Msa 2 Icap

Management Professional
Competence
Workbook
Second edition 2022
ISBN 9781 5097 2359 1 A note about copyright
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i
Contents
Contents
Page
Question Index iv
Preparation questions 3
Exam style questions 38
Past exam questions 96
Answers to preparation questions 167
Answers to exam style questions 216
Answers to past exam questions 301
ii
iii
Index
Question Index
Marks Question Answer

Section 1: Preparation Questions
1 VisionPak 25 3 167
2 BMG 25 7 171
3 Elite Clothing 25 10 177
4 First Bank 25 14 181
5 Fresh ‘n’ Frozen 25 17 185
6 Ali & Co. 25 20 191
7 PJ 25 25 198
8 PRT 25 28 201
9 PCT 25 31 206
10 Solar Research Pakistan 25 34 211
Section 2: Exam Style Questions
11 PDT 50 38 216
12 KMC 50 46 228
13 Graffoff 25 52 239
14 PCL 25 56 245
15 Khan and Co. 25 59 250
16 Lahore World Travel Ltd 50 63 255
17 The Fresh Fish Company 30 68 263
18 Techcon Ltd 20 71 268
19 Ashir and Arham 25 76 272
20 Rabia Limited 50 79 277

21 Kalam Hotels 50 88 286
Section 3: Past Exam Questions

22 TNS Textiles (June 17) 50 96 301
23 YSJ Chartered Accountants (June 17) 25 102 311
iv
Marks Question Answer
24 Chromium Mining Ltd (June 17) 25 105 318
25 SGC Construction (December 17) 50 108 323
26 TTA Airlines (December 17) 25 115 333
27 Paragon Fitness Ltd (December 17) 25 118 339
28 XYZ Industries (June 18) 50 124 346
29 KIT Solutions (June 18) 25 129 358
30 Farid Textile (Dec 20) 50 132 364
31 Faisalabad Surgical (Dec 20) 25 137 372
32 Karachi Pharmaceuticals Limited (KPL) (Dec 20) 25 141 377
33 RhanaPharm (June 21) 50 145 381
34 Razaport (June 21) 25 152 387
35 A2Z (June 21) 25 156 393
36 Jazeera Machinery Ltd (June 18) 25 160 398
v
Question Bank
1
2
Question Bank
Preparation questions
1 VisionPak
VisionPak was founded almost 30 years ago by Husain Mahmood, who to this day
remains the company’s Non-Executive Chairman. Starting out with a single optician’s
shop in Lahore, Husain steadily built the company up, and, via a number of acquisitions
throughout the next three decades, acquired a dominant position as the largest company
in the opticians sector. The company remains privately owned, with Husain owning 85%
of the share capital, with the remainder being spread across a few members of his family
and some senior employees, who have been offered shares via a share ownership scheme.
As well as being the market leader in Pakistan, VisionPak acquired a reputation for
quality, traditional optical products, such as glasses, contact lenses and sight testing.
Although its head office is based in Lahore, it operates over 500 optician shops across
all of the major towns and cities throughout the country, with notable concentrations in
Lahore, Islamabad and Karachi. In Lahore alone it operates over 80 shops, some of
which are rented, however a few are owned outright as a result of acquiring rival
companies which owned freehold buildings.
Until the last five years, the company had enjoyed growth in both sales and profits in
each and every year of its existence. Much of this growth was underpinned by acquisitive
and organic expansion, however, Husain never lost sight of the strict cost controls and
well-regulated business processes that enabled him to make such a success of his original
shop. When setting up his first shop, Husain believed that the ability to offer customers
a personalised service would enable him to deliver high levels of customer service, and
even allowing for the additional costs of this would allow him to run the business at a
relatively high level of profitability. His early success meant that this approach became
part of the company’s culture, and Husain was careful to embed these values in any
companies that he acquired down the years.
A desire to spend more time pursing his personal interests, namely playing and watching
cricket, meant that executive control was handed down to Husain’s only child, Malik in
20Y6. Malik had worked for the company since completing his MBA in England in
20X8, initially being given responsibility for overseeing the performance of shops in
Lahore, before being promoted to the head of the whole Punjab region. In 20Y6 Malik
was appointed as the company’s CEO, following Husain’s decision to retire from this
role.
Unfortunately, Malik’s time in charge of VisionPak did not go well. It quickly became
apparent that any previous success he had enjoyed was more of a reflection of the
company’s wider strategy, and a buoyant economy, rather than any decisions that Malik
himself had been taking. Within a short time of Malik taking on the role of CEO, the
company’s fortunes began to decline, which came as a huge shock given its historic
financial success. Husain was determined to give his son the time and resources required
to come to terms with the role of CEO, even returning to work three days a week. After
a further year of declining sales and profitability, Husain reluctantly came to the
conclusion that Malik lacked the drive and skills necessary to return the company to
growth, so was forced to terminate Malik’s contract of employment and retake the role
of CEO in an interim capacity.
3
Husain was surprised by how much the market had changed in his absence. New
technologies had emerged, and with these some of the existing barriers to entry to the
market had been lowered. Of particular concern were new entrants who had been using
advances in production and diagnostic technologies, as well as the internet as a sales
channel, a concept with which Husain was wholly unfamiliar. By 20Y7 Husain took the
decision to recruit a new CEO, and head-hunted Adiba Bhutto directly from a growing
rival, Specs4less.
Adiba was forced to spend six months on garden leave (paid leave during which Adiba
was forbidden from working for VisionPak) when leaving Specs4less, but nonetheless
when she joined VisionPak she was able to summarise how her former company had
been able to capture some of VisionPak’s market share. Key to Specs4less’s growth
strategy were partnerships with a high-street shopping group, and a national chain of
department stores. These partners operated shops in which Specs4less installed mini-
labs. These labs use the latest technology for carrying out eye examinations, and deployed
machinery which allowed them to prepare and dispense common prescriptions for
glasses and contact lenses within an hour. Whilst Adiba’s knowledge was now slightly
out-of-date, she was certain that Specs4less would be looking to forge partnerships with
well-known fashion designers to create up-market ranges of designer frames and
sunglasses.
When she started her new role, Adiba established the need for improved financial
performance as a priority at VisionPak, because despite cash and cash equivalents
standing at Rs 26,545 million, the company’s results had continue to deteriorate since
her appointment was first announced six months ago. Two of the first things Adiba did
were to commission reports on the internal processes, and recent financial performance
of VisionPak. Extracts from these reports can be found in Exhibits 1 and 2.
The company did receive some good news this week then the country's T20 cricket
captain recently received a prestigious international award wearing a pair of VisionPak’s
spectacles, providing a welcome, if accidental case of good publicity for the company.
However, set against this, some financial analysts have speculated that the Pakistan
economy may see a significant fall in its growth rate in the next couple of years, though
spending amongst people aged 18–30 is expected to continue to grow.
Requirement
(a) Produce a corporate appraisal of VisionPak, taking account of internal and
external factors, and discuss the key strategic challenges facing the company.
(16 marks)
(b) Corporate appraisal offers a 'snapshot' of the present. In order to focus on the
future, there is a need to develop realistic policies and programs.
Recommend, with reasons, strategies from your appraisal that would enable
VisionPak to build on its past success.
(9 marks)
Total = 25 marks
4
Question Bank
Exhibit 1 – Extracts from report on internal processes

(i) The marketing approach is ‘to let the product and level of personalised customer
service speak for itself.’
(ii) Production costs remain relatively high.
(iii) Sales targets are set centrally and shops report monthly. Site profitability varies
enormously, and fixed costs are high in shopping centres.
(iv) Individual shops exercise no control over job roles, working conditions, and pay
rates.
(v) Individual staff pay is increased annually according to a pre-determined pay
scale.
(vi) All staff also receive a small one-off payment based on group financial
performance.
Exhibit 2 – Extracts from VisionPak’s most recent financial statements

20Y7 20Y6 20Y5
Rs'm Rs'm Rs'm
Revenue 65,464 62,946 56,202
Cost of sales (40,588) (38,912) (33,341)
Gross profit 24,876 24,034 22,861
Operating expenses (14,926) (13,529) (12,265)
Profit from operations 9,950 10,505 10,596
Finance costs (245) (232) (278)
Profit before tax 9,705 10,273 10,318
Tax (3,009) (3,185) (3,199)
Profit for the year 6,696 7,088 7,119
Tutorial guidance before you begin

The area of revision here is the SWOT approach to corporate appraisal, and it’s
important to remember that this will require an assessment of internal as well as
external factors. You will therefore need to scan the scenario carefully to find relevant
points to discuss. Once you have identified relevant areas you will need to briefly
discuss each in turn. In exam questions, perhaps unlike the real word, it pays to try
and balance out your answer e.g. identify a roughly equal number of strengths and
weaknesses etc.
Aside from this there is a sub-requirement that requires you to discuss the key strategic
challenges. To do this you will need to review your SWOT analysis and focus on the
most important area of improvement that the company needs to focus upon. Here you
will need to justify your choice of strategic area.
5
The second requirement is a natural progression. A SWOT should be undertaken for
a purpose e.g. it should lead to further decisions and actions. In this question you
need to recommend follow-on strategies and in essence this should be a fairly logical
task. With a SWOT we often think of how to neutralise strengths, and exploit
opportunities etc. You will however need to read the requirements carefully, you not
only need to identify strategies, you will then need to justify the strategies that you
identify.
6
Question Bank
2 BMG
You work for the advisory department of the firm Osman Nawab & Company, Chartered
Accountants (ON). The Balochistan Mining Group (BMG) is a key client of your
department. Your manager has asked you to accompany her to a meeting with Faisal,
the Finance Director of BMG.
BMG is a long-established mining company. It started out as a coal-mining company,
but it has subsequently diversified into a number of different commodities, notably
copper, gold and even salt mining in the Khwera region. However, despite these attempts
to diversify the company’s income streams it is still heavily reliant on coal mining (see
Exhibit 1), and, given the global trend towards renewable and clean energy sources, the
company has seen its sales and profits fall as the price of coal falls.
At the meeting, Faisal explained that if current projections for commodity prices are
correct, then the company will be at risk of breaching its banking covenants. Historically,
the bank has been very supportive of the company, however, unless BMG can come up
with up a compelling business case, Faisal fears that the bank will recall its loans, placing
the company at risk of bankruptcy.
Faisal went on to explain that BMG was pinning its hopes on investments in renewable
technologies, specifically wind farms along the coastal region of Balochistan. Faisal is
of the belief that not only can this sector be penetrated successfully, but also that the
company will face little competition in the short-term, and if it is able to establish itself
as the market leader, this should help it obtain a longer-term competitive advantage.
There are, however, numerous obstacles to this plan. Firstly, the possible sites identified
as having the necessary levels of wind are located close to areas of outstanding national
beauty, with the preferred site being home to several species of endangered birds (see
Exhibit 2). Faisal believes that although this land is owned by the Balochistan State it
could be leased on commercial terms.
Secondly, BMG lacks the know-how to build wind-farms. However, Faisal is adamant
that this can be overcome by importing the machinery and engineering expertise from a
company in Denmark where his cousin works as a structural engineer.
Thirdly, there is a lack of infrastructure near the preferred sites, for instance there are no
cables to transport any electricity generated to the national gird.
On top of these issues there have already been some suggestions that local residents are
heavily against this form of development (see Exhibit 3).
Set against these problems Faisal did point out some opportunities that he felt were
significant. For instance the national government is keen to address the frequent power
outages that affect some of the rural areas of Pakistan, and the Balochistan Provincial
Assembly is committed to adding more villages to the national grid.
The success of this proposal ultimately hinges on BMG’s ability to gain planning
permission from the Provincial Assembly, and potentially some form of financial
funding or guarantees to underwrite the initial capital expenditure required.
7
Requirement
(a) Discuss the ethical issues that should have been considered by the Provincial
Assembly when granting permission for wind farming to go ahead. Explain the
conflicts between the main stakeholder groups.
(12 marks)
(b) Using an appropriate framework, analyse how the interest and power of pressure
and stakeholder groups can be understood. Based on this analysis, identify how
BMG might respond to these groups.
(13 marks)
(c) Explain the incentive available in the form of extra depreciation to alternate
energy project and the benefit of available of said benefit from tax perspective.
Also identify any provisions as to carry forward and use of such accelerated
depreciation in subsequent years.
(5 marks)
Total = 30 marks
Exhibit 1 – Summary Financial Information for BMG, including breakdown of
revenue streams.
20Y7 20Y7
Rs'm Rs'm
Revenue 25,464 Coal 16,679
Cost of sales (18,085) Copper 3,756
Gross profit 7,379 Salt 2,234
Operating expenses (6,453) Gold 1,453
Profit from operations 926 Others 1,342
Finance costs (865) 25,464
Profit before tax 61
Tax (20)
Profit for the year 41
Exhibit 2 – Report from Laila Shah – BMG’s senior environment officer

The preferred siting of wind turbines could have an adverse impact on the habitat and
migration patterns of a number of animals. From the analysis I have performed, these
can be largely categorised as common (Sea Gulls etc) and endangered species
(Greater Spotted Eagles and Laggar Falcons). The degree to which our planned
activities would cause disruption cannot be modelled with certainty. However,
evidence from European wind farms indicates, for instance, that the number of bird
deaths from striking turbines is actually much lower than reported by environmental
pressure groups such as the Balochistan Bird Protection League.
8
Question Bank
Exhibit 3 – Extract from a story in the Gwadar Times newspaper

There were minor skirmishes today outside of the local offices of the mining
company BMG. Demonstrators waving placards spent several hours protesting
against the company’s proposed move into wind turbine technology. The
demonstrators appeared to be a mix of anti-capitalist and environmental activists,
and local residents, who seemed concerned at the possible blight to the landscape
that a wind farm may bring, along with the additional traffic and pollution caused
during the construction phase.
Local elections are due next month, and with the declining local economy at the top
of most voters list of concerns, it will be fascinating to see whose side the Provincial
Assembly will come down on if BMG go ahead with a planning application and a
request for financial subsidies to help cover the cost of developing the new
technology.

