Answer 19

• Shareholders can spread their risk by investing in a number of entities. Managers have personal and financial capital invested in the entity and so may be averse to investing in a risky investment.
• Shareholder wealth will be maximised by investing in projects with positive net present values. Managers may be more interested in short-term payback than NPV as the investment criterion, in order to help further their own promotion prospects.
• Managers of entities that are subject to takeover bid often put up a defence to repel the predator. While arguing this action is in the shareholders’ best interests, shareholders of acquired entities often receive large gains in the value of their shares. The managers of the acquired entity often lose their jobs or status.
• Managers may be motivated to award themselves and staff better terms and conditions of service. This will incur costs and reduce profits. If equity investors are losing too much as a consequence, they may sell their shares and the market value of the entity will fall.

Question 20

What is goal congruence?

Answer 20

In a control system, the state which leads the individuals or groups to take actions which are in their self-interest and also in best interest of the entity.

Question 21

What are the progress and performance indicators?

Answer 21

In order to achieve the overall objective companies should set specific targets, financial and non-financial, in order to both communicate direction and measure performance. For example:

1. Financial:
   - Profitability
   - Cash generation
2. Non-financial
   - Market share
   - Customer satisfaction

Question 22

Discuss some of the financial performance indicators.

Answer 22

Financial:

-Return to investors - the return from ownership of shares in a profit-making entity can be measured by formula:
Annual return to investors=((P1 - P0) + dividend)/P0
This is the capital appreciation on shares (the difference between p1 and p0 - the share price at the end and the start of the year respectively), plus dividends received through the year.

• Cash generation - Poor liquidity is a greater threat to the
  survival of an entity than is poor profitability. Unless the entity is prepared to fund growth with high levels of borrowings, cash generation is vital to ensure investment in future profitable ventures. In the private sector the alternative to cash via retained earnings is borrowing. In the public sector this choice has not been available in the past, and all growth has been funded by government. However, in the face of government-imposed cash limits, local authorities and other public-sector entities are beginning to raise debt on the capital markets, and are therefore beginning to be faced with the same choices as profit-making entities.
• Value added - this is primarily a measure of performance. It is usually defined as revenues less the cost of purchased materials and services. It represents the value added to an entity’s products by its own efforts. A problem here is comparability with other industries - or even with other entities in the same industry. It is less common in public sector, although the situation is changing and many public sector entities - for example those in the health service - are now publishing information in their own value added.
• Profitability - may be defined as the rate at which profits are generated. It is often expressed as profit per unit of input (e.g. investment). However, profitability limits an entity’s focus to one output measure - profit. It overlooks quality, and this limitation must be kept in mind when using profitability as a measure of success.
• Return on Assets (RoA). This is an accounting measure, calculated by dividing annual profits by the average net book value of assets. It is therefore subject to the distortions inevitable when profit, rather than cash flows, is used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation policy, inventory revaluations, write-off of intangibles such as goodwill, etc. A further defect is that RoA ignores the time value of money, although this may be of minor concern when inflation is very low.

Question 23

What are the criticisms of profitability as a performance indicator?

Answer 23

• it fails to provide a systematic explanation as to why one business sector has more favourable prospects than another;
• it does not provide enough insight into the dynamics and balance of an entity’s individual business units, and the balance between them;
• it is remote from the actions that create value and cannot therefore be managed directly in any but the smallest entities;
• the input to the measure may vary substantially between entities.

Question 24

What are the points which may affect interpretation of RoA in the public sector?

Answer 24

• difficulty in determining value
• there may be no resale value
• are for use by community at large
• charge for depreciation may have the effect of double taxation on the taxpayer

