Management Accounting Strategy Litungeni .H.

Nakambull Student no: 45059012 Unique no: 827984

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 Section A Question 1 2 Question 2 3 Question 3 3 Question 4 2 Question 5 1 Question 6 2 Question 7 4 Question 8 3 Question 9 3 Question 10 1 Question 11 2 Question 12 1 Question 13 3 Question 14 4 Question 15 4 Question 16 4 Question 17 3 Question 18 3 Question 19 1

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Section B Question 2
Controls that could be introduced in order to more effectively manage risks throughout the product lifecycle include the following: Formulation of a clear set of criteria against which any development proposals will be judged. For example, product one is sold internally and therefore has implications for the volume levels for company sales outlets. It may be desirable to include this fact in any appraisal decision, in addition to the pure financial information. The judgment criteria may be kept confidential to the decision making team or Board of Directors, but should be used to prioritize the choices; Verification of the information provided by engineering and marketing staff. It is possible that the statistics on either costs or sales may be subject to a bias and so requests for evidence to support the figures or the preparation of drafts by two members of staff instead of just one may assist in confirming their validity; The introduction of sensitivity analysis and scenario tests. Single scenario estimates are unlikely to be realized in practice and so if alternative market conditions or engineering conditions are simulated, this could lead to a range of project values on which to base a development decision, rather than depending upon a single figure; (b) Memo To: Head of Product Development Division From: Assistant Accountant Subject: Investment selection Date: May 2007 Taking a purely financial perspective, the data provided indicates that the optimal choice of project depends entirely upon whether or not the company chooses to apply a risk adjustment to the hurdle rate for different products. Without any risk adjustment and assuming that NPV ranking is the selection basis to be applied, Product 2 is significantly more attractive, but the initial investment that is required is much higher. Selecting an investment on NPV alone may, however, be rather a simplistic approach. Given that the NPV for Product 2 switches from positive to negative when the discount rate increases from 75% to 10%, it may be useful to also look at the internal rate of return on this investment. The IRR could act as an additional benchmark against which to assess the relative risk in investing in Product 2. If it is the case that these two new products are not the only investment opportunities available within the company, then some account needs to be taken of the opportunity cost of the investment.

 Unfortunately, however, the information offers no insights into alternative uses or rates of return on surplus capital. This means that the overall rate of return on company assets cannot be ascertained without additional data, and ideally the selection of the product to be developed should be based upon maximizing the return across the whole organization and not a single project. Under such circumstances, an alternative basis for the decision would be a comparison of the two options on the basis of NPV per dollar invested in design and development. Using this criterion, and applying a common discount rate, the decision is reversed as Product 1 yields 4066% (244/600) compared with just 672% (430/6,400) for Product 2. The problem here is that although the percentage gain is much higher, in absolute terms it is much lower. The risk of much heavier investment in Product 2 is counterbalanced by the fact that revenues begin to flow more quickly, but these are initially at a relatively low level. The difference in the relative size of the two projects has wider implications that serve to further complicate the decision. Product 1 is relatively small scale and would thus potentially leave capital underutilised. This problem may be overcome by investigating whether or not there is scope to expand the investment to cover other markets apart from just the USA, but this would require production of revised cash flow forecasts. At the same time, the small scale investment also means that in principle there is scope to fund it at a later date from the proceeds of Product 2. The potential to exploit this opportunity depends, however, upon both the time frame of the regulatory restrictions and the potential for postponement. The company needs to consider which types of investment it wishes to encourage large or small - local or international - and over what time frames. Financial outcomes are just one part of the bigger strategic picture and choices that need to be made. Amongst the broader factors that need to be taken into account is the impact of the two alternatives across other parts of the business. For example, Product 1 is to be sold through company owned outlets in the USA. As noted in part (a), this is important to take into consideration because if these outlets are currently operating below capacity, then the new product may serve to increase the contribution made by those outlets to the group profit. Similarly, the potential additional costs of the foreign exchange risks created by Product 2 may counteract the additional cash flows that it generates. The use of a risk-adjusted hurdle rate provides one possible mechanism that may be used to encourage or discourage particular types of investment, so that strategic objectives are more effectively fulfilled. In this way, it can be used to adjust for the non-financial factors that influence a decision. Rates of return may be increased to adjust for variations in product life cycle length, payback periods, company impact and differing scale of investment such as those highlighted in the information provided. The term riskadjusted rate is thus a little misleading, as it is adjusting for a wide range of factors that influence strategic positioning which fall under the broad umbrella of risk. Mixing high and low risk projects helps the company to adhere to its overall risk appetite, whilst still achieving target rates of return. The risk-adjusted rates that are suggested imply that Product 2 is deemed significantly more risky from a companywide perspective (at 10% hurdle rate) than Product 1 at 85%.

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 Unfortunately, however, there is no information that can be used to assess the basis for calculation of the respective risk premiums for the two projects, and so the validity of the risk adjusted rates may be open to question. It must therefore be assumed that they reflect the overall risk appetite of the company. Using the risk-adjusted rates given in the question, the optimal product choice is reversed and Product 2 should not be selected due to the negative NPV. In other words, the choice of whether to use the company hurdle rate, or the risk-adjusted rate becomes critical to the relative ranking of the two products. For this reason it is extremely important for the Board of Directors to carefully review the rationale that underlies the risk adjustment process. In conclusion, risk-adjusted hurdle rates provide a formal means of incorporating risk into the investment appraisal decision, but the apparent precision of the calculation of the relative risk adjustment must be viewed with caution. It is critical to ensure that the adjusted rates are valid because of the sensitivity of the NPV to the discount rate. Additionally, the final selection of investment also needs to reflect the risk appetite of the Board of Directors. On balance, taking into account the financial results indicated by using both the standard and risk adjusted hurdle rates, and bearing in mind the limitations of this approach to decision making, I would recommend investment in Product 1.