When approaching this requirement you need to be aware that there are two parts to
the question: (i) discussing the ethical issues the Provincial Assembly needs to
consider; (ii) explaining the conflicts between the main stakeholder groups.
Although the ethical interests are more to do with conflicts of interest than simply
notions of 'right' and 'wrong' you must make sure you don't duplicate points between
the two parts of the requirement.
Note. Also that you must examine the ethical considerations from the Provincial
Assembly's perspective – not from the perspective of BMG, the business concerned.
Note. That for the second part of the requirement you are required to explain the
conflicts between the main stakeholder groups – not just identify them. Although a
framework is asked for very few marks are available for this element. To obtain a
pass mark, you would have to explore the implications of the various points of view
in some detail. Make sure you give a balanced account of the interests of the various
stakeholders.
9
3 Elite Clothing
You work in the Lahore office of KJ Chartered Accountants, and having worked on the
audit of one of your firm’s largest clients, Elite Clothing (EC) for the last three years,
you have now been seconded onto a team to work on an advisory project for this client.
EC is a medium-sized manufacturer of clothing, owned by Mahood Rawal. EC operates
out of a single factory in Lahore, employing over 750 people. EC’s main clients are
Western European retailers, who gave up manufacturing their own clothes in the 1980s
and 1990s when they realised that high-quality garments could be made in Asia at a
much lower cost, even accounting for the additional transportation costs. Prior to taking
on work for the European retailers, EC was a much smaller company that designed,
manufactured and supplied fabrics and clothing to the domestic market only. However,
once orders started to flow in from European clients the supply of fabrics and clothing
to Pakistan-based customers was reduced, and was finally discontinued in 20X3 (fifteen
years ago), as this was the only way that EC could adapt to the ‘fast fashion’ principles
(see Exhibit 1) of its largest customer – Picanto.
Before it became an outsource supplier to European retailers, EC had built up a strong
reputation in the Punjab region as a quality supplier of fabrics alongside clothes
manufactured with appealing designs, concentrated on the straight cut shalwar kameez.
The designs of its dresses were mainly of a traditional nature, but the fabrics and dress -
making skills deployed were of the highest quality. It was with some personal regret that
Mahood decided that the company’s resources could be much more efficiently deploying
serving the European market rather than the domestic market, so the fabric
manufacturing and clothes design businesses were closed down so that the company
could focus on making clothes for the designed supplied by its European customers.
For a number of the years the company enjoyed continued and sustained growth, as it
was able to demonstrate its ability to convert design concepts into quality finished
garments within short deadlines, and this allowed the EC to utilise the full capacity of
its current manufacturing base. Whilst he was tempted to expand the company, Mahood
exercised caution, and was rewarded, when, during the global economic downturn two
of EC’s main customers went into liquidation. EC was able to downsize its work force
whilst it found new European clients. However, the reduced demand, coupled with
increased competition from manufacturers in Pakistan, India and Bangladesh meant that
the peak turnover and outputs enjoyed in 20X8 (immediately prior to the downturn) have
yet to be reached since.
Several years after the global economic crash, Mahood concluded that the company was
unlikely to recapture all of the outsourced European business it had lost whilst also
maintaining its normal profit margins. Rather than resort to ‘buying’ market share (by
discounting prices) Mahood decided that EC could generate more revenue and could
improve profit margins by diversifying through forward integration and reverting to the
design of clothes in-house rather merely manufacturing garments to the European
retailers’ own designs. Aware that EC would struggle to design clothes suitable for the
European market, Mahood decided that EC’s spare manufacturing capacity could be put
to use designing and manufacturing traditionally themed Pakistani clothing, for sale in
the domestic market, principally in the Punjab region. Given that EC had not been
involved in design for some years, the design expertise was acquired by buying a small
but well-regarded dress design company in Lahore, specialising in traditional products,
targeted mainly at the middle-aged and middle-income markets in Pakistan.
10
Question Bank
This acquisition, made in January 20Y6, was initially very successful, with sales
turnover for this venture increasing significantly during the first two years post-
acquisition (See Exhibit 2). This increased turnover and profit could be attributed to two
main factors: firstly, the added value generated by designing and manufacturing end-
products for the domestic market, and secondly, the increased throughput of the factory,
increasing the overall efficiency of the company’s manufacturing process.
In the last financial year (to December 20Y8), however, EC had experienced a significant
slow-down in its level of growth and profitability. EC's penetration of its chosen retail
segment – the independent stores specialising in sales to the middle-class market – may
well have reached saturation point. The business had considered further expansion by
negotiating a deal to supply clothes for the leading Pakistani supermarket. However the
buying power of this store would have forced EC to accept significantly lower prices,
and therefore unacceptable profit margins. The dress design company, which is a 100%
beneficially owned subsidiary of EC has suffered tax loss for the year and future
projections suggest that the tax loss is unlikely to be absorbed by future tax profits (if
any) of the subsidiary company.
Mahood has been discussing the company’s options to return to growth, and the
prevailing mood amongst his senior management team is to integrate the company even
further forward by moving into retailing itself. EC is now considering the purchase of a
small fashion retail chain, which has a presence across the Punjab region, with multiple
stores in Lahore, Islamabad, Faisalabad and Multan.
At the purchase price of Rs 920 million, EC would have to borrow substantially to
finance this acquisition.
Requirement
You have been asked by your team leader to compile your thought on the following
topics for inclusion in a report to the senior management team of EC.
(a) Evaluate how EC’s strategy of integrating forward into dress design has affected
its ability to compete.
(12 marks)
(b) Identify the strategic opportunities and risks that EC’s potential expansion into
retailing presents to the company.
Evaluate the consequences of such a move for the business, and, assess the change
in competences which would be required by the newly expanded business, if EC
purchases the fashion retail chain.
(13 marks)
(c) EC understands that injection of some cash into the dress design company is
necessary to avoid future losses but it also wants to use current year losses for tax
relief to the group. Identify relevant provisions of Income Tax Ordinance, 2001
in this regard.
(5 marks)
Total = 30 marks
11
Exhibit 1 – Fast-Fashion
The traditional model of fashion retailing is based around the concept of four
seasons, with a new range of clothing brought out for each season e.g. summer,
autumn, winter and spring collections. Fast-fashion garments tend to be of
comparatively low quality, as the only way consumers can be convinced to replenish
their wardrobes so frequently is by making the clothes feel ‘expendable’
The global fashion giant Zara adapted the manufacturing model of ‘quick response’
fashion, in the late 1990s, recognising that if it were able to change its collections
every four to six weeks then it could offer its customers more choice and, sell more
items, as there was always something different in its shops for customers to look at
each time they visited. The ability to do this depends on being able to design, procure
and sell these fast evolving fashions in very tight windows, requiring slick logistics
and close working relations with manufacturers. To encourage repeat purchases there
is a necessary emphasis on optimising all aspects of the supply chain, so that the new
fashions can be designed and manufactured quickly and inexpensively to allow
the mainstream consumer to buy current clothing styles at a lower price. As a result
of Zara’s success, many of its competitors have adopted the fast-fashion model.
Exhibit 2 – Statement of profit or loss for the years ending 31 December 20Y8 –
EC
20Y8 20Y7 20Y6
Rs'm Rs'm Rs'm
Revenue (Note 1) 6,543 6,804 7,213
Cost of sales (5,954) (6,023) (6,455)
Gross profit 589 781 758
Operating expenses (294) (292) (302)
Profit from operations 295 489 456
Finance costs (45) (48) (38)
Profit before tax 250 441 418
Tax (78) (136) (129)
Profit for the year 172 305 289
Note 1
Sales to European customers 5,954 6,187 6,936
Domestic sales 599 617 277
6,553 6,804 7,213
12
Question Bank

This question begins by looking at the topic of forward integration e.g. moving into
the next stage of the value system, in this case a manufacturer moving into retailing.
Here you are asked to evaluate this strategy, so it is important to assess the
advantage/pros of this approach, and weigh these against the disadvantages/cons. In
exam questions it is common that these part of your answers should be weighted
equally. This is because in the ‘real world’ such decisions are rarely clear-cut,
therefore your analysis should be balanced.
The second part of this question contains many layers, and, as with the first part it is
important that you weight your answers accordingly. You need to identify
opportunities and risks. For each you will need to briefly describe why something is
either a good or a bad thing. Secondly you must evaluate the consequences of this
strategy on the competencies of EC. To tackle this you must identify the new
competencies required to become a successful retailer, then, discuss whether EC has
these, or, is well-placed to acquire these.
13
4 First Bank
First Bank of Punjab is one of the largest retail and investment banks in Pakistan. The
company is listed on the Pakistan Stock Exchange. The Chairman and Chief Executive
Officer (CEO) is Ms Maria Umar, a direct descendant of the bank’s founder – Ali Umar.
The Umar family trust retains an 18% shareholding in the company, making it the largest
single investor in the company. No other investor holds more than 2% of the company’s
share capital.
The company has a large number of foreign institutional shareholders, who are not happy
with the present corporate governance arrangements. In particular they consider that the
roles of Chairman and CEO should be separated, and that Ms Umar wields too much
influence over the rest of the Board, three of whom are also members of the founding
family.
The institutional shareholders have also raised concerns over what they perceive to be
poor risk management within the bank. Several months ago, the bank suffered extremely
large losses on an unauthorised derivative trade. An internal review has yet to be
completed, but its interim findings have been leaked to the press (see Exhibit 1). Even
though the review is only at the interim stage, two members of the risk committee have
been sacked based upon its initial findings. The third member, Ali Akbar, remains on
the board and is now the only remaining member of the risk committee. Ali is considered
to be independent by the First Bank of Punjab’s board.
At the recent annual general meeting, Ali Akbar stood for reappointment as a director,
and, whilst he was reappointed, this appointment was opposed by 42% of the votes cast.
The appointment was swayed by the support of the Umar family trust. In spite of the
investor revolt, Ali has reaffirmed his commitment to the board, and he retains the
confidence of Ms Umar.
In response to shareholder concerns, the Board has appointed two new Non-executive
Directors (NEDs), one of whom, Peter Lim, is classified as an independent member of
the board. The other is Shoaib Zaman, the former Chief Risk Officer (CRO) of the bank,
who has appointed to the Risk Committee. The two new additions bring the size of the
Board to 18 and the number of independent NEDs to 10, or 11 if Shoaib Zaman is
considered to be independent.
As of today there are currently two members on the risk committee, Shoaib Zaman, and
Ali Akbar.
The changes to the Board do not appear to have improved risk management at First Bank
of Punjab. Bad news, and negative publicity continue to plague the organisation, with
the Board being accused of an attempted accounting fraud – see Exhibit 2 for details.
This news story has prompted the resignation of the chair of the audit committee, and
the Chief Finance Officer (CFO). Ms Umar acted immediately by appointing two new
directors to replace them on an interim basis. The new company CFO was, however, not
appointed to join the board. The chair of the audit committee was replaced by promoting
a long-serving senior manager to the board, whilst an external appointment was made to
add an ordinary director to replace the sacked CFO. Ms Umar stated ‘I have the utmost
confidence in these outstanding individuals as I have worked closely with them in the
past, and can personally vouch for their abilities to serve the Bank and its shareholders
well’.
14
Question Bank
Prior to these board room changes, on the recommendation of the company's senior
management team, the Board approved a major investment in a country in the Middle
East. Seven of the independent NEDs were critical of the decision, but accepted the
majority view of the rest of the Board. The chief concern amongst the dissenting NEDs
was that the political instability in the Middle East country posed too much of a risk to
the investment. The management team was of the view that the potential for high returns
justified the risk exposure.
In light of recent events, the Nominating Committee (NC) has been asked to make
recommendations to the Board about the procedure for carrying out performance reviews
of the Board, its committees and its individual directors, something that Ms Umar has
resisted to date.
Requirement
(a) Comment on the size, composition and committees of the Board in this scenario.
(6 marks)
(b) Recommend two actions the Board should take to improve the bank’s corporate
governance procedures. Justify your recommendations. (4 marks)
(c) Assess the influence independent NEDs have on decision-making by the Board if
they make up just over half of the total number of Board members. Ensure your
determination refers specifically to the incident of fraud and the decision by the
Board to invest in the Middle East. (6 marks)
(d) The NC has been asked to make recommendations to the Board about the
procedure for carrying out performance reviews of the Board, its committees and
its individual directors. Recommend five actions the NC should take to carry out
the request from the Board. Justify your recommendations. (5 marks)
(e) Identify ways in which the performance of the board of directors of the bank
could be improved. (4 marks)
Total = 25 marks
Exhibit 1 – Critical news report – Punjab Daily Bugle

Investors have been warned off investing in the troubled First Bank of Punjab by the
leading banking analyst, Mira Sharaf. In a note published on her popular website,
Investments Today, Ms Sharaf shared details of what appear to be a leaked internal
report detailing how and why the bank’s recent derivative scandal unfolded.
Worryingly, Ms Sharaf asserts that many of the systematic failures that allowed this
scandal to unfold remain unresolved, exposing investors to unacceptable levels of
risk. The highlights of the report are:
 The bank’s trading department lacks robust internal controls, such as
segregation of duty for executing and clearing trades
 There is a weak control environment, with managers routinely ‘turning a blind
eye’ towards unauthorised trading activities
 Ms Umar instructed the sacking of two members of the three-man risk
committee in order to deflect attention away from her own failings
 Concerns about Ms Umar’s domineering attitude, and a reluctance amongst
other board members to stand up to her
15
Exhibit 2 – Accusation of attempted financial accounting fraud against First Bank
of Punjab
The recently sacked Chair of the Audit Committee and the CFO of First Bank of
Punjab are suspected of attempting to perpetrate an accounting fraud involving the
acquisition of shares in a foreign subsidiary. The share acquisition was planned so as
to allow the bank to fraudulently hide the losses it had sustained on the rogue
derivative contracts. The transaction would have effectively netted these losses off
the company’s published financial statements, allowing the losses to be spread over
several accounting periods. The sacked Chair of the Audit Committee said that the
transaction had been intended to protect the company's shareholders from loss of
value, and had been made with the best of intentions. The independent NEDs,
including those who were members of both the Audit Committee and the Risk
Committee, were unaware of the fraud until it was exposed by an internal
whistleblower.

This question is focused solely on corporate governance. There is a short scenario
and two exhibits to read. This will lend the context you need to give advice to the
company on how to improve its corporate governance procedures.
Parts (a) and (b) can be answered with some knowledge of the Code of Corporate
Governance 2012 and a read through of the main question scenario.
Part (c) looks specifically at the influence of NEDs on decision making. In this
question you must refer to Exhibit 2 to keep your answer question-specific.
Parts (d) and (e) look at performance management at the executive level. Firstly you
need to explain how to assess the performance of a company board, then, you need
to recommend specifically how the performance of this company’s board can be
improved.
16
Question Bank
5 Fresh ‘n’ Frozen

You work in the Lahore office of PJK Chartered Accountants, and having worked on the
audit of one of your firm’s clients, Fresh 'n' Frozen Co. (FF) for the last two years, you
have been seconded onto a team to work on an advisory project for this client.
Company background
FF was set up seven years ago by Qirat Sharif. The company specialises in the delivery
of frozen foods including ready meals, fruit, meat and fish products. Deliveries are made
to the homes of customers living within 25 kilometre of the central distribution hub in
the centre of Lahore. FF operates a fleet of 45 specially modified vans. Each van has
been fitted with a freezer unit allowing frozen goods to be transported at the required
temperature. Ensuring that the food does not spoil while in transit after leaving the
company's depot is of critical importance. Although Lahore has a well-developed
transport infrastructure, its rapidly increasing population is resulting in worsening traffic
congestion. This presents a growing challenge for the company's drivers as they are able
to fulfil fewer customer orders per day, due to time lost in traffic jams.
Online ordering
FF buys in frozen food products from a number of suppliers, and the products are then
packaged and marketed under the FF brand. Customers place their orders through the
company's website. When they make their order, customers also need to provide their
name, address, contact details and payment details. Customers are currently unable to
request a precise time of delivery as the company can only offer a 4 hour delivery
window. Once an order has been received, the Head of Delivery will allocate a driver to
make the delivery on the specified day within the agreed delivery window. The customer
is notified confirmation of the delivery date and time window by FF’s customer service
team, who often contact customers via landline telephone or text message.
In the event that a customer is not home to take the call informing them of delivery a
voice mail message and a text message is left, using the phone details provided. In the
event that the customer does not respond to the message, it is assumed that the allocated
delivery slot is to the customers liking and no further action is taken. Qirat has made it
a company objective that all deliveries must be fulfilled within four days of being placed.
Delivery route management
When new drivers start working at FF they are allocated a particular route from which
deliveries are made. Most routes were determined by the previous Head of Delivery who
retired from FF nearly two years ago. The routes were based on historic patterns of
deliveries made at the time, taking into account the anticipated distance covered to make
a delivery. Distance was determined by using a well-known mapping website which
provided the shortest distance between any two locations.
There have recently been some instances where a driver has been sent out with a partial
load of deliveries (defined as less than 10 drops) on their assigned route (See Exhibit 1),
whilst at the same time other drivers have had to return to the depot to reload their truck
to allow them to fulfil the orders placed on their assigned route. This has resulted in an
increased number of allocated delivery slots not being
fulfilled. When this happens, the customer’s order is taken back to the depot at the end
of the driver’s shift, and prioritised for delivery the following day.
17
Drivers are paid an uncompetitive basic hourly rate, but this is supplemented by generous
bonuses that are payable on a monthly basis for meeting the company’s delivery success
target of 95%. As a result of the recent inefficiencies the company’s overall delivery
success rate has fallen below 90% for the first time, and some drivers are rarely receiving
bonus payments.
Management meeting
Due to dip in FF's delivery performance, Qirat held a meeting with her management
team, during which some concerns raised by Wahid Vali, the Head of Delivery, were
shared (See Exhibit 2). Dibba Mir, Head of Customer Services added:
'The points being raised here would support the findings from some recent customer
research that I carried out. A number of customers have started to complain about the
service they receive from us, with one customer stating 'I have used FF for a number of
years. However, the fact that I cannot specify a delivery time to fit around my work
commitments means I can simply no longer use this service. I have recently started using
the home delivery service of a supermarket due to the flexibility they offer'. Another,
customer said 'I am sick of waiting for my delivery to turn up only for it not to turn up
at all. When I contact FF I get told that my delivery driver was held up in traffic and that
my delivery will be dispatched again the following day'.
Dibba finished by highlighting the key findings from a business news article she had
read. 'This article mentioned something called 'Big Data' and 'Big Data Analytics'. The
journalist seemed to suggest that the widening use of data has now become as important
as the internet has become in modern business. I wonder if this could help us here at FF?'
Intrigued by the Dibba’s inputs, Qirat has contacted your firm requesting a report on the
role of Big Data and its potential use at FF.
Requirement
The senior manager working on the FF advisory project has asked you to draft the
following extracts to go into the report being prepared for FF
(a) Briefly explain and discuss what is meant by the term 'Big Data' and the 'Vs'
model. (4 marks)
(b) Explain how the management at FF could make use of Big Data and Data
Analytics to improve the company's performance. (13 marks)
(c) Discuss the practical implications that FF would need to consider before
attempting to capture more data about its customers. (8 marks)
Total = 25 marks
Exhibit 1 – Company Delivery Targets

Average number of deliveries per day 15
Average hours driven per day 7.5
Average hours paid per day 8.0
Overtime premium 50%
Target of deliveries on time, first time each month 95%
18
Question Bank
Exhibit 2 – Email from Head of Delivery

From: Wahid Vali To: Qirat Sharif
Subject: Fleet problems Hi Qirat
As requested, I have been undertaking a review of operations in response to our falling
delivery success rate. My team of drivers has experienced an increase in the number
of delivery slots being missed. Customers appear to be unwilling to wait in to take
receipt of a delivery much beyond the allocated time slot. This generates a lot of extra
work for us, as the depot staff have to unload the undelivered food and make
alternative arrangements for delivery. Upon further investigation I have also
discovered:
1 – Since Imran Mullah, the previous Head of Delivery retired last year, the delivery
routes have not been updated.
2 – I have noticed an increase in the amount of fuel that has been purchased in the last
few months – this appears to be largely driven by the older vans in our fleet, which
are relatively inefficient to drive, as well as requiring more energy to power their
refrigeration units. We have had some issues with a couple of vans whereby the freezer
units were barely working at all on the hottest days.
3 – Morale amongst our drivers is very low since bonus payments became less
predictable.
I fear that without substantial investment in new IT systems and trucks we will not be
able to address the fall in delivery punctuality.
Kind regards,
Wahid