Question 25

Discuss some of the non-financial indicators

Answer 25

• Market share - A performance indicator that could conceivably be included in the list of financial measures, market share is often seen as an objective for an entity in its own right. However, it must be judged in the context of other measures such as profitability and shareholder value. Market share, unlike many other measures can take quality into account - it must be assumed that if customer do not get the quality they want or expect, then the entity will lose market share. Gaining market share must be seen as a long term goal of entities to ensure outlets for their products and services, and to minimise competition. However, market share can be acquired only within limits if a monopoly situation is to be avoided.
• Customer satisfaction - this can be linked to market share. If customers are not satisfied they will take their business elsewhere and the entity will lose market share and go into liquidation. Measuring customer satisfaction is difficult to do formally, as the inputs and outputs are not readily defined or measurable. Surveys and questionnaires may be used but these methods have known flaws, mainly as a result of respondent bias. It can of course be measured indirectly by the level of sales and increase in market share.
• Competitive position - the performance of an entity must be compared with that of its competitors to establish a strategic perspective. A number of models and frameworks have been suggested by organisational theorists as to how competitive position may be determined and improved. A manager needing to make decisions must know by whom, by how much and why he is gaining ground or being beaten by competitors. Conventional measures, such as accounting data, are useful but no one measure is sufficient. Instead, an array of measures is needed to establish competitive position. The most difficult problem to overcome in using competitive position as a success factor is in collecting and acquiring data from competitors.
• Risk exposure - Risk can be measured according to finance theory. Some risks can be managed by use of hedging mechanisms. Shareholder entities can therefore choose how much risk they wish to be exposed to for a given level of return. However, risk can take many forms, and the theory does not deal with risk exposure to matters such as recruitments of senior personnel or competitor activity.

Question 26

Which of the following is an efficiency target that not for profit organisation might put in place?

A Negotiation of bulk discounts
B Pay rates for staff of appropriate levels of qualification
C Staff utilisation
D Customer satisfaction ratings

Answer 26

C

Question 27

VFM is an important objective for not-for-profit organisations. Which of the following actions is consistent with increasing value for money?

A Using a cheaper source of goods and thereby decreasing the quality of not-for-profit organisation services
B Searching for ways to diversify the finances of the not-for-profit organisation
D Decreasing waste in the provision of a service by the not-for-profit organisation
D Focusing on meeting the financial objectives of the not-for-profit organisation

Answer 27

C

Question 28

TO some extent, the decision to which investment appraisal methods to use depends on the circumstances. For example, if the company has short term liquidity problems, which methods would be useful? (A)
Alternatively if a manager is being appraised based on the ROCE generated, what methods he may use? (B)
When trying to assess the sensitivity of the project to changes in input factors, what should be used after NPV? (C)

Answer 28

A - Payback period
B - ARR
C - IRR

Question 29

List the System Development Life Cycle (SDLC) or also called System Project Life Cycle (SPLC) main stages.

Answer 29

1. Planning
2. Analysis
3. Design
4. Development
5. Implementation
6. Review

Question 30

Explain Planning stage in SDLC/SPLC

Answer 30

The planning stage involved undertaking a feasibility study which looked at whether the project or development was actually possible, how much it might cost and whether the company could raise the funds, whether there were sufficient skills available, etc.
The risks at this stage might cover whether a feasibility study was carried out, and whether all parts were covered adequately. Management should not continue any further, thereby wasting time and money, unless the feasibility study demonstrates that the future project is feasible. Controls to ensure this might include setting up a specific committee (with expertise) to ensure sufficient planning was conducted prior to any later stages, and whether all parts of the feasibility study were adequately researched, concluded and authorised.

Question 31

Explain Analysis stage in SDLC/SPLC

Answer 31

This stage involves the consideration of any current system and the problems with it. It may be too expensive, have errors in it, users don’t like it etc. Research and questionnaires will be used to ascertain what the real problem is.
Risks at this stage are that the actual problem is mis-diagnosed and consequently the incorrect solution is developed. Controls will include sufficient budget and time to get to the root of the problem, and the consultation of all interested parties. Money and time spent at this stage should save waste later in the stages developing the incorrect solution.

Question 32

Explain Design stage in SDLC/SPLC

Answer 32

Once the problem is ascertained experts should now design the new, improved system. This might involve flowcharts showing information flows, initial computer coding and etc. A prototype might be developed to give the end users an idea of what is being developed. This will give the end user a change to overcome any problems they envisage.
Controls should involve all users being consulted when the prototype or design has been generated. Budget over run can be a problem at this stage - generating a perfect solution that is too costly (the costs outweighing the benefits). The finance department should be consulted to check that the solution comes within budget.

Question 33

Explain Development stage in SDLC/SPLC

Answer 33

Development takes the prototype a stage further and starts to build the full new system or project. This is usually in the hand of computer programmers these days, since many systems used in business are computerised.
The risks arising at this stage are that as the developer gets deeper into their solution they amend the design, or that they have insufficient expertise or time to develop a good solution. To control this, management should receive constant feedback on the projects progress, and there should be an expert overseeing the developers activities to ensure that they are developing what was agreed.