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Question 4
It is important to recognize that there is a very low level of existing gearing, and the scale of the proposed extra borrowing is fairly insignificant; 63% of the existing borrowing is floating rate and will be redeemed in two years; and the companys sensitivity to interest rate risk (its financial gearing) will be affected by its level of business risk and operational gearing. In considering the factors that may be taken into account in deciding whether to raise fixed rate or variable rate debt, one of the key issues to consider is a companys attitude to risk, and its preferences for hedging any such risks either internally or externally. If an organization is indifferent to financial risk then, regardless of interest rate trends, it will also be indifferent between fixed or variable rate borrowings. Equally, if it is sensitive to downside risk, but happy to accept upside risk then there may be a preference for variable over fixed rate borrowing in a world of falling interest rates. Similarly, if the overall preference is for cash flow certainty, then fixed rates may be preferred. Consequently, the first factor that may influence the decision is the risk preferences of the Board of Directors. A second important consideration is the relative scale of the exposure. In the case of FBR the company is considering raising debt finance of 18 million, against assets of 2 billion and therefore, even taking into account the existing amount of long term debt, the exposure remains relatively insignificant. In other words, it probably does not matter whether the debt is of a fixed or variable rate nature, because of its small scale. Under such circumstances, the cost of hedging the exposure may outweigh the potential cost of remaining exposed to interest rate movements. The question of whether to select one type of debt over another is dependent, in part, upon the treasurers view of future interest rate movements. If he/she believes that interest rates are likely to rise, then locking into a fixed rate may be desirable; equally, if rates are expected to fall then a variable rate loan would be preferable. Furthermore, consideration must be given as to whether any anticipated changes in interest rates may also affect the level of activity in the underlying business. Where this might be the case, such as in an industry like construction, the higher interest rates leading to falling sales will mean that being locked in to fixed interest payments may not be desirable. It is unlikely, however, that the retail book market is interest rate sensitive. The existing debt mix (fixed: variable) is also likely to influence the choice of how to fund new ventures. At current exchange rates, FBR has slightly more fixed rate borrowing than variable rate (15 million versus 123 million respectively). Overdependence on either form of debt can increase exposure and hence incur additional hedging costs. In this instance, however, the additional borrowing is sufficiently small for this not to matter very much. The absolute cost of the alternative forms of hedging is also important. If the exposure can be hedged internally via, for instance, the granting of matching credit facilities against revenue streams, then the hedging cost would be close to zero. FBR does not appear to have the opportunity to take advantage of such internal hedging and so if the hedging is arranged externally via, for example, the purchase of a forward-rate agreement or a broker arranged swap, then costs will be incurred and the scale of such costs may influence the borrowing decision. The limited availability of hedging options may thus affect the specific borrowing choice.

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 (i) Transactions if swap is agreed:

Variable interest rate FBR Fixed interest rate MBTO

6% fixed

Euro Libor + 2.5%

Original Lenders FBR swaps a fixed rate loan for a variable rate one based on Euro Libor. (ii) Workings FBR Borrows at Euro Libor + 25% Pays to MBTO Net interest cost MBTO Borrows at Receives Pays to FBR Net interest cost

Original Lenders

6% (64%) 68% Euro Libor + 14%

Euro Libor + 25% (68%) 64% 71% fixed

The quality spread differential is 02% which is shared equally between the two parties. Variations in the workings are possible. The rates paid between the two parties will be open to negotiation. Therefore, the only certainties are the rates at which the two companies borrow from the market and the resulting net interest cost to each of them. The result is a net saving to both parties is 01% interest of the terms that they could otherwise have obtained, that is FBR pays 64% instead of 65% variable and MBTO pays 71% fixed instead of 72%. On a loan of 18 million this generates a saving of 1,800 per year for FBR. This saving has to be offset against the additional risk arising from the swap because of the counterparty risk. FBR faces the risk that MBTO will not make the cash payments on time, and any default losses would have to be covered. The credit risk can be minimized by seeking a credit rating on the counterparty before agreeing to a swap.

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 (iii) Interest rate swaps are a useful tool for the management of interest rate risk because they allow a company to switch between fixed and variable rate loans, and therefore take a position on the future direction of interest rates. For example, a company may believe that interest rates have bottomed out and hence choose to swap its variable rate loans for fixed rate ones set at the current low interest rate level. In making this swap, the company is affirming its belief that future rates will rise, that is, taking a position. In many but not all cases, swaps are used to obtain funding at a lower rate than that available elsewhere, but they can also be used beneficially to manage future cash flow patterns. If, for example, a company is operating in a market where its incoming cash flows are uncertain, it may wish to use a swap to ensure that it has fixed rate commitments that are wholly predictable. In so doing, it minimizes uncertainty of outgoings even if it cannot eliminate the uncertainty re incoming cash. Interest rate swaps may also be used to manage interest rate risk in respect of investments rather than borrowings. In such cases a swap may be useful in enhancing the returns via speculation on interest rate movements, for example swapping a variable rate for a fixed rate investment in the belief that interest rates will fall. Over and above cost, an advantage of interest rate swaps over simply borrowing appropriately in the first place, is that they allow the organization to change its borrowing profile without having to renegotiate with lenders if circumstances change after the original borrowing.

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