Big data is very topical, both in the ‘real word’ and in examinations. You start to this
question is very gentle as you are asked to merely explain the meaning of this. You
may find that the ‘Vs’ model will help you here.
As you read through the scenario you will discover that the company is not very
‘mature’ in its development and deployment of IT. They have made some efforts to
modernise, but, are far from being market leaders in the way that they use exploit what
you may consider to be every-day technologies. As such in part b of this question you
should find that a careful scan of the question scenario reveals many simple
improvements that can be made. The ‘trick’ to this part of the question however is
how you tie-this back to the requirement. Be careful to think about how simple
technological improvements – such as modern Sat-Nav units – can be combined with
Big Data and Data Analytics. You must refer to Big Data and Data Analytics to score
in this section.
The final requirement gets you to think about practical aspects. Therefore you must
refer and relate your observations back to the specifics of the scenario – FF and its
current position. All companies would like to have world class IT, however, there are
numerous practical reasons as to why this is not always possible. Identify these issues
in FF to ensure your answer is scenario specific and addresses the requirement.
19
6 Ali & Co.
You work as a senior in the corporate finance department of a Lahore based accounting
practice, Ali & Co. You have been given some analysis to perform in relation to two of
your firm’s assurance clients.
Client 1 – Shumaila Software Solutions
The Board of Shumaila Software Solutions (SSS) has just returned from a very pleasant
and informative meeting with the owner of a business they are interested in acquiring –
C2Cycle (C2C).
C2C has developed and patented battery-powered smart-spectacles (glasses) for use by
cyclists. The glasses are lightweight, scratch-resistant and impact-resistant, and have
high resolution screens built into the lenses, with high-speed 'Bluetooth' connectivity.
The glasses contain rechargeable batteries in the arms, which power the glasses for up
to 12 hours on a single charge. The lenses are transparent like regular glasses; however,
information can be superimposed into the field of vision, semi-transparently, so the
cyclist can still see their environment clearly. The company is still experimenting with
different glass compositions in the hope that tinted glasses can be developed, offering
protection from the sun also.
SSS is a well-established software developer and it feels that it could be an ideal business
partner for C2C. SSS has recently developed software, originally designed to be used in
advanced handle-bar mounted cycle computers. Ashar Ahmad, the founder and lead
engineer of SSS, believes that the software could be adapted for use in the C2C glasses.
The combined product would incorporate a digital display of user-specified statistics
(e.g. speed, distance, gradient), and provide satellite navigation along pre-defined routes,
and even a virtual cycling partner for race practice and training programmes. To facilitate
this, the glasses would connect to a smartphone app via Bluetooth.
Amal Malik, the owner and founder of C2C has been seeking partnerships with cycle
accessory manufacturers to help launch the C2C glasses, but to date has met nothing but
scepticism. Whilst Amal believes in the product she is aware that it may need to be
developed further before it can be launched onto the market. Having met with her, Ashar
believes that although Amal would like to see her invention through to market, she was
also open to the idea of selling the company to the right buyer.
Ashar is keen on acquiring C2C, preferably with Amal being retained for her technical
knowledge. However, the Board of SSS are struggling with arriving at a valuation of
C2C. Some financial data about C2C has been provided in Exhibit 1.
Client 2 – BiOs
BiOs is an unlisted software company. It has been trading for four years. It has an
excellent reputation for providing innovative and technologically advanced security
software, and has a growing portfolio of clients, including many of the major banks and
pharmaceutical companies in Pakistan. The company employs 18 software engineers
plus a number of sales staff. BiOs has just won a major new contract and is planning to
recruit additional staff to help it deliver the new contract. The company outsources most
of its administrative and accounting functions, allowing it to focus on software
development.
20
Question Bank
A major barrier to growth has been an inability to recruit well-qualified and experienced
staff, as well as the need to invest in expensive computing hardware, software licenses
and network architecture needed to support a wider network of clients. As a result BiOs
has had to turn down work because of a lack capacity.
The company's two owners/directors are brothers, Ali and Wasim Safraz, and
between them they own all of the company’s shares. They have been approached by
the marketing department of an investment bank, whom they provide services to.
The bank’s representative asked the Safraz brothers if they have considered using
venture capital financing to expand their business. No detailed proposal has been
made, but the bank has implied that its venture capital department would be prepared
to provide substantial finance in exchange for a majority stake in the equity of BiOs.
The bank’s representative asked indicated that they would want to exit from the
investment in five to six years' time.
BiOs is all-equity financed and neither of the Safraz brothers is wholly convinced that
they are prepared to give up sole control of the company.
BiOs operates in a niche market, and there are relatively few listed companies in Pakistan
doing precisely what BiOs does. However, if the definition of the industry is broadened
to cover other technology companies the following figures are relevant:
Price/earnings (P/E) ratios
Industry average: 18
Range (individual companies): 12 to 90 Cost of equity
Industry average: 12%
Individual companies: Not available
Requirement
(a) Identify two key issues associated with valuing C2C using conventional valuation
techniques. (2 marks)
(b) Outline two approaches that ASS might use to value C2C. (3 marks)
(c) Calculate a range of values of BiOs to be used in negotiation with a venture
capitalist. State all of your assumptions. (5 marks)
(d) List the advantages and disadvantages of using either venture capital financing to
assist with expansion of BiOs, or, alternatively seeking a listing on the stock
exchange to raise the necessary finance (5 marks)
(e) Explain considerations around structuring a venture capital deal, highlighting the
use of earn-out clauses and deferred consideration, and the likely exit routes for
the venture capital company. (5 marks)
(f) Advise Sarfaraz Brothers about the tax implications of each of the above terms
and recommend which offer to accept. (Your answers should be based upon five
year planning period). Use the tax rates in Exhibit 3 to demonstrate the effect of
above offers. (5 marks)
Total = 25 marks
21
Exhibit 1 – financial data about C2C
 Realisable value of net assets: Rs 16,665,911
Recent profit performance:
 Current year loss: Rs (5,612,871)
 Prior year loss (first year of trading): Rs (7,339,908)
 Revenue each year: Rs Nil
Exhibit 2 – financial data about BiOs

Revenue in year to 31 December 20X3 Rs 311 million
Shares in issue (ordinary S$1 shares) 100,000
Earnings per share 653 rupees
Dividend per share 0
Net asset value Rs 34 million
Note. The net assets of BiOs are the net book values of purchased buildings,
equipment and vehicles plus net working capital. The book valuations are considered
to reflect current realisable values.
Forecast
 Sales revenue for the year to 31 December 20X4 is projected at Rs 367 million.
This is heavily dependent on whether or not the company is able to fulfil the
new contract.
 Operating costs are expected to average 50% of revenue in the year to 31
December 20X4. You can assume that the company being a services company
has minimal property, plant and equipment and depreciation and other non-cash
adjustments can be disregarded for the purpose of your computations.
 Company tax rate is 31%
 Assume book depreciation equals capital allowances for tax purposes. Also
assume for simplicity that profit after tax equals year-end cash flow.
 Growth in earnings in the years to 31 December 20X5 and 20X6 is expected to
be 30% per annum, falling to 10% per annum after that. This assumes that no
new long-term capital is raised. If the company is to grow at a faster rate than
expected then additional financing will be required.
22
Question Bank
Exhibit 3 – Taxation
Assuming that Sarfaraz Brothers accept venture capital company's proposal of
obtaining finance for Bio's and in return Sarfaraz Brothers have agreed to continue
working for the company. Venture Capital Company has propose following
employment terms.
Offer 1:
Each of them will be offered following monthly Salaries
Basic salary 100,000
Travel Allowance 20,000
Cost of Living allowance 30,000
In addition to the above, they will also be entitled to following:
(i) Bonus equal to four month's basic salary
(ii) Company maintained car for his personal use. Cost of the car shall be Rs
2,000,000
(iii) Furnished accommodation. The fair market value of the rent is estimated to be
Rs 40,000 per month. Rent is subject to annual increment of 10%.
Offer 2:
Commission equal to 0.75% of the total sales made each year.
Tax Rates for Every Individual and Association of Person Except for Salaried
Taxpayer
S. No. Taxable income Rate of tax
1. Up to Rs 400,000 0%
2. Exceeds Rs 400,000 but does not 7% of the amount exceeding Rs
exceed Rs 500,000 400,000
3. Exceeds Rs 500,000 but does not Rs 7,000 + 10% of the amount
exceed Rs 750,000 exceeding Rs 500,000
4. Exceeds Rs 750,000 but does not Rs 32,000 + 15% of the amount
exceed Rs 1, 500,000 exceeding Rs 750,000
5. Exceeds Rs 1,500,000 but does not Rs 144,500 + 20% of the amount
exceed Rs 2, 500,000 exceeding Rs 1,500,000
exceed Rs 4,000,000 exceeding Rs 2,500,000
exceed Rs 6,000,000 exceeding Rs 4,000,000
8. Above Rs 6,000,000 Rs 1,319,500 + 35% of the amount
exceeding Rs 6,000,000
23
This question deals with the specific difficulties in valuing start-up unlisted
companies, and, the merits of venture capital as a source of finance for such
companies.
In parts (a) and (b) you tackle the valuation of unlisted companies. Here you need to
be practical, it might help to think what these sorts of companies lack that larger,
mature, listed companies have by comparison.
Part (c) switches to the second company in the scenario, and here the focus is on the
valuation attached by a venture capital investor. Here you need to think about why
venture capital is used by start-up companies e.g. because they are too risky to be
able to raise money from more traditional lenders such as banks. From here you can
explain how this risk affects the valuation techniques used.
Part (d) asks you to exam the merits of venture capital as a source of finance.
Unusually for an exam question you may find more downsides than positives here.
Part (e) requires you to explain some of the common methods used by venture
capital investors to incentivise the business founders to manage the company to
success.
24
Question Bank
7 PJ
PJ is a privately owned supplier of textiles to retailers to the UK and other western
European countries. Its factory is based in Karachi, and whilst the company is profitable
it has spare capacity that it wishes to utilise. Although the company has well-established
trading links in its current markets, it has struggled to expand its sales over the last
number of years, and so has decided to explore the option of market development.
Having considered various new regions of the world, the directors of PJ have settled on
South America as their new target market. However, they are keen not to over-commit,
so they wish to trial their products in one country to assess the potential demand for their
products in the wider region. One of the lessons learned when PJ first exported to Europe
twenty years ago, was the importance of establishing local knowledge and market
access, and to that end the board of PJ are keen on the idea of partnering with a local
South American firm. Having spent some time touring the region, the Sales Director of
PJ, Wahid Usted, has identified a company in Venezuela, VZ Holdings (Venezuela)
(‘VZ’) as its preferred partner (See Exhibit 1).
Discussions with VZ are at an advanced stage and in outline the companies have agreed
that when the JV is formed (for an initial period of three years) each partner company
will each own 50% of the limited liability company and will share profits equally. Rs
220 million of the initial capital is being provided by PJ, and the equivalent in
Venezuelan Bolivars (Bs) is being provided by VZ. The forecast net operating cash flows
in nominal terms are presented in Exhibit 2.
For tax reasons it has been agreed that the JV company would be registered in Venezuela,
as the government there is offering generous tax concessions to attract inward
investment.
Your firm, KJ Khan and Co. are the financial advisers retained by PJ to advise on
business related matters. You have been seconded onto the team to compile a report to
the board of PJ.
Requirement
(a) (i) Ignoring taxation, and using the forecast net operating cash flows,
calculate the NPV of the project under the two scenarios below and
recommend whether or not the joint venture should proceed, based solely
on these calculations (7 marks)
Scenario 1
Venezuela has exchange controls which prohibit the payment of dividends above 50%
of the annual cash flows for the first three years of the project. The accumulated balance
can be repatriated at the end of the third year.
Scenario 2
The government of the Venezuela is considering removing exchange controls and
restrictions on the repatriation of profits. If this happens all cash flows will be distributed
as dividends to the partner companies at the end of each year.
Using a discount rate of 16% and ignoring taxation, for both scenarios:
Ahead of the meeting to discuss the joint venture a series of questions were posed by the
board of directors of PJ to their Finance Director. He has asked for your firm’s assistance
in dealing with these.
25
Requirement
(b) Discuss the three questions raised by the managers of PJ, and advise them of any
other practical issues which should be considered before they whether or not
decide to proceed with the venture. (18 marks)
Total = 25 marks
Exhibit 1 – Email of internal discussion about JV

From: Wahid Usted
To: Directors, PJ
Subject: Joint Venture
Dear fellow directors, I think it is imperative that we make a final decision on the
proposed Joint Venture with VZ Holding (Venezuela). As you know we have been
in discussion with their owners for a couple of months and we are approaching the
point where we either need to agree a deal, or, else seek another JV partner. I am
personally of the opinion that, although Venezuela is not our ideal trading location,
VZ themselves seem like a good cultural fit for us so I am inclined to take the risk
and forge ahead with the outline deal that we have with them. As you know the risks
are mitigated somewhat by the short-term nature of the planned JV so irrespective of
whether things go well or not we will be able to review our options before we get in
too deep.
I propose we meet tomorrow at 2pm so that we can make our final decision.
Regards,
Wahid.
Exhibit 2 – Forecast cash flows for the first 3 years of the Joint Venture
Forward rates of
Bs Millions
exchange to the R
Year 1 80,000 550
Year 2 125,000 575
Year 3 165,000 600
26
Question Bank
Exhibit 3 – Questions from the directors of PJ

(1) 'In reality we will exchange our Bolivar cash flows into Rupees at the spot rate
prevailing at the end of each year. How reliable are forward rates of exchange
as predictors of spot rates?'
(2) 'If exchange controls exist we will not get much of our cash for three years.
Surely we should be using a higher discount rate for Scenario 1?'
(3) 'Under either assumption we have to accept substantial exchange rate risk. Could
we use a currency swap to help us minimise this risk?'
Exhibit 4 – News report on the Venezuelan Economy

The latest news on the Venezuelan economy is somewhat mixed. Whilst there remain
excellent growth opportunities, the Central Bank looks set to maintain high interest
rates to combat the stubbornly high levels of inflation. The problem of capital flight
continues, and to prevent the worsening of this the existing capital controls will
remain in place for at least the next 12 months, at which point the Central Bank has
promised that it will review the situation. In the meantime, to encourage inward
investment the Government continues to maintain corporation tax rates lower than
its regional neighbours. These measures, however, have to prop-up the value of the
Bolivar which continues to slide downwards, with no signs of a short-term recovery.