Question 34

Explain Implementation stage in SDLC/SPLC

Answer 34

During the implementation stage there are several activities such as file conversion, changeover, testing and training. Changeover (direct, parallel, phased and pilot) and risks included the system not working at all, cost overruns, errors, bugs in the system and etc. A lack of staffing training would mean that further errors could be made, staff inefficiency and low morale/resignations if they became frustrated with the system. Ultimately the system could be rejected by staff if it is not implemented correctly.

Question 35

Explain Review stage in SDLC/SPLC

Answer 35

The last stage considers the success of the project some time after it was implemented. It is meant to consider improvements to the current project and to be a learning tool, so that future projects and their management run more smoothly.
Risks here might be that management don’t care or have time to review a project and therefore never learn or improve in the future. Criteria that are usually covered include time, cost and quality. The review stage often includes a review after the event, called a post completion review or post completion audit.

Question 36

What is PCA?

Answer 36

Post completion audit can be defined as an objective independent assessment of the success of a capital project in relation to a plan. It covers the whole life of a project and provides feedback to managers to aid the implementation and control of future projects.

PCA reviews the cashflow from the project after the project has been finished, or sometimes during the life of the project. The aim is to identify any variances from the original budget and particularly to discover the causes of those variances. A project’s PCA provides the mechanism whereby experience of past projects can be fed into the entity’s decision-making processes as an aid to the improvement of future projects.

Question 37

Explain scope and purpose of PCA

Answer 37

A good PCA report does not set out to identify the costs and benefits of a project in precise detail, but rather seeks to identify general lessons to be learned from a project. It is not a policing exercise, and, if it is to be effective, should not be seen as such. A PCA will nevertheless encourage honesty in facing problems at all levels of the organisation, as attempts to ignore or hide realities are unlikely to remain uncovered.

The key thing is that management will try to identify the causes of any variances from budget, and the lessons which can be learned to help with future project implementation.

Causes of variances could include poor management decisions, lack of controls over expenditure, poor application of the process, or problems with the process itself. For example, if it can be identified that there were insufficient controls over the costs at a particular stage of the project implementation, this will show management where resources should be targeted during the next project implementation.

Its main purpose is to enable the experiences - good or bad - gained during the life of one project to be made available for the benefit of future projects. The role of a PCA is thus essentially a forward-looking one; it seeks to establish lessons from the past for the future benefit of the organisation.

Question 38

What are the benefits of PCA?

Answer 38

Six potential benefits from the operation of a PCA system have been identified and these are listed below in the order in which they appear in Management Accounting Guide 9: Post Completion Auditing:

1. It improves the quality of decision-making by providing a mechanism whereby past experience can be made readily available to decision-makers
2. It encourages greater realism in project appraisal by providing a mechanism whereby past inaccuracies in forecasts are made public.
3. It provides a means of improving control mechanisms by formally highlighting areas where weaknesses have caused problems.
4. It enables speedy modification of underperforming/over-performing projects by identifying the reasons for the under or over performance.
5. It increases the frequency of project termination for ‘bad projects’.
6. It highlights reasons for successful projects which may be important in achieving greater benefits from future projects.

Question 39

What are the reclassified benefits of PCA according to Mills and Kennedy?

Answer 39

Type a - those which relate to the performance of the current project, i.e. the project under review
Type b - those which relate to the investment system itself
Type c - those which relate to the choice and performance of future projects

Using this subdivision, the benefits listed in the Guide are grouped under the three categories:

Type Guide benefit
A 4.5
B 3
C 1, 2, 6

The authors reported that all the surveyed entities that had an operational PCA system at the time of their research gained type B benefits from their system, and almost 40% sought type C benefits. Only 20% of the entities sought type A benefits, which may b e considered surprising.

Question 40

What are limitations of PCA?

Answer 40

• the process can be costly and time consuming
• it requires good data collection system to be in place
• it is not a panacea for all the business’s problems
• it can be used to blame rather than learn from past mistakes

Question 41

The primary reasons why companies undertake a PCA of a capital project are: (Select all that apply):

A To identify any variances and to discover the cause of them
B To improve future projects by avoiding past mistakes
C To identify the exact costs and benefits of a project
D To identify who to blame for past mistakes

Answer 41

A B

Question 42

A typical capital expenditure progress report would include data on:

A The date the project started
B Details of any penalties
C Estimated costs to completion
D Who was to blame for any overspends

Answer 42

A B C

Question 43

The directors of AB have commissioned some market research to assess the key design features of a potential new product which they think customers require.

This activity would take place in which stage?:

A The conceptual stage
B The development stage
C The control stage
D The operating stage

Answer 43

A