The biggest challenge you may have find in (a) is setting out the layout clearly. It is
useful to plan in advance layouts that might be difficult to fit on a page, for instance
layouts with lots of columns as in (a). Attempting to restart calculations is a massive
waste of time, in a question that is very time constrained due to the volume of
information provided you may find that spending a little time thinking and planning
calculations can save you more time later in the exam.
Part (b) requires knowledge of the relationship between forward rates and spot rates
and the workings of currency swaps, as well as posing an interesting discussion on
whether exchange control risk should affect the discount rate used in investment
appraisal.
All three statements in Exhibit 3 merit at least 6 marks to do justice to the discussion,
bringing out the qualifications and problems with the views raised, so you could have
been hard-pressed to finish this question in time.
In the first statement the distinction that your answer needs to bring out is the
difference between an unbiased and an accurate prediction.
In the second statement the key point is that adjusting the discount rate is an
alternative to adjusting cash flows for the effects of exchange controls.
The third statement demonstrates how a swap would work, but to get good marks on
this part, it is more important to discuss the problems of swaps and whether other
methods (e.g. forward contracts) might do the job more effectively.
27
8 PRT
PRT is a company listed on the Pakistan Stock Exchange (PSX) in the transport sector.
The company is relatively diverse. Having started out as a bus operating company, it has
acquired interests in taxi services and also owns a regional airport. Within its portfolio,
PRT owns a regional airport 100km outside of Gwadar, as well as a number of urban
and long-distance bus companies, as well as taxi services in Quetta, Khuzdar and Turbat.
The company was founded 30 years ago, and obtained a listing eight years ago. In its
first three years as a listed company its profits and sales grew rapidly, and this delighted
investors as the company was able to deliver impressive dividend growth of 6.5% per
annum, which drove the share price steeply upwards. However the company was failing
to invest sufficiently for the future, and that meant its dividend pay-out ratio of around
40% was unsustainable. The resulting freezing of dividend payments caused a
significant drop in the company’s share price, and, coupled with a minor accounting
scandal, involving the mistreatment of some contingent liabilities, the company’s
founder, and CEO, Davouk Shakour and the Director of Finance were forced to resign
two years ago.
In the short-term, Benezir Dewan, the non-executive chairwoman stepped in as interim
CEO until a suitable appointment as CEO could be made. After a long search Ejaz Shah
was appointed as the new CEO, and has been tasked by Benezir with restoring the
reputation and share price of the company.
After taking some time to become familiar with PRT’s structures and processes, Ejaz
undertook a strategic review, and, after careful consideration decided that the future of
the company lay in focusing on bus and taxi services. Ejaz discovered that the company’s
airport handled a mixture of short-haul scheduled services, holiday charter flights and
air freight, but does not have a runway long enough for long-haul international
operations.
After consulting with experts he came to realise that the lack of available land for
expansion, coupled with the distance from Gwadar meant that there were very few
growth opportunities for the airport. By contrast, the continued growth in the population
of the main cities in Pakistan meant that demand for bus and taxi services is expected to
grow for the foreseeable future. As a result Ejaz has convinced the board that PRT should
divest itself of the regional airport that it owns. Having unveiled this strategy to investors
the share price of PRT rose 8%.
The existing managers of the airport, along with some employees, are attempting to
purchase the airport through a leveraged management buyout, and would form a new
unquoted company, PAK-AIR (PA). The total value of the airport (free of any debt) has
been independently assessed at Rs 4,200 million.
The managers and employees can raise a maximum of Rs 480 million towards this cost.
This would be invested in new ordinary shares issued at the par value of 60 rupees per
share. PRT, as a condition of the sale, proposes to subscribe to an initial 20% equity
holding in the company, and would repay all debt of the airport prior to the sale.
NBB Bank is prepared to offer a floating rate loan of Rs 2,400 million to the PA
management team, at an initial interest rate of KIBOR plus 3%. KIBOR is currently at
6%. This loan would be for a period of seven years, repayable upon maturity, and
28
Question Bank
would be secured against the airport's land and buildings. A condition of the loan is that
gearing, measured by the book value of total loans to equity, is no more than 100% at
the end of 4 years. If this condition is not met the bank has the right to call in its loan at
one month's notice. PA would be able to purchase a 4-year interest rate cap at 11% for
its loan from NBB Bank for an upfront premium of Rs 96 million.
A venture capital company, AV, is willing to provide up to Rs 1,800 million in the form
of unsecured mezzanine debt with attached warrants. This loan would be for a 5-year
period, with principal repayable in equal annual instalments, and have a fixed interest
rate of 14% per year.
The warrants would allow AV to purchase 10 PA shares at a price of 100 rupees each
for every R 1,000 of initial debt provided, at any time after 2 years from the date the loan
is agreed. The warrants would expire after five years.
PRT has offered to continue to provide central accounting, personnel and marketing
services to PA, with the first fee, payable in year one, of Rs 360 million for the first
year’s services. All revenues and costs (excluding interest) are expected to increase by
approximately 5% per year.
Requirement
(a) Establish proposed finance mix and analyse the issues arising from the proposed
finance mix for the management buyout. (9 marks)
(b) Evaluate whether or not NBB Bank's gearing restriction in four years' time will
be met?
(All relevant calculations must be shown. State clearly any assumptions that you make.)
(10 marks)
(c) You work for a Venture Capital Company and it has been approached by the
management buyout (MBO) team for a loan of Rs 1,200 million. Discuss what
information, other than that provided above, would be required from the MBO
team in order to decide whether or not to agree to the loan. (6 marks)
Total = 25 marks
29
Exhibit 1 – Most recent statement of profit or loss for the airport
Landing fees Rs'm
Other revenues 1,680
1,032
2,712
Labour 624
Consumables 456
Central overhead payable to PRT 480
Other expenses 420
Interest paid 300
2,280
Taxation profit 432
Taxable profit (at 33%) 143
Retained earnings 289

This is a complex and time-consuming question – planning here, especially the
calculations will be critical to getting this question answered within the time allowed.
In part (a) you will need to quickly assess the proposed finance mix, then, discuss the
issues that arise from this mix e.g. impact on gearing and costs of paying back the
different debt instruments being used.
In part (b) the instructions are quite clear – will the gearing in year 4 be a problem?
Here you need to model the cash flows in Exhibit 1 forward to derive the four-year
gearing ratio, then assess whether the 100% gearing restriction is prohibitive, bearing
in mind the additional conditions imposed by the proposed financing mix. In
preparing this forecast you will need to make and state your assumptions, for
instance, that no dividends will be paid, KIBOR will remain unchanged and that the
warrants will be exercised. Once you have the year 4 gearing calculation you can
then discuss the impact of each of these assumptions not holding true.
Part (c) is fairly independent of the earlier parts of this question. Try and be practical
here – imagine you have been approached to lend a business a very large sum of
money; what additional information would you need? Remember, in this instance
you need to refer to PRT and what information its lender, AV would be interested in.
AV are a venture capital provider, so think about the specifics of this type of lender.
30
Question Bank
9 PCT
You work in the corporate finance department of Malik, Malik and Company, Chartered
Accountants. You work in the Islamabad office, and have extensive experience in
advising clients of various sizes on a range of issues, including debt and equity financing,
as well as flotations and merger and acquisition activity. Your firm has been engaged by
an audit client, PCT, a leading communications and telecoms firm listed on the Pakistan
Stock Exchange, to advise on a potential merger transaction. You have been seconded
to work on this engagement.
PCT has been trading for 15 years. The company started life when its founder, Shoaib
Ali, left university after completing his doctorate in electrical engineering. He had a keen
interest in telecommunications, and corporate telephones in particular. For example, the
first product that PCT launched was a desk-based telephone that incorporated a
switchboard facility. This allowed small companies to link together all of their internal
employees via a single telephone system. The success of that product allowed PCT to
grow rapidly, and in time it was able to acquire the company that it had outsourced the
production of the telephone systems to. This meant that PCT was able to offer the
physical product, as well as the installation and ongoing maintenance of its systems.
PCT was able to patent several aspects of its products, meaning that it has also made
significant profits licensing its technology across Asia.
Five years ago PCT obtained a stock market listing, and used the cash that it raised to
pursue a policy of aggressive growth via acquisition. The emergence of high-speed
internet allowed the company to branch out into wireless and mobile technologies. The
opportunities offered by the internet were matched by the threat of new entrants, and, as
a result PCT has acquired a number of start-up companies in the last few years, in an
effort to acquire the knowledge, technologies and intellectual property of these fledgling
rivals. As with all acquisitions, some have been more successful that others, but, in the
main this strategy has added value for PCT’s shareholders.
Shoaib remained the CEO of PCT until two years ago, when he retired to pursue his
dream to run a cricket franchise. He is a financially prudent man, who, despite his
immense wealth shunned many of the trappings of his success. Shoaib is very wary of
getting into debt. Therefore under his stewardship, PCT rarely borrowed money, and,
when it did loans were quickly repaid. As a result, PCT’s is currently an all-equity
financed company, with an ordinary share capital of Rs 5,750 million in shares of Rs 25
nominal (or par) value.
The company's results to the end of June 20X2 have just been announced. Profits before
tax were Rs 14,628 million. The chairman's statement included a forecast that earnings
might be expected to rise by 4%, which is a lower annual rate than in recent years. This
is blamed on economic factors that have had a particularly adverse effect on high -
technology companies, notably over-supply in the domestic market. The abundance of
start-ups and new entrants to the market, including some multinational companies, has
caused pressure on sales and margins for all companies in the technology and
communications sector.
TST is a telecommunications business, like PCT, but TST been established longer, with
a trading history stretching back 25 years, and it has been a listed company for ten years.
TST mainly provides services to other large companies, but, is also heavily reliant on
national and provincial government contracts. TST has traditionally been seen as a
31
steady and safe investment by analysts, however in recent years its earnings record has
been erratic. Press comment has blamed TCT’s recent performance on poor management
and the company's shares have been out of favour with the stock market for some time.
Its current earnings growth forecast is also 4% for the foreseeable future. TST has an
issued ordinary share capital of Rs 21,000 million with Par Value of Rs 100 per shares.
Pre-tax profits for the year to 30 June 20X2 were Rs 12,365 million.
The Board of TST has now received an offer from PCT – the details of which can be
seen in Exhibit 1.
Following the announcement of the offer, the market price of PCT shares fell 10%
while the price of TST shares rose 14%. The P/E ratio and dividend yield for PCT,
TST and two other listed companies in the same industry immediately prior to the
bid announcement are presented in Exhibit 2.
Requirement
(a) Evaluate whether the proposed share-for-share offer is likely to be beneficial to
shareholders in both PCT and TST. You should use the information and merger
terms available, plus appropriate assumptions, to forecast post-merger values. As
a benchmark, you should then value the two companies using the constant growth
form of the dividend valuation model. (13 marks)
(b) Discuss the factors that the shareholders of TST will consider when deciding
whether to accept or reject the bid, and, the relative benefits/disadvantages of
accepting shares or cash. (8 marks)
(c) Discuss how institutional shareholders of TST are likely to respond to the offer,
based on your calculations/considerations. (4 marks)
Total = 25 marks
Exhibit 1 – Offer from the Board of PCT

Dear Sirs,
We have undertaken a strategic review of our business, and the wider
communications and telecoms sector. We are now firmly of the belief that significant
value can be added to the shareholders of our respective companies by merging them
together. To this end we would like the make the following formal offer:
Share for Share exchange: Merge the companies with a consideration of 5 new shares
in PCT for every 6 TST shares.
OR
Friendly takeover: PCT will buy 100% of the share capital of TST at a price of 385
rupees per share.
32
Question Bank
Exhibit 2 – Share price and investor ratio details

Note 1: All share prices are in rupees.
20X2
High Low Company P/E Dividend yield %
498 375 PCT 11 2.4
355 282 TST 7 3.1
216 141 CD 9 5.2
266 184 WX 16 2.4
Note 2: Both PCT and TST pay tax at 30%.
Note 3: PCT's post-tax cost of equity capital is estimated at 13% per annum and
TST's at 11% per annum.

A briefing note need not be as formally laid out as a report. In (a) you need to
compute the values of both companies before the announcement, which you can do
by using their earnings and P/E ratios. You are then told how the share prices react
to the announcement: good news for PCT shareholders but not for TST.
The normal arrangement on a cash or shares offer is that the cash equivalent is lower,
because cash is less risky. This does not appear to be the case here, though, for
reasons that are difficult to understand. When discussing the factors to consider, you
should include PCT’s motives and plans for the merger, and whether large
shareholders in TST plc wish to retain their influence on the board of directors.
Part (a) is a tough question, but, is clearly sign-posted. Work out the value that each
set of shareholders will derive from the merger on the terms proposed, then, compare
to the value under the dividend valuation model.
Part (b) requires you to consider the bid from the perspective of TST’s shareholders.
If you were an investor in this business would you rather take the share, or, cash-
based offer?
In Part (c) you are essentially summarising your analysis from part (b). You need to
be decisive here and give some advice – express an opinion on how you think TST’s
shareholders will ultimately respond to the offers in front of them.
33
10 Solar Research Pakistan
Solar Research Pakistan (SRP) is one of Pakistan’s few locally-owned solar energy
research, design and installation companies. Most other companies in this industry
operating in Pakistan are subsidiaries of foreign-owned entities. SRP was founded eight
years ago by Muhammad Afridi, an electrical engineer. After graduating from the
University of Punjab, Muhammad studied for his PhD at the Massachusetts Institute of
Technology (MIT) in the United States of America, where his research paper contained
a number of innovations in solar panel technology. After failing to gain financial backing
to commercialise his ideas in the USA, Muhammad returned to Lahore. Upon his return
Muhammad worked part-time at the University of Punjab, which gave him access to the
laboratories he needed to continue his research.
Muhammad patented his technology, and after some initial operational troubles getting
his solar panels to work in the field, he was able to set-up a working demonstration of
his technology at his mother’s village, easing the power shortages that had blighted it
for a number of years. This allowed Muhammad to secure some bank finance which he
used to form SRP. From these humble beginnings, the company has expanded rapidly,
requiring Muhammad to recruit not only more engineers, but also professional staff, such
as Directors of Finance, Sales and Operations as Muhammad is still more comfortable
in the laboratory than the board room.
The Board of SRP is looking to maintain the growth of the company, and to that end
they have entered negotiations with an Australian-based company, TSD, for a four-year
contract to manufacture and supply their solar panels. TSD designs and installs
renewable energy systems for the Australian and international market. TSD is a small
and innovative company which is privately owned and operated by Bruce Harris, a
fellow alumni of MIT like Muhammed. Australia, like Pakistan has enjoyed a period of
strong economic growth.
SRP’s directors are very aware of the risks of foreign exchange transactions, but lack the
experience of dealing with them. They have engaged your professional services firm,
Khan & Co. to assist them with a range of tasks – such as analysing the financial impact
of exchange rate movements, and how to forecast currency movements – which will be
needed to help them assess the proposed contract with TSD. The proposed contract with
TSD is for a term of four years. Some financial information relating to this contract is
presented in Exhibit 1.
As well as the negotiations with TSD, the directors of SRP are also considering the sale
of their systems directly to a neighbouring country, Country T. Details of this proposal
are presented in Exhibit 2.
Aside from the financial viability of this project, the directors of SRP are concerned
about the issue of exchange controls implemented by the Government of Country T.
These controls are outlined in Exhibit 3.
You have been seconded onto the team working to advise the Board of SRP, and have
been asked for you inputs in the following areas:
Requirement
(a) Identify and critically evaluate the types of foreign exchange (FX) risks that will
arise from the proposed contract with TSD. Describe how economic risk can be
estimated using exchange rate forecasting in this case. (4 marks)
34
Question Bank
(b) Present a forecast of the Rupee/Australian Dollar exchange rate in the January
for Years 2, 3 and 4 (to one decimal place). (4 marks)
(c) Show a computation of the Rs cash flows of the proposed SRP project in Country
T, ignoring the exchange controls. (8 marks)
(d) Explain what is meant by the term ‘exchange controls’. With exchange controls
in place, compute the NPV of the project and recommend whether the investment
in Country T should be approved. (5 marks)
(e) Recommend two strategies SRP could utilise to manage these exchange controls.
(4 marks)
Total = 25 marks
Exhibit 1 – Financial information relating to the proposed contract with TSD

Exchange rates
Assume the S$/A$ exchange rate in January of Year 1 of the proposed investment is
A$1 = 85 rupees.
Inflation rates
The rate of inflation in the following 3 years are expected to be 5.5% in Pakistan
and 1.9% in Australia.
Exhibit 2 – Proposed project in Country T

The proposed new project is for SRP to open a number of solar panel installation
branches in Country T, a neighbouring country, which uses currency T$. Market
research has already been undertaken at a cost of Rs 12 million. If the proposed project
is approved, additional logistics planning will be commissioned at a cost of Rs 15
million payable at the start of the project, effectively Year 0.
Other forecast project cash flows
T$ m
Initial investment on 1 January Year 1 8,000
Residual value at the end of Year 5 1,600
Net operating cash inflows
Year 1 1,800
Year 2 and Year 3 growing at 20% per year from Year 1
levels
Year 4 and Year 5 growing at 6% per year from Year 3
levels
35
Additional information
 The exchange rate for the R/T$ during the life of the project is forecast to be 1
rupee = T$2.1145
 Business tax is 20% in Country T, payable in the year in which it is incurred.
 Tax depreciation allowances are available in Country T at 20% a year on a
reducing balance basis
 All net cash flows in Country T are to be remitted to Pakistan at the end of each
year.
 An additional 5% tax is payable in Pakistan based on remitted net cash flows
net of rupee costs, but no tax is payable or refundable on the initial investment
and residual value capital flows.
 The project is to be evaluated in Pakistan rupees at a discount rate of 12% over
a 5-year period.
Exhibit 3 – Exchange controls introduced in Country T

The government in Country T has recently introduced exchange controls which
restrict payments out of Country T. The controls relevant to payments made by local
companies to foreign parent companies are as follows:
 In Years 1 and 2, there will be a total ban on dividend payments.
 In Years 3 and 4, companies will be able to pay up to 80% of their after-tax
profits in dividends to foreign companies.
 In Year 5 the exchange controls will be completely lifted.
When assessing any investment in Country T you are to make no allowance for the
investment of funds in Country T.
36
Question Bank

This question allows you to recap the topic of foreign exchange risk. Like many exam
questions it builds in difficulty, starting with a knowledge based requirement, before
adding calculation and application elements later on.
Part (a) requires a simple restatement of the different types of foreign exchange risks.
Part (b) asks for future exchange rates, here you will need to deploy the purchasing
power parity model as the relative inflation rates are given in Exhibit 1.
Part (c) is a ‘standard’ NPV calculation, however, take care with the tax depreciation
working – remember to use the tax rate of the relevant country – 20%.
Part (d) looks at exchange controls. These are imposed by governments to restrict the
purchase/sale of domestic currency to retain more economic stability. You need to
follow the instructions in Exhibit 3 to assess the impact these control will have on the
investment, as some future cash flows will be deferred.
Part (e) asks for two methods to work-around the exchange controls. When looking
for legal avoidance strategies it is important to read the relevant laws carefully to see
what is and what is not restricted.
37
Exam style questions
11 PDT
PDT, a company listed on the Pakistan Stock Exchange, operates data centres in a
number of Asian cities. See Exhibit 1 for an explanation of data centres, and the nature
of PDT's business.
PDT’s Board of Directors is led by Abdul Sharif, who is both Chairman and Chief
Executive Officer (CEO), and who has ambitious plans for growing the company. The
company, assisted by investment bank advisers, has been in discussions with a company
called Y-Tech which is located in a neighbouring country, Country Y, with a view to
agreeing a friendly takeover.
Y-Tech operates data centres, similar to PDT’s, but mainly in Country Y, where PDT
does not yet have a business presence. Y-Tech’s shares are quoted on Country Y's stock
exchange (the YSX). Country Y's Takeover Code is based on Pakistan's Code of
Takeovers and Mergers.
Y-Tech has provided PDT with a summary statement of its current financial position.
PDT's accountants have also been able to produce an estimate of the incremental free
cash flows that would accrue to the company in the event of a takeover, before allowing
for any interest costs relating to additional borrowing to finance an acquisition. These
details can be found in Exhibit 2. Abdul Sharif thinks that these cash flow estimates are
conservative, because they do not take into consideration the synergies that should be
achievable through an acquisition or merger.
Summary financial statements for PDT are provided in Exhibit 3.
Abdul is considering an offer price for the shares of Y-Tech. PDT company evaluates
new capital investments and acquisitions using a weighted average cost of capital of
12%.
Abdul would like to make an all-cash offer for the shares, but is aware that the Board of
Directors of Y-Tech may be prepared to consider an all-share merger arrangement.
Guideline company data for comparable listed data centre companies in South East Asia,
including Country Y, is provided in Exhibit 4. PDT’s shares are currently quoted on the
Pakistan Exchange at Rs 850 per share, giving a price-earnings ratio of approximately
34.
Although Abdul is enthusiastic about the potential deal, Malala Bhutto – the Lead
Independent Director of PDT – is not convinced by Abdul’s assurances that acquiring
Y-Tech will be beneficial for PDT. Abdul has said that a takeover or merger would help
to create a more sustainable business, but Malala wants to know more about what he
means by this. Malala has also informed Abdul that the Board of PDT should expect an
explanation as to how the company may expect to gain synergies from a takeover or
merger of Y-Tech.
Additionally at the next Board meeting, when a decision about making an offer to
acquire Y-Tech will be discussed, the Chairman of the Risk Committee will make a
presentation about risks that would arise with an acquisition of Y-Tech's business, and
the control activities that the company would need to apply to manage these risks. A list
of the key risks are provided in Exhibit 5.
38
Question Bank
Requirement
(a) Recommend an offer price for the acquisition for cash of shares of Y-Tech,
indicating how you might allow for risk in the price that you recommend. Justify
your recommendations. (10 marks)
Note. Use mid-year cash flows
(b) Explain how the proposed share for share merger would work at the offer price
that has been suggested, and, assess the impact of the acquisition on the capital
structure and cost of equity of PDT. (10 marks)
(c) On the assumption that the shares of Y-Tech are acquired for cash, identify
alternative ways in which the acquisition might be financed. Indicate with reasons
which of these methods of financing you would recommend. (6 marks)
(d) If the acquisition of Y-Tech is to be a financial success then synergies must be
realised. Explain and evaluate how synergies might be achieved from an
acquisition of Y-Tech in the following areas:
(i) Procurement
(ii) Operations
(iii) Sales and marketing
(iv) General administration (8 marks)
(e) Review the risks listed in Exhibit 5. For each risk briefly recommend and justify
one risk control activity to mitigate the risk. (8 marks)
(f) For each of the risks listed in Exhibit 5 list them in order of severity (from the
most severe to the least severe), briefly justifying your assessment of the risk level
of each. (8 marks)
(g) Acquisition of Y – Tech results in the merging of both companies into a single
company named PDT. Discuss the tax implications of such transaction on PDT.
(5 marks)
Total = 55 marks
39
Exhibit 1 – Data centres explained
What is a data centre?
A data centre is a location that houses computer systems and associated components,
such as telecommunications and storage systems. It provides secure and highly-
connected environments for IT and telecommunications equipment. It is an enabling
environment, in which separate internet data networks meet and are connected, and
it can also host bandwidth-intensive applications and internet content on behalf of
client organisations.
An essential requirement for a data centre is that the systems of client organisations
must never experience an operating failure. A centre will therefore include redundant
or backup power supplies, redundant data communications connections, as well as
environmental controls (such as air conditioning and fire suppression systems) and
security devices.
Note. Redundant items are items of equipment that are not usually required for normal
operations, but which are available for use in the event that the operational equipment
suffers a malfunction or breakdown.
PDT data centres
Some companies, such as major telecommunications companies, operate their own
data centres. PDT, however, operates data centres for client organisations (such as
internet content providers) that do not have their own centres. PDT’s data centres
connect content to the internet.
PDT’s data centres provide a hardware platform for content providers, and a secure
environment for organisations looking to house their bandwidth-intensive hardware
and 'mission critical' equipment. Many customers are content providers (of games,
music, videos etc); but PDT's customers also include financial services organisations,
as well as telecommunications operators that use data centres to connect to internet
exchanges, each other and to internet content companies.
PDT's data centres also offer providers of cloud computing services a means of
connecting to customers through private networks, rather than over the public internet.
PDT's customers agree service contracts for at least one year, but usually longer. This
means that the company has regular recurring income, including rental charges for
housing customers' equipment, providing connectivity, equipment maintenance, and
charging for use of power.
PDT data centre fundamentals
Data centres must have access to high-capacity power supplies. They have
Uninterruptible Power Supply (UPS) systems and standby diesel generators capable
of supporting the site indefinitely in the event of a failure of power from the electricity
grid. Centres also provide an appropriate environment for IT hardware to operate
effectively (including, for example, cooling and humidity control systems), as well as
high levels of security and fire protection.
Centres are supported by engineering teams, on site twenty four hours a day and seven
days a week, to manage the facility and provide customer support. Customer
equipment is connected to data centre networks by means of physical cable
connections, which are installed and managed by PDT engineers.
40
Question Bank
Exhibit 2 – Y-Tech statement of financial position and estimates of free cash flows
from an acquisition by PDT
Y-Tech current statement of financial position (summarised) as at 30 June 20X7
All amounts are shown here in Pakistan rupees, having been translated from Country
Y$ at the rate of Y$1 = Rs 85.
Rs'm Rs'm
Non-current assets
Intangible assets 4,284.0
Tangible assets 16,175.5
20,459.5
Current assets
Trade receivables and prepayments 909.5
Cash and cash equivalents 2,167.5
3,077.0
Total assets 23,536.5
Equity (50 million shares) 11,415.5
Borrowings 9,095.0
Current liabilities 3,026.0
Total equity and liabilities 23,536.5
Y-Tech's shares currently have a market value of Y$9.41 per share.
Y-Tech's net profit after tax for the year to 30 June 20X7 was Rs 1,309 million.
Estimates of free cash flows from an acquisition by PDT
All amounts are shown here in Pakistan dollars, having been translated from
Country Y$ at the rate of Y$1 = Rs 85.
Year following acquisition Free cash flow
Rs'm
1 1,623.5
2 1,972.0
3 2,295.0
4 2,635.0
5 onwards Increasing by 7% each year indefinitely
41
Exhibit 3 – Summary financial statements for PDT
Summary statement of profit or loss for the year to 30 June 20X7
Rs'm
Revenue 16,192
Cost of sales (7,063)
Gross profit 9,129
Sales and marketing costs (629)
Administrative expenses (3,910)
Operating profit 4,590
Finance costs (1,003)
Profit before taxation 3,587
Taxation (1,076)
Profit after taxation 2,511
Summary statement of financial position as at 30 June 20X7 Rs'm

Intangible assets 9,231
Tangible non-current assets 37,094
Trade receivables and prepayments 2,966
Cash and cash equivalents 689
Total assets 49,980
Equity shares and reserves (120 million shares) 19,099
Borrowings 24,973
Current liabilities 5,908
Total equity and liabilities 49,980
Market information
Share price: R 850 per share
P/E ratio: 34
Beta value (equity beta) of PDT shares: 1.25
Risk-free interest rate: 7%
Market risk premium: 6%
Rate of taxation on company profits: 30%
42
Question Bank
Exhibit 4 – Comparable company information

The guideline companies are listed data centres in the South East Asian region,
including Country Y.
Comparable Effective Market value Asset beta Latest trailing

company tax rate D/E P/E
Datastore 17% 27.3% 1.17 32.0
Perm-a-data 19% 33.6% 1.25 28.6
E-Store 17% 20.1% 1.26 38.3
FilingData 15% 45.6% 1.33 37.4
Exhibit 5 – Risks arising from the acquisition of Y-Tech

Identified risks
Risk Potential impact
1 An over-supply of data Lower returns on investment
centre capacity in Country Y Reduction in profitability and cash flow
could lead to downward
pressure on prices.
2 The complex nature of data If customer requirements change
centres mean that unexpectedly over time, the company's
maintaining an efficient data centres may have a shortage of the
centre requires an required equipment, which may be in the
understanding of the nature wrong place, of the wrong size or of the
of future changes in wrong type
customer requirements.
3 The company's data centres Employees could injure themselves whilst
contain complex electrical working on site
and mechanical equipment
which must be operated and
maintained.
4 New data centres planned for Capacity may not be available when
Country Y, or upgrades to customers demand it
existing data centres in Returns on investment may not be
Country Y, could suffer from achieved
completion delays or cost
Reduction in future profitability and cash
overruns.
flow
43
Identified risks
Risk Potential impact
5 The market in which the Systems and infrastructure may not be
company operates could be compatible with new technologies or
subject to material technological operational techniques, which could limit
or operational change. the company's ability to serve customers
Reduction in future profitability and cash
flow
6 Acquisition may not deliver Loss of business value
the expected synergies.
7 Acquisition may not deliver the Financial and strategic goals may not be
expected financial results. realised
8 Foreign currency risk: There Adverse effect on future cash flows
may be significant changes in Adverse effect on reported results
the exchange rate between the
Country Y dollar and the
Pakistan dollar.
44
Question Bank

This is a 50 mark question, so, as you should expect it is long, complex and covers a
range of syllabus topics, and requires a number of calculations. With these types of
questions planning will be critical as there is a lot to do in the time required, and, with
so many calculations you must take care to leave enough time to write up the narrative
sections of your answers. A sensible approach would be to:
1 – read and briefly plan the requirements
2 – scan the exhibits and note which sub-requirement each relates to
3 – complete and check your plan of the requirements – have you broken down
each requirement correctly?
4 – tackle the question sequentially, sticking rigidly to a time plan. It is generally
better to spend the last 10 minutes writing up a new requirement than finishing
off an earlier one – you should accumulate marks more quickly at the start of
your answers than the end.
Part (a) is fairly simple NPV, but, with a twist, you need to use mid-year cash flows.
The trick to this is to use a mid-year discount factor e.g. the 12% DF at times T0.5 and
T1.5 etc
In Part (b) you should demonstrate the impact of (i) PDT issuing new shares to give
to Y-Tech’s shareholders and (ii) forming a new parent company and splitting the
equity between the shareholders of both companies. You can then use the CAPM
formula and the Hamada equation to work out the effect that the merger will have the
cost of capital of PDT.
Part (c) is mainly narrative in nature. Try and identify three different sources of
finance, and briefly explain the merits of each approach.
The question then changes direction, with a focus of synergies and risks in the latter
parts.
In Part (d) you are given a list of areas in which synergies could be achieved.
Remember, achieving synergies is often critical to driving value from a business
combination, so, critically evaluate whether or not the companies are likely to achieve
synergies in these areas.
Part (e) requires a control activity that will mitigate the risks listed. For each activity
you should remember to explain how each activity will work.
Part (f) asks you to list the risks in order of severity, but, more importantly you need
to justify the risk ranking. It is the justification that will provide the bulk of the marks
here – focus on this rather than spending too much time thinking about the actual order
of risks – this aspect will always be fairly subjective.
45
12 KMC
KMC is listed on the Pakistan Stock Exchange (PSX) and operates a factory on the
outskirts of Karachi making motorbikes for the domestic market. KMC manufactures,
assembles, and markets motorcycles in Pakistan. It remains one of the country’s few
independent manufacturers, as many of its rivals are subsidiaries of multinational
manufacturers, making motorbikes under license. KMC was established over 50 years
ago, starting life as a family-run tractor manufacturer. The switch to motorbike
production occurred 35 years ago in response to the increasing competitive forces the
company was facing, alongside the greater opportunities in the automotive industry.
For a number of years, KMC was able to grow rapidly by exploiting two basic designs
for 70cc and 125cc motorbikes. However, in recent times KMC found its growth
opportunities limited by the success of multinational manufacturers setting up
subsidiaries in Pakistan, where a combination of low production costs and superior
technologies have allowed them to gain market share rapidly at the expense of traditional
companies like KMC. This prompted KMC to sign an agreement with an Italian
manufacturer to build and market their 50cc scooters for distribution in Pakistan. This
move was viewed favorably by the stock market, and sales of the scooters now account
for over half of the company’s turnover. Whilst KMC’s own designs are somewhat
dated, there remains a large latent demand for these robust, reliable and cheap
motorbikes.
At a recent board meeting, the decision was made to exploit the company’s recent
success, and, off the back of the scooter deal to look for further opportunities for
expansion. KMC’s CEO, Abdul Khan, is keen on expanding into the production of small
cars. However, other board members feel that the company lacks the financial resources
to compete in this industry, despite the potential growth in domestic car ownership in
Pakistan.
After some discussion it was agreed that KMC should look to move back towards it
roots, as it was felt that the recovery in the domestic tractor market would provide a level
of risk/return acceptable to the company’s shareholders. After some research a target
company was identified – The Pakistan Agricultural Machinery Cooperative (PAMC).
PAMC makes tractors and spare parts, with almost all of its output being sold in the
domestic market. Much like KMC, PAMC’s is listed on the PSX and its own designs
are somewhat dated. However, its product range is significantly cheaper than foreign
designed tractors, making them relatively affordable for smaller farm holdings.
Discussions have already taken place between the directors of the respective companies,
and whilst no offer has yet been made a mutual rapport has been established between the
boards. Adbul Khan is confident that if a realistic bid is made the takeover will be
approved by the board of PAMC. In the short term, Adbul plans to let PAMC carry on
with its current operations with little or no interference from KMC. However, he is
confident that, in the longer term, an agreement can be struck with a Japanese or
American manufacturer so that PAMC can start to manufacture and distribute more
modern designs for the domestic market, and, perhaps even start exporting across the
Asian region. Adbul has not discussed this strategy with the board of KMC.
On the basis of published accounts, industry information and discussions with PAMC's
directors, KMC's directors have forecast the following year-end post-tax cash flows for
PAMC.
46
Question Bank
Year
1 2 3 4 and
beyond
Net after tax cash flows (Rs'm) 92.90 98.90 104.50 114.40
In determining the cash flows, the Directors have made the following assumptions:
(1) These cash flows include growth due to expected increases in sales volumes in
Year 1 to Year 4. No further growth has been forecast after Year 4 due to
uncertainties of long term planning.
(2) All cash flows are assumed to fall at the year-end for valuation purposes.
(3) These cash flows are stated in real terms; that is they do not include inflation.
(4) These cash flows are stated before loan interest on PAMC's existing debt
liabilities, because these have to be repaid in the event of an acquisition.
The Directors of KMC expect inflation in Years 1 and 2 to be 5% per annum, and
inflation to be 4.5% per annum in Years 3 and 4. Inflation in Year 5 and beyond
is estimated to be 4% per annum.
KMC evaluates all its investment decisions at a nominal, post-tax discount rate of
11% which is equivalent to its weighted average cost of capital. PAMC's directors
estimate that its current company cost of capital is 12%.
Whilst the board of KMC have agreed there are potential benefits to be gained
from acquiring PAMC, the directors have very differing views about how to
finance any potential expansion. The views of some of the directors of KMC are
Extracts from the most recent financial statements of the two companies are
Separately to the proposed takeover of PAMC, the board of KMC is also
considering a proposal from the head of its internal audit department to establish
a risk committee of the board. If it does so, some of the current responsibilities
of the audit committee will be transferred to the newly-formed risk committee.
The head of the audit committee has argued the internal audit department must
retain some responsibilities for risk, and, by establishing a risk committee, there
may be two separate committees of the board with differing, and possibly
conflicting, attitudes towards risk and risk management. Other members of the
board of KMC fully understand the concerns of the audit committee chairman,
but are in favour of the formation of a risk committee.
Requirement
(a) Identify and explain four strategic reasons in favour of KMC if the acquiring
PAMC. (4 marks)
(b) Conduct a present value calculation for the acquisition of PAMC to determine a
current value for the company's equity shares. Show all calculations.
Comment on the reliability of your results and explain any reservations. (13 marks)
47
(c) Evaluate the comments made by the three Directors (in Exhibit 1) about the
financing options for the expansion of KMC. In doing so, evaluate the potential
feasibility of financing the acquisition of PAMC using additional debt finance,
and explain the feasibility of two other financing options available to KMC. (8
marks)
(d) Based on your findings in parts (b) and (c), recommend, with reasons, whether
the acquisition of PAMC should proceed, and identify five post-acquisition
integration risks if KMC decide to acquire PAMC and determine how each of
those risks can be mitigated. (10 marks)
(e) List the most urgent matters that the internal auditors should review and
investigate. (5 marks)
(f) Recommend how the responsibilities for risk should be divided between the audit
and the risk committees of the Board, and evaluate what arrangements should be
put in place to reduce the likelihood of disagreements or misunderstandings
between the two committees. (5 marks)
(g) Advise the Audit Committee board on how to react to the news of health and
safety breaches. (5 marks)
Total = 50 marks
Exhibit 1 – Directors of KMC – views on financing the takeover

Abdul Khan: 'To save issue costs and the uncertainty involved in raising new external
finance, we should use our retained profits to finance our expansion. We should
consider selling one of our traditional motorcycle business lines to help raise
additional funds.'
Operations Director Benazir Zardari: 'Our share price has risen by more than 50%
over the last year. To finance expansion we should issue new shares. We should act
quickly to take advantage of our currently high share price. Our dividend yield is
only 3% – this is cheap finance at low risk.'
Finance Director Waqar-ul-Haq: 'We should raise new debt to finance the expansion.
The return on this acquisition is bound to be greater than the cost of debt, so a profit
is assured, and thus the risk is minimal. We could either issue corporate bonds, for
which I have calculated a post-tax cost of 6.12%, or we could raise a bank loan at a
post-tax cost of 5.12%.'
48
Question Bank
Exhibit 2 – Financial statements of KMC and PAMC

Summary of financial statements of acquirer (KMC) and takeover target (PAMC)
Statement of consolidated income for the year ended 31 March 20X7
KMC PAMC
Rs'm Rs'm
Revenue 12,045 2,655
Operating profit 964 234
Finance costs (including overdraft interest) 339 68
Profit before tax 625 166
Taxation 188 52
Profit after tax 437 114
Statement of financial position as at 31 March 20X7

Assets KMC PAMC
Non-current assets Rs'm Rs'm
Property, plant and equipment 9,395 2,543
Current assets
Trade receivables and inventories 5,281 1,744
Cash and cash equivalents 739 68
Total assets 15,415 4,355
Equity and liabilities Equity
Share capital (Nominal value of Rs 100) 6,000 3,000
Retained earnings 2,344 346
Total equity 8,344 3,346
Non-current liabilities
Secured loan stock 7% repayable 20Y0 4,800
Secured loan stock 10% repayable 20Y1 643
Current liabilities
Trade and other payables 2,271 366
Total liabilities 7,071 1,009
Total equity and liabilities 15,415 4,355
Other financial information:
Share price today 101 52
Shares in issue 60 million 30 million
Shares last traded on 19 May 20X7 31 January 20X7
High-Low share prices in past 12 months 108 – 48 48 – 33
- Rupees
Taxation – both companies expect to pay tax at an average of 31% from next year for
the foreseeable future.
Extract from Debt agreement between First Bank and PAMC – there is a clause in
PAMC's debt agreement that says the whole of the Rs 643 million debt is repayable
immediately in the event of a successful takeover bid.
49
Exhibit 3 – Report of the Head of Internal Audit KMC needs to review its internal
controls
KMC’s manufacturing processes involve the handling of toxic materials, and the
company and its Board are aware of the need for strict safety procedures to prevent
accidents to employees and damage to the environment (which could create public
health problems).
I have personally informed the Chairman of the Audit Committee that internal
tolerance limits for environmental protection have been breached on 25 separate
occasions in the past six months. Our company health and safety policy states that
the tolerance limit is five ‘minor’ breaches in any six-month period.
To further strengthen our internal controls I have requested that the chairman of the
Audit Committee instigate an investigation into internal control measures for health
and safety in the company's manufacturing operations. Alongside this I would urge
the board to consider the formation of a Risk Committee to demonstrate a firm
commitment to the company’s health and safety compliance.

This is a 50 mark question, so, as you should expect it is long, complex and covers a
range of syllabus topics, and requires a number of calculations. With these types of
questions planning will be critical as there is a lot to do in the time required, and, with
so many calculations you must take care to leave enough time to write up the narrative
sections of your answers. A sensible approach would be to:
1 – read and briefly plan the requirements.
2 – scan the exhibits and note which sub-requirement each relates to.
3 – complete and check your plan of the requirements – have you broken down
each requirement correctly?
4 – tackle the question sequentially, sticking rigidly to a time plan. It is generally
better to spend the last 10 minutes writing up a new requirement than finishing
off an earlier one – you should accumulate marks more quickly at the start of
your answers than the end.
Part (a) is a ‘nice’ introduction to this question, you need to identify and briefly
explain the strategic logic behind a potential acquisition. Remember – avoid generic
advantages, use facts in the scenario to support the logic of a potential deal.
In Part (b) is a fairly standard NPV calculation. The ‘twist’ in this questions is the
requirement to deal with inflation. As there are multiple inflation rates you will need
to inflate each income/cost then apply a uniform money cost of capital as the discount
factor. Don’t forget the later part of this requirement – make sure you leave time to
discuss your reservations over this calculation; there are plenty of uncertain variables
for you to discuss.
50
Question Bank
Part (c) has a long list of tasks – evaluate 3 different statements, the feasibility of
using additional debit finance, and suggest two other financing methods. Needless to
say, you will need to be concise here to answer all of these elements within the time
that you have allocated.
In Part (d) you are given clear instructions – recommend whether to proceed – yes or
no, and crucially you must provide reasons in support of your advice. Next you are
to identify 5 key risks, then, a control activity for each. Given there are 10 marks
overall you can see here that you must be brief if the section on risks.
Part (e) appear quite simple – list the issues that the IA department should investigate.
You should provide a list, and, ensure you explain briefly what areas they should
review.
Part (f) is brief but has two aspects, you therefore need to identify how the audit and
risk committees each have a role to play in risk reduction, and, how to ensure these
committees do not clash in this regard.
In Part (g) you need to explain how the audit committee should respond to the issues
in Exhibit 3.
51
13 Graffoff
Kamran Baba is an industrial chemist who worked for an oil refinery in the Sindh region
for more than 20 years. In his spare time, he has been experimenting with formulating a
product that could remove graffiti from all surfaces. Graffiti is a particular problem in
certain quarters of Karachi and all previous removal methods were expensive, dangerous
to apply, and did not work on all surfaces. After many years of experimentation, Kamran
formulated a product that addressed all these issues. His product contains several
noxious chemicals and must be applied safely e.g. in a well-ventilated area wearing
protective clothing and gloves. Graffoff removes graffiti from all surfaces, and it can be
produced economically in small, as well as large, volumes.
Three years ago, Kamran left his job in the oil refinery to focus on perfecting the product
and bringing it to market. He formed a company limited by shares, Graffoff, with the
initial share capital funded by his savings, his family's savings and a legacy from a
wealthy relative. He is the sole shareholder in the company, which is based in a factory
in central Karachi. The company has filed two years of results (see Figure 1 for extracted
information from year (2), and it is expected to return similar net profit figures in its
third trading year. Kamran takes a significant dividend out of the company each year
and he wishes that to continue, without drawing a salary. He also wishes to remain the
sole owner of the company.
Four years ago, Kamran was granted a patent for the formula on which his product is
based, and a further patent on the process used to produce the product. In Pakistan,
patents are protected for twenty years and so Kamran has sixteen further years before
his formula becomes available to his competitors to copy. Consequently, he wants to
rapidly expand the company, and plans to lease premises to create 30 new graffiti
removal depots in Pakistan, each of which will supply graffiti removing services, both
the product and the trained staff to use it, in its local area. Kamran needs Rs 80 million
to finance the organic growth of his company.
Kamran has mixed feelings about his proposed expansion plan though. Despite the
apparent success of his company, he prefers working in the laboratory to managing
people. 'I am just not a people person', he has commented. He is aware that he lacks
business experience and, despite the technical excellence of the product, he has failed to
build a highly visible brand. He also has particular problems in the accounts receivables
department, where he has failed to address the problems of over-worked and
demotivated employees. Kamran dislikes conflict with customers and so he often offers
them extended payment terms to the dismay of the accounts receivables section, who
feel that their debt collecting effectiveness is being constantly undermined by his
concessions. In contrast, Graffoff pays bills very promptly, due to a zealous
administrator in accounts payable who likes to reduce creditors. Kamran is sanguine
about this. 'I guess we have the money, so I suppose we should pay them.' In Kamran’s
previous company, the accounts receivable department was shut down when a debt
factoring company was hired. The factoring company paid up 80% of the receivables
balance upon invoicing, with a remaining 17% released once the customer’s payment
had been collected.
In Karachi it is customary to supply goods to customers on 30 days credit. However, in
the services sector that Graffoff is trading in, the average settlement period for payables
(creditors) is 40 days. One supplier commented that 'Graffoff is unique in its punctuality
of payment.'
52
Question Bank
Kamran is currently reviewing how to finance his proposed organic growth. He is

unwilling to take on any further external debt and consequently he has also recently
considered franchising as an alternative to organic growth. In his proposed arrangement,
franchisees would have responsibility for leasing or buying premises to a specification
defined in the franchise agreement. The franchisee would have exclusive rights to the
Graffoff product and application services within a defined geographical region.
The Equipment Emporium has 57 stores throughout Pakistan selling tools and machines
such as air compressors, generators and ventilation systems. It is a well-recognised brand
with a strong marketing presence. It focuses on selling specialist products in bright, well-
lit superstores. It has approached Graffoff to ask whether it can sell tins of Graffoff’s
product through its superstores. Kamran has rejected this suggestion because he feels
that his product requires proper training if it is to be used efficiently and safely, and
worries that allowing a retailer to sell the product, without the expertise to use it safely
may cause the product to be used incorrectly, and ultimately harm the brand. He sees
Graffoff as offering a complete service (graffiti removal), not just a product (graffiti
removal equipment) and so selling through The Equipment Emporium would be
inappropriate.
Requirement
(a) Evaluate the franchising option being considered by Graffoff, highlighting the
advantages and disadvantages of this approach from Kamran's perspective.
(9 marks)
(b) Franchising is only one of the potential forms of strategic alliance available to
companies. Evaluate how other forms of strategic alliance might be appropriate
approaches to strategy development at Graffoff. (5 marks)
(c) Discuss various sources of Finance that are available to Kamran's company to
generate the funds needed to support its growth plans organically. Consider
Kamran's priority of not accessing external debt. Support your answers with
calculations (where practicable) (6 marks)
(d) What difference would it make if Mr. Kamran is to draw market salary from the
company instead of dividends. (2.5 marks)
(e) In the case that Graffoff does opt to go for franchising option, discuss the tax
implications of entering into franchising agreement both inside and outside
Pakistan. (2.5 marks)
Total = 25 marks
53
Exhibit 1 – Extracted financial data for Graffoff's second year of trading, reported
at 31 December 20X9
Extract from the statement of financial position: as at 31 December 20X9
Assets Rs'm
Non-current assets
Property, plant and equipment 258
Intangible assets 19
Total non-current assets 277
Current assets
Inventories 19
Trade receivables 48
Cash and cash equivalent 6
Total current assets 73
Totals assets 350
Equity and liabilities
Share capital 279
Retained earnings 6
Total equity 285
Long-term borrowings 47
Total non-current liabilities 47
Current liabilities
Trade and other payables 14
Current tax payable 4
Total current liabilities 18
Total liabilities 65
Total equity and liabilities 350
Extract from the statement of profit or loss as at 31 December 20X9

Rs'm
Revenue 298
Cost of sales (256)
Gross profit 42
Administrative expenses (19)
Finance costs (3)
Profit before tax 20
Income tax expense (4)
Profit for the period 16
54
Question Bank

This question starts with a requirement about franchising as a method of expansion.
There is clear direction to discuss the advantages and disadvantages of franchising and
here you must be careful. It is easy to get drawn into a generic discussion of the
pros/cons of a given method of expansion. However, at the strategic level of your
studies you are expected to focus on the specifics of the scenario, and, in this case
you talk about why franchising is good/bad in the eyes of Kamran, the owner and
founder of the business. You therefore need to read the scenario carefully and tailor
your analysis accordingly.
You are then asked to evaluate other expansion methods, so, you need to identify
other methods, then, discuss their suitability through the eyes of Kamran. If you are
stuck here this about Lynch’s expansion matrix, or, Ansoff’s matrix.
Finally you need to perform some calculations to assess whether the mooted plans
can be funded out of retained earnings. You always need to be careful with
calculations as it’s easy to get carried away and spend too much time with a
calculator, thus running out of time to write-up other parts of the question. You
should avoid the temptation to perform this part of the question first. Leave these
calculations to the end, and, before starting to press buttons on your calculator think
about what you are trying to prove with your workings and think about the most
concise way of getting to the analysis you need. In this instance Rs 80 million is
needed, and the scenario mentions (i) tightening credit controls (ii) delaying supplier
payments (iii) debt factoring. Think quickly about how you can work out the cash
saving that each of these ploys could generate.
55
14 PCL
PCL undertakes civil engineering and mining activities across the whole of Pakistan.
PCL is headed by an executive main board, but due to the diversity of its operations, the
company is divisionalised below the board. Each division is headed up by divisional
director who has a large degree of operational autonomy. However, any large-scale
strategic investments require the authorisation of the executive board of PCL. Once
authorisation has been granted for a capital allocation, the divisional director is given
wide discretion over where and how to invest the funds. Each divisional director reports
to the executive board on a monthly basis, with a full review of the divisional directors’
performance undertaken on a six monthly basis.
Under the terms of the management incentive plan, which is currently in operation, the
directors of each division are eligible to receive annual bonus payments which are
calculated by reference to the return on investment (ROI) earned during each of the first
two years by new investments. ROI is calculated using the average capital employed
during the year. PCL depreciates its investments on a straight-line basis.
One of the most profitable divisions during recent years has been the IOA Division,
which is engaged in the mining of iron ore. The management of the IOA Division is
currently evaluating three projects relating to the extraction of iron ore in three different
regions of Pakistan: Nokundi, Chinot and Kalabagh. The management of the IOA
Division has been given approval by the board of directors of PCL to spend Rs 4,080
million on one of the three proposals it is considering (i.e. Nokundi, Chinot and
Kalabagh projects).
The net present value (NPV) calculations have been prepared by the Management
Accountant of the IOA Division (See Exhibit 1).
The following additional information concerning the three projects is available:
(1) Each of the above projects has a nil residual value.
(2) The life of the Chinot project is three years. The Nokundi and Kalabagh projects
are expected to have lives of four years each.
(3) The three projects have a similar level of risk.
(4) Ignore taxation.
Requirement
(a) Briefly discuss the benefits and potential drawbacks for an organisation of
introducing reward schemes for its employees. (5 marks)
(b) Explain (with relevant calculations) why the interests of the management of
the IOA Division might conflict with those of the board of directors of PCL.
(8 marks)
(c) Discuss whether the adoption of residual income (RI) might prove to be a superior
basis for the management incentive plan operated by PCL.
(Note. No illustrative calculations should be incorporated into your explanation.)
(4 marks)
56
Question Bank
The IOA Division is also considering whether to undertake an investment in the Haripur
region of the country (the Haripur project). An initial cash outlay investment of Rs 2,040
million will be required and a net cash inflow amounting to Rs 850 million is expected
to arise in each of the 4 years of the life of the project.
The activities involved in the Haripur project will result in some by-products that will
need to be discharged into the Dor River. This discharge contains some contaminants
and will discolour a stretch of the river. Whist this pollution will fall within legal limits,
its effects will be visually noticeable.
It is estimated that at the end of Year 4 a cash outlay of Rs 340 million would be required
to restore the river to its original colour. This would clear 90% of the pollution damage
caused as a result of the mining activities of the IOA Division.
The remaining 10% of the river pollution caused as a result of the mining activities of
the IOA Division could be cleared up by a further cash outlay of Rs 340 million.
Requirement
(d) Evaluate the Haripur project and, stating your reasons, comment on whether the
board of directors of PCL should spend the further Rs 340 million in order to
eliminate the remaining 10% of pollution. (Note. You should ignore taxation) (5
marks)
Haripur is designated as an underdeveloped area by the Government of Pakistan
and companies are encouraged to set up business in this area. PCL is expected to
employee 125 personnel on the Haripur Project. 85% of the expenditure of Rs
2040 million will be made on installation of on ground Plant/machinery and
equipment and such expenditure will have a residual value equal to 150% of their
written down values for tax purposes at the time of disposal.
(e) Discuss tax implications of the above during the life of the project. (3 marks)
Total = 25 marks
Exhibit 1 – Net Present Value calculations

Nokundi project Chinot project Kalabagh project
Net cash Present Net cash Present Net cash Present
inflow/ value inflow/ value inflow/ value
(outflow) at 12% (outflow) at 12% (outflow) at 12%
Rs'm Rs'm Rs'm Rs'm Rs'm Rs'm
Year 0 (4,080) (4,080) (4,080) (4,080) (4,080) (4,080)
Year 1 1,020 911 1,955 1,746 2,040 1,822
Year 2 1,360 1,084 1,955 1,558 1,700 1,355
Year 3 2,295 1,634 1,955 1,392 1,530 1,089
Year 4 1,785 1,135 0 0 510 324
NPV 684 616 510
57
The scenario suggests that PCL's management incentive plan may lead to a lack of
goal congruence between individual divisions and the company as a result of the way
the annual bonus payments are calculated. This should remind you that the benefits
of reward schemes arise when they promote behaviour which is beneficial for an
organisation, but they can be problematic when poorly designed performance
measures promote behaviour which is not beneficial for the organisation. Although
you do not have to link your answer for part (a) to the scenario, you may find it useful
to use the potential issues with PCL's reward scheme as an illustration.
In part (b), note that two of the projects had a life of four years, one had a life of three
years, and that capital employed is based on the average during the year.
Depreciation is on a straight-line basis. So the capital employed at the end of Year 1
will be the value of the investment less one year's depreciation on a straight-line basis.
Your comments for part (b) should also pick up on the ideas about short-term decision
making and lack of goal congruence from part (a). Here, however, your answer must
be specifically linked to the scenario.
Part (c). Note that you are not asked to describe how RI should be calculated but, in
effect, to discuss whether it is a superior measure of performance to ROI.
Part (d). There are two elements to this requirement. One is the calculation, this is a
fairly brief and straightforward – calculate the project NPV, then, adjust for the costs
of clearing 90% of the pollution, then again for clearing the final 10%. The second
part is the discussion around the non-financial issues involved – for example, public
opinion/reputational risk, corporate social responsibility issues, and PCL's moral
obligation to clear up the pollution it creates.
58
Question Bank
15 Khan and Co.

Khan and Co. is a medium sized construction company. The company has been trading
for over 15 years, and is mainly engaged in commercial construction contracts, such as
building small office blocks and warehouses in the Punjab region, mainly in and around
Rawalpindi. The company was formed by Wahid Khan, and he remained the CEO to
this day. Mr. Wahid Khan is also owner of another company (Wahid & CO.) which
provides engineering services to different clients in the same region. The profit margins
of engineering company are much higher as compared to the construction company.
In the early years, the company was able to benefit from the boom in construction.
However, whilst the company was able to increase its revenues, it lacked the internal
financial acumen to underpin this growth, and subsequently Khan and Co. needed to be
restructured in order to place it on a more secure financial footing. Key to this was
securing a Rs 1,250 million loan, secured with a fixed and floating charge against the
company’s non-current and current assets.
Given the company’s previous over-trading, the bank insisted on numerous covenants
in the loan agreement, including interest cover and gearing ratios. Wahid found the
process of securing the loan humiliating, as, in his family he had been brought up only
to spend what he could generate. Applying this ethos to Khan and Co. resulted in the
company becoming over-reliant on its overdraft and trade payables as sources of
finance. Eventually Wahid was forced to seek additional finance when he realised that,
despite his company’s relative profitability, he was at risk of being unable to meet his
payroll costs. The trauma of effectively begging the bank to bail out his company left
Wahid determined to get his company’s cash flows under control.
Part of the restructuring involved Wahid handing almost complete control of Khan and
Co’s finance function to his cousin Salman Khan. Unfortunately, Salman abused his
position and embezzled a significant amount of company funds before disappearing.
This is the point at which your firm, Sharif and Co. was invited to assist Khan and Co.
in helping to stabilise its financial position. You have been seconded onto a team tasked
with piecing together the mess left by Salman.
Of particular interest to Wahid is establishing the company’s cash flow generation over
the next three years. He is planning to retire in three years’ time, so, will be looking to
sell the company as a going concern at that point. He therefore wishes to understand the
indicative value of the company.
The assistant management accountant has compiled the company's latest statement of
profit or loss, and, alongside that they have extracted some key balances from the latest
statement of financial position, which are presented in Exhibit 1.
Some further information on costs and revenues has also been summarized in Exhibit
2.
One of your first tasks is to prepare for the Wahid a forward cash flow projection for
three years, and to value the firm on the basis of its expected free cash flow to equity. In
discussion with Wahid and the assistant management accountant you made notes which
can be found in Exhibit 3.
59
Another task assigned is to identify strategy for taxation with respect of engineering
services by Wahid & Co. The taxation of construction services is fairly straight forward
being under final tax regime however engineering services attract deduction of tax under
section 153(1)(b) of Income Tax Ordinance, 2001 and have been subject to normal tax
regime. Currently the services are being rendered in the Province of Punjab and are
covered by the heading 'technical, scientific and engineering' services which are subject
to sales tax @ 16% of value of services in the Punjab. The rate of deduction of income
tax on such services is 8% of the gross turnover inclusive of sales tax. Previously the tax
so deducted was adjustable against the normal tax liability however now the tax so
deducted is minimum tax by virtue of changes in the law. Mr. Wahid is aware that some
of his competitors are obtaining exemption certificates from tax authorities by giving an
undertaking to the tax authorities that they would surrender themselves for tax audit. Mr.
Wahid however considers that administrative costs of handling a tax audit are too high
and is wondering if he should also pursue to obtain exemption certificate to save the 8%
tax deducted at source. He has required you to advise him the legal requirements and
whether it would be suitable for him to obtain the exemption certificate. Please see
exhibit 4 for projected profit & loss account of Wahid & Co. for tax year 2019.
Requirement
(a) Prepare, using the data supplied, a three-year cash flow forecast for Khan and Co.
highlighting the free cash flow to equity in each year. (12 marks)
(b) Estimate the value of the business based upon the expected free cash flow to
equity and a terminal value based upon a sustainable growth rate of 3% per annum
thereafter. (6 marks)
(c) Advise Wahid on the assumptions and the uncertainties within your valuation.
(7 marks)
(d) Advise Mr. Wahid on taxation regime applicable on engineering services and
options available to him under the said regime. (5 marks)
Total = 30 marks
Exhibit 1 – Extracts from the Financial Statements

Statement of profit or Rs'm Statement of financial position – Rs'm
loss extract
Revenue 5,785 Opening non-current assets 1,386
Cost of Sales 3,354 Additions 76
Gross profit 2,431 Non-current assets (gross) 1,462
Other operating costs 2,178 Accumulated depreciation 424
Operating profit 253 Net book value 1,038
Interest on loan 94
Profit before tax 159 Net current assets 315
Income tax expense 50
Profit for the period 109 Long-term loan (1,250)
Net Assets Employed 103
60
Question Bank
Exhibit 2 – Current cost/revenue information from the assistant management

account
868
1,164
146
Exhibit 3 – Notes taken from meeting with management

1 – The company will not dispose of any of its non-current assets but will increase its
investment in new non-current assets, cumulatively, by 20% per annum. The
company's depreciation policy matches the currently available tax write off for
capital allowances. This straight-line write off policy is not likely to change.
2 – Wahid is forbidden by the loan covenants from taking a dividend for the next
three years.
3 – The level of the loan will be maintained at Rs 1,250 million and, on the basis of
the forward yield curve, interest rates are not expected to change in the foreseeable
future.
4 – Wahid has set a target rate of return on their equity of 10% per annum which he
believes fairly represents the opportunity cost of the invested funds.
61
In part (a), layout is very important, not just to make things clear for the marker, but
also for you to ensure that no figures are missed. There are numerous workings
involved in this part of the question therefore you need to be able to keep track of
where figures are coming from. Remember that cash flow statements never include
depreciation so ensure that you account for this when calculating the free cash flow
to equity. Make sure you answer the question – you are asked for the free cash flow
to equity so you will have to deduct any new investment in non-current assets.
Part (b) is straightforward if you can remember the formula but remember to show
your workings. Also write the formula in notation form in your answer to show the
marker which formula you are using!
Part (c) is testing your understanding of how estimates can affect the valuation figure.
Two of the more important figures are growth rates and required rate of return so
make sure you comment on those.
62
Question Bank
16 Lahore World Travel Ltd

It is 1 December 2018 and you are a trainee accountant of Derawal & Sahi, a Lahore-
based accountancy firm, who have been engaged by Lahore World Travel Ltd (LWT) to
provide business consultancy advice regarding possible acquisition of a UK-based
company, Safari Adventure plc, listed on London Stock Exchange.
LWT is a long established, large and successful travel company based in Lahore and is
listed on the Pakistan Stock Exchange. LWT provides travel services to different sectors
of the travel and holiday market including:
 corporate travel services;
 low cost travel packages to destinations in Pakistan, Europe and Asia; and
 travel solutions for the luxury travel market, such as arranging bespoke travel and
holiday requirements, world cruises and guided adventure tours.
LWT provides a personal service by assigning a personal travel advisor to each customer
and also arranges adventure tours such as trekking in the Himalayas Mountains. LWT
has sales and customer service centres in Pakistan's main cities so customers can book
in person as well as over the telephone.
Zahid Bashir is the Chief Executive Officer of LWT. He considers LWT's approach to
customer service and creative travel solutions as the two principal reasons why LWT
has achieved continual growth and profitability over the past thirty years to become one
of the best known travel companies in Pakistan.
Zahid believes growth and shareholder value can be achieved by applying its core
competencies and unique resources to other types of travel businesses. LWT has recently
been approached by the directors of Safari Adventure plc with an offer for sale. The
LWT Board of Directors has requested your assistance in valuing the potential
acquisition of Safari Adventure plc and advising on how it should proceed.
Requirements
(a) Critically evaluate the potential acquisition of Safari Adventure plc by LWT
(Appendix 1 and Appendix 2). Your evaluation should include a performance
analysis and pros and cons of the potential acquisition. (10 Marks)
(b) Determine the value of the new combined group after the acquisition and the
maximum price that LWT may pay. Also advise the Board of Directors of LWT
whether or not to proceed with the offer price of Rs. 9,000 million (Appendix 3).
Note: All workings should be done to the nearest Rs. in million. State and explain
any assumptions. (13 Marks)
(c) Assuming the offer of Rs. 9,000 million is accepted, determine the impact on
control, gearing and earnings per share if the acquisition is funded with new debt
or by issuance of shares and give appropriate recommendations to the LWT's
Board of Directors. Note: Ignore tax (10 Marks)
(d) Explain the key areas which a due diligence exercise should include prior to
finalizing the agreement to acquire Safari Adventure plc. (07 Marks)
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(e) In the last board meeting, while discussing the potential acquisition of Safari
Adventure plc, Shahbaz Karim, one of the directors of LWT apprised that through
Finance Act 2018, a concept of Controlled Foreign Company (CFC) has been
introduced. Accordingly, the income of Safari Adventure plc would be considered
as income received from CFC. He also stated that LWT may also opt to be taxed
as one fiscal unit.
Draft a note for the board of directors covering the tax implications of the following
matters:
 Views expressed by Shahbaz Karim
 Treatment of dividends to be received from Safari Adventure plc
 Each financing option being considered by LWT (10 Marks)
Total 50 Marks
64
Question Bank
APPENDIX 1 – STRATEGY AND ACQUISITION OPPORTUNITY

Four years ago, LWT acquired a competitor travel company in Pakistan, Lux Travel, which
was very successful in providing luxury travel arrangements to many of Pakistan's wealthiest
people. This acquisition has been largely successful, however it was expensive and financed
with loans which are repayable in 2024. The acquisition has occupied a great deal of
management time over the past few years. A key focus has been to resolve integration issues
with LWT's own travel booking processes and computer systems.
LWT's recent strategy has been to focus on growing its corporate travel services division.
However, the board of directors has become increasingly concerned about a forecast decline
in LWT growth. In response, the CEO, Zahid Bashir believes it is time to consider further
acquisitions to help LWT achieve its strategic objective of being the market leader in the
package, corporate and luxury travel markets.
As a result, the board of directors is considering purchasing two safari parks in Malawi (an
East African country) and one safari park in Botswana (a South African country) operated
by a UK company, Safari Adventure plc (Safari). It is unclear why Safari is looking to sell,
however, Zahid believes this is an opportunity to buy a company at a low price and create
new revenue opportunities by selling luxury safari holidays to LWT's extensive wealthy
client base.
This acquisition represents a diversification from its current operations as LWT has no
previous expertise in running hotels or safari parks, but the board understands that the
existing management of Safari is talented and the employees operating the safari parks have
significant expertise. None of the LWT directors has yet visited Safari's head office in
London or any of the three safari parks in Malawi and Botswana.
LWT’s share capital consists of 40 million shares which are currently trading at Rs. 500 per
share. Additionally, LWT has outstanding loans of Rs. 10,000 million which are due for
repayment in December 2024.
The directors of Safari have submitted a letter to the LWT Board of Directors stating that
their shareholders are likely to accept an offer of Rs. 9,000 million for 100% equity in Safari
Adventure plc. This offer price represents a 20% premium on Safari’s current London Stock
Exchange share price of £2.50 per share.
Safari is currently ungeared and its paid up capital consists of 20 million shares.
APPENDIX 2 – COMPANY PERFORMANCE DATA PROVIDED BY USMAN
SARBANI, LWT'S OPERATIONS DIRECTOR
Dear colleagues at Derawal & Sahi,
As you know, LWT hasn't extensively advertised in the past ten years as our policy has been
to rely on our reputation, returning customers and word-of-mouth recommendations.
Each customer enquiry is assigned to a travel executive who deals with all of the customer's
booking needs. Returning customers who wish to make another travel booking contact the
company's general telephone number or their previously assigned travel executive. Once a
travel booking is complete, it is filed with a transaction reference number. However, there is
rarely a need to access a past travel booking unless there is a customer complaint. This has
never been too much of a problem for LWT.
Historically, LWT has avoided expensive, detailed management reporting as we have
focused on customer service. However, here is the recent performance data of the companies
from our management accounts and from information emailed to me by Safari Adventure
plc.
65
I've also included the following useful extracts from the October 2018 LWT board minutes
which will help with your evaluation.
The Finance Director, Adeena Malik, explained that LWT's failure to meet its 2018 revenue
target of Rs. 12.5 billion was attributable to challenging economic conditions affecting the
travel market. Recent growth has been predominantly in the corporate sector by winning
tenders to exclusively supply corporate travel services.
The Commercial Director said that growth at Safari Adventure plc is impressive, with an 8%
increase in customers in 2018 and 7% increase in customers in 2017. This information was
included in their recent letter offering the company for sale for Rs. 9,000 million. LWT's
own research indicates that popularity of safari holidays has increased over the past five years
as wealthy travellers seek a different vacation experience and are particularly attracted by
the opportunity of observing a wide variety of African wildlife such as lions, giraffes and
elephants in their natural environment. He expects this growth trend to continue. He informed
that the three Safari Adventure plc sites are vast wildernesses of many hundred square
kilometres and are often booked up during high season at least one year in advance.
Expansion of the Botswana site in 2017 increased the number of available rooms by one
third.
APPENDIX 3 – EMAIL FROM ADEENA MALIK, THE FINANCE DIRECTOR OF
LWT
The Commercial Director said that growth at Safari Adventure plc is impressive, with an 8%
increase in customers in 2018 and 7% increase in customers in 2017. This information was
included in their recent letter offering the company for sale for Rs. 9,000 million. LWT's
own research indicates that popularity of safari holidays has increased over the past five years
as wealthy travellers seek a different vacation experience and are particularly attracted by
the opportunity of observing a wide variety of African wildlife such as lions, giraffes and
elephants in their natural environment. He expects this growth trend to continue. He informed
that the three Safari Adventure plc sites are vast wildernesses of many hundred square
kilometres and are often booked up during high season at least one year in advance.
Expansion of the Botswana site in 2017 increased the number of available rooms by one
third.
To: Derawal & Sahi Partners
Date: 4 December 2018
Subject: Valuation of Safari Adventure
As we discussed, LWT is considering an offer to purchase Safari Adventure plc for Rs. 9,000
million. This acquisition could represent good value for our shareholders and an opportunity
for LWT to diversify within the travel sector and apply our focus on customer service to add
value.
66
Question Bank
We would like Derawal & Sahi to determine the combined value of LWT and Safari
Adventure plc. Here are our forecast of free cash flows (FCF) which are stated after all taxes
for both companies based on our own projections for LWT, and from information supplied
by Safari Adventure plc in their offer for sale.
Year to Year to Year to Year to Year to
30-Jun-19 30-Jun-20 30-Jun-21 30-Jun-22 30-Jun-23
Rs. in million
Lahore World Travel 2,500 2,700 2,900 3,000 3,100
Safari £ in 5.2 5.4 5.5 5.5
million 5.0
Here is some additional forecast financial information which I have compiled for you to assist
with your valuation:
 Additional profit after tax of Rs. 150 million per annum will be generated from
2019 onwards by selling luxury safari holidays to LWT's existing customer base
although this revenue synergy could be much higher.
 Surplus land at one of the Malawi safari parks can be sold to a local housing
developer for equivalent to Rs. 500 million at the end of 2019 without impacting
on the forecasted free cash flows. This land is not currently used by the guests of
the Safari park.
 To be prudent I would like you to assume combined group cash flows for 2024
and beyond are forecast as remaining the same as 2023.
 LWT's post-tax weighted average cost of capital will remain at 9% following the
acquisition of Safari Adventure plc so this can be used to value the new combined
entity.
 The existing exchange rate of £1: Rs. 150 is not expected to change significantly.
There are two possible financing options.
Option 1 – Borrow and acquire with cash
We could finance the acquisition with a further bank loan at a post-tax interest rate of 6%
which is comparable to our existing bank loans.
The directors of LWT have expressed some concern about the current level of gearing,
however Zahid and myself believe that the additional operating profit generated by the safari
parks will far exceed the cash required to service the additional debt finance.
Option 2 – Acquire with a share for share exchange
An alternative is to acquire Safari Adventure plc by offering new LWT shares instead of
cash. An investment bank has initially advised that based on current equity values, an offer
of 1 new LWT share for each existing Safari Adventure plc share would be acceptable to the
shareholders of Safari Adventure plc.
Kindest regards,
Adeena Malik
67
17 The Fresh Fish Company
The Fresh Food Company is based in Karachi and is a very large corporation in the
Pakistan food industry. It owns many food processing companies and its Board of
Directors is currently considering the strategic value of its fishing subsidiary, the Fresh
Fish Company (FFC). FFC has three operating divisions as follows:
(1) The Fishing Division: This division operates a large fishing fleet operating off the
coast of Karachi for catching of fish and shellfish. The catch is transferred to
FFC's processing and restaurant divisions as well as local fish markets, other local
fish processors and restaurants. This division also owns and operates four fish
farms in various coastal areas in Pakistan.
(2) The Fish Processing Division: This division is concerned with processing and
canning fish, which is sold and transported to other external fish markets and to
Karachi-based restaurants. This division operates its own fleet of trucks to
transport fish directly from the Fishing Division and fish canning plants to the
restaurants managed by Fish Restaurant Division and external customers
(including wholesalers, supermarkets and fish markets.)
(3) The Fish Restaurant Division: This division operates the 'Karachi Fish Diner'
chain of twenty restaurants across Pakistan's major cities.
The Fishing Division
Fishing is a significant industry in Pakistan due to the 1046 km coastline along the
Arabian Sea. Karachi Fish Harbour is the largest fishing harbour in Pakistan and can
accommodate almost all modern commercial fishing vessels.
Fishing provides a large amount of employment along these coastal areas and is a major
contributor to Pakistan's exports. 90% of fish and other seafood caught in Pakistan pass
through the Karachi Fish Harbour. The popularity and the price of fish has risen in recent
years due to increasing affluence driven by economic growth in Pakistan.
The Pakistan fishing industry is regulated by the Fisheries Development Board which is
part of the Ministry of National Food Security & Research. The Fisheries Development
Board sets the rules and policies regulating the fishing industry in Pakistan and ensures
its waters are not over-fished.
The Fishing Division was formed in 1992 when the company bought three small fishing
fleets and consolidated them into a single fleet. The Fishing Division has over 200
fishing vessels of different sizes and ages and accounts for just over 10% of the total
number of fishing boats operating in Pakistan's waters. The main catch is shrimp, tuna,
snapper, grouper and sardines. The Fishing Division has recorded consistent profits since
its formation but it is operating in an increasingly competitive market place with new
competition each year fishing in the same Pakistan waters.
Since the Arabian Sea has suffered from over-fishing in recent years, the Pakistan
government introduced quotas several years ago in an attempt to conserve fish stocks.
In response, four saltwater fish farms were acquired six years ago by the Fishing
Division. These are in areas of the ocean close to land where fish are protected from both
fishermen and natural prey. Fish stocks can be built up quickly in these fish farms. FFC
originally saw this acquisition as a way of ensuring supply to its other divisions.
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Question Bank
40% of fish caught or farmed by the Fishing Division is currently processed by the Fish
Processing Division and 10% is sold to the Fish Restaurant Division. The rest of the
catch is sold to other fish processors in Pakistan, wholesalers and restaurants.
The Fish Processing Division
The Fish Processing Division was acquired nearly 20 years ago when FFC bought the
assets of the Karachi Canning Company. Government grants were made available to the
Fish Processing Division to develop industry in an attempt to address the economic
decline and high unemployment in the area resulting in the largest major fish processing
and canning capability in the area.
The Fish Processing Division is situated near the Karachi Fish Harbour and its relatively
low prices have made it attractive to many fishing companies. Fish processing is
manually intensive as the processing machinery, which continues to operate well, has
been unchanged since the division was acquired. The division has its own fleet of trucks
which it uses to collect fish from the Fishing Division and deliver processed fish products
to wholesalers, supermarkets, the Fish Restaurant Division and other restaurants in
Pakistan.
The Fish Restaurant Division
The 'Karachi Fish Diner' chain of restaurants was founded nearly eight years ago. The
chain enjoyed early success as it quickly became a fashionable place to eat with its range
of high quality, healthy fish meals in a modern setting. Much of Karachi Fish Diner's
success was built on the quality of its food and service. There are now 20 large Karachi
Fish Diner restaurants across Pakistan. The menus contain a wide range of dishes which
haven't changed and have remained popular since the restaurants were first launched.
In the past two years, the financial performance of Karachi Fish Diners has declined
although the reasons for this are not yet fully understood by the management. At a recent
meeting one of the employees called for new restaurant managers who can change with
the times and effectively manage staff.
The Fish Restaurant Division currently buys half of its fish products from the other two
divisions and the rest from local wholesalers. The Board of FFC want to see a significant
change at the Fish Restaurant Division so that it can return to profitability as soon as
possible.
Recent divisional performance in the year to September
2018 2017
Fishing Division
Turnover of market sector (Rs. in million) 24,950 23,750
Turnover of the Fishing Division (Rs. in million) 2,940 2,688
*Divisional gross profit (Rs. in million) 138 131
Divisional volume of fish caught and farmed (tonnes) 53,400 52,125
Number of divisional fishing vessels 202 200
Fish Processing Division Turnover of market sector 5,580 5,100
(Rs. in million)
69
2018 2017
Turnover of the Fish Processing Division (Rs. in million) 2,212 2,065
*Divisional gross profit (Rs. in million) 194 218
Divisional volume of fish processed (tonnes) 32,040 31,850
Restaurant Division Divisional turnover (Rs. in million) 7,388 7,677
*Divisional gross profit (loss) (Rs. in million) (700) (628)
No. of divisional restaurants 20 20
Average number of meals served by the Restaurant Division 7,768 8,340
per day
*All inter-divisional sales are made at arm’s length
Requirements
(a) Assess the performance of the three divisions in FFC. Your assessment should
include a strategic recommendation for each division. (15 Marks)
(b) Advise on the required actions necessary to achieve a turnaround of the Fish
Restaurant division. (05 Marks)
(c) Advise how value can be added at FFC in the following areas:
 Use of new technology
 Customer relationship management
 Use of specific key performance indicators
 Creation of a shared service centre (10 Marks)
Total 30 Marks
70
Question Bank
18 TECHCON LTD
Techcon Limited (Techcon) is a listed Karachi based company which manufactures a
small portfolio of leading-edge technology products. It was founded in 2003 by Salman
Umar, who started his career with a large technology company but quickly became
impatient with their processes and wanted to start up on his own. The company grew
rapidly. It quickly became admired for its innovation and dynamism, and it floated on
the Pakistan Stock Exchange in 2014. The company is now mostly owned by financial
institutions, although Salman still owns 15% of the company and other employees own
approximately 10%. Salman continues to be CEO and Chairman of the company.
Financial results have been improving, but the company has not yet made a profit and
some shareholders are becoming impatient.
CEO behaviour
Salman is a visionary businessman and known for pushing himself and his employees to
excel. He has a high media profile, spending his wealth on luxury cars, yachts and
homes. He uses social media extensively and has over 500,000 followers on Twitter and
Instagram. He regularly posts personal information, business updates and opinions about
current issues.
In recent months, the board of directors and shareholders have become increasingly
concerned about Salman's erratic behaviour, including his criticism of celebrities and a
meeting he held with key shareholders where he lost his temper and walked out after a
shareholder criticised the performance of the company. At one point he was criticised
for arriving late to an awards ceremony and commented on social media:
'I was using my own satnav (navigation device), so of course I got lost and was late!
He later insisted it was intended as a joke, but he was heavily criticised by employees,
shareholders and the public on social media for damaging the reputation of Techcon's
products.
A week later, on 22 October 2018, there was a traffic accident in Lahore and the driver,
who was injured, blamed his Techcon satnav for directing him into a one-way street the
wrong way. Following on from Salman's earlier flippant social media remark, the
driver's claim received extensive publicity – Appendix 1 is an example of media report.
An extract from the board minutes following the accident is provided in Appendix 2.
Requirements
Assume the date today is 30 October 2018.
(a) Explain the ethical and commercial implications of the CEO's behaviour and the
accident (Appendix 1) (06 Marks)
(b) Using the information above and board minutes (Appendix 2), advise the board
of directors on specific improvements that should be made to the governance of
Techcon Limited. (05 Marks)
71
Subsequent developments
Two months after the traffic accident, Techcon announced that Salman Umar would be
stepping down as their CEO and Chairman, although he would remain on the Board of
Directors as he is a key shareholder. A new interim Chairman was appointed and his first
task was to oversee the recruitment of a new CEO. The Nomination Committee drew up
a draft person specification (summarised in Appendix 3) and began to review the
Curriculum Vitaes (CVs) of potential candidates (two CVs are provided in Appendix 4).
You are a consultant in GFD & Company. Following the traffic accident, your manager
has asked you to draft sections of a report to the client.
Requirement
(a) Identify any additional requirements that should be included in the person
specification for the CEO’s role (Appendix 3). Provide a preliminary
recommendation, with reasons, as to which of the two candidates (Appendix 4)
you would recommend to be the new CEO. (09 Marks)
Total 20 Marks
72
Question Bank
APPENDIX 1 – 'DAILY NEWS' REPORT

Techcon boss in further trouble after accident
Not so long ago, Techcon was one of the fastest rising shares in the market and its founder
and CEO, Salman Umar, is a high-profile figure in Pakistan. However, several recent
incidents have called into question his professional judgement, especially that famous remark
on social media about his own satnav products. He protests that it was a joke, but staff and
customers didn't find it at all humorous.
And now it's only getting worse. Last night in Lahore a man named Adeel Iqbal was involved
in a collision with a lorry as he was going the wrong way down a one-way street, breaking
his arm and collarbone. No one else was hurt in the incident. From hospital, Adeel told our
reporter that his Techcon satnav had clearly directed him to turn into the road and travel
down it the wrong way, commenting 'Even the CEO admits the Techcon satnav doesn't work
and now it has caused real injuries to me.'
APPENDIX 2 – EXTRACTS FROM TECHCON LIMITED BOARD MINUTES
Date: 29 October 2018
Attending:
Executive Board Non-executive Board
Salman Umar (SU, CEO and Non-executive Director 1 (NED1), representing
Chairman) Finance Director (FD) Techcon's largest external shareholder.
Marketing & Sales Director (MSD) Non-executive Director 2 (NED2), CEO of a
well-established oil company.
IT Director (ITD) (taking minutes in
the absence of the Company Non-executive Director 3 (NED3), Salman's
Secretary) brother, a major shareholder in Techcon and CEO
of a large retailer.
Apologies for absence: Company Secretary (CS), Operations Director (OD), HR
Director (HRD).
Minutes:
(1) The board approved the minutes of last meeting of the board held on 4 April 2018.
(2) NED1 requested an update on the incident where a driver blamed his Techcon
satnav for a collision. SU assured the Board that no technical problems had ever
occurred with satnavs in use and he was certain the driver's claim was without
foundation. He intended to vigorously resist any legal claim resulting from the
accident.
MSD expressed the view that recent incidents may cause some damage to the
Techcon brand, and this was discussed. SU strongly disagreed with this view,
saying that he believed the brand was stronger than ever, and helped by his
growing profile in the press and on social media. This was partly due to the work
of a branding consultancy, which has been hired a month ago to improve the
profile of the business. MSD said that she was not aware of these consultants
being retained and SU explained that the consultants were not expensive and
therefore, to avoid delays, he himself had taken the decision to hire them.
73
NED2 was concerned about the allegation that Techcon products may
be faulty and in some cases this may endanger safety. As Chairman of
the audit committee, he expressed the view that the internal audit
function should review the controls around quality and safety testing as
a matter of urgency. SU said that as the allegations were without
foundation this was not necessary and that it was a higher priority for
internal audit to review the product development process, as product
innovation was the most critical area of focus for the company as a
whole.
APPENDIX 3 – DRAFT PERSON SPECIFICATION FOR CHIEF EXECUTIVE
OFFICER
Essential attributes
 Significant experience at senior management level, ideally as a CEO, including
strategic planning and financial management
 Experience of managing in a fast-growing environment
 Experience of managing relationships with shareholders, suppliers and other key
stakeholders
 Understanding of the technology industry and leading-edge technology
developments
 Experience of representing an organisation publicly to the media
 Strong presentation and communication skills
 Educated to degree level or equivalent
 Desirable attributes
 Advanced degree in a technology-related field and/or management
 Senior management experience within the technology industry
APPENDIX 4 – SUMMARISED CVS OF TWO CANDIDATES
Candidate A Candidate B
Professional Qualifications and Professional Qualifications and Experience

Experience
 Chief Executive Officer of
 Chief Executive Officer of DYJ, the Ama.pk, a fast-growing e-commerce
largest provider of IT strategies and business, 2013–present
solutions in Pakistan, 2015–present
 Chief Operating Officer of Ama.pk,
 Finance Director of DYJ, 2010– 2010–2013
2015
 Senior Vice-President for Strategic
 Qualified accountant and MBA Planning of DB Limited, a media
company, 2005–2010
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Question Bank
Candidate A Candidate B
Experience and duties Experience and duties

 Developing and executing strategy  Driving strategy and vision in a fast-
to maximise financial returns for changing market
DYJ's private equity owners
 As CEO, led growth of 300% in turnover
 Developing new talent management and successful floatation on the Stock
strategy and processes focused on Exchange in 2015
attracting and retaining the best staff
 Improving focus on controls and
 Leading the development of new efficiency in a fast-growing business
and improved services to offer to
 Identifying and hiring a strong senior
corporate clients
management team
 Producing regular presentations to
 Managing relationships with
Board members to keep them
shareholders, the media and other key
updated and fostering critical
stakeholders
discussions
Key skills and competencies Key skills and competencies

 Inspiring and leading a talented team  Commitment to put the customer at the
to deliver excellent service and centre of everything and driving world-
innovative solutions to a range of class service
corporate clients
 Proven record of managing a successful,
 Strong vision and strategic fast-growing business
capability
 Successfully managed the cultural,
 Ability to develop strong operational and management changes
relationships with key clients and required in taking a business public
influencers
 A charismatic leader able to inspire
 Experience of managing complex confidence and communicate direction to
projects in a changing organisation a range of stakeholders
 Highly effective interpersonal and  Enterprising and creative thinker, with a
communication skills talent for seeing and exploiting
commercial opportunities
 Excellent financial and commercial
management skills
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19 Ashir and Arham
Ashir & Arham Co. (AA) is a multinational company, dealing in chemical fertilizer. AA
produces and sells various fertilizer products, including urea, DAP, SOP and Zinc etc.
AA is listed on Pakistan Stock Exchange and it's head office is located in the Balakot.
You are working in consulting and assurance service line of Chartered Accountant firm
i.e. Babar & Rizwan (BR). One of your senior colleague, Harris Rauf, asked you to come
with him for a meeting with the CEO of AA.
A snapshot of meeting with CEO
CEO started the meeting with the welcome remarks and explained the purpose of
meeting to us. He told us that company has suffered heavy losses in recent past due to
poor risk management function. The performance of audit committee, responsible for
strategic & operational risk management, is also not satisfactory. In this regard, AA
intend to engage BR for consultancy services to improve our risk management function.
CEO also provided company background information (Exhibit-1) and existing risk
management policies & procedures (Exhibit-2) for our better understanding. AA has also
started working on some initiatives internally, based on initial assessment, to improve
their risk function. As a way forward, AA has also established a board committee to
manage GRC function. The board committee will comprise of CEO, a non-executive
director and two executive directors. CEO will be chairman of the committee. However,
our board is not too much satisfied with the performance of committee.
Considering the mentioned facts, our board has decided to engage third party to
restructure our risk management functions. The initial scope will include following
activities:
(1) Manage overall risk function as well as identified financial risk (Exhibit-3)
(2) Risk assurance services to provide assurance report on effectiveness of controls
after completion of 1st engagement i.e. redesigning of risk function including
designing of related policies & procedures. We may add your assurance report in
our annal accounts for shareholders.
In past, board also highlighted the important factors to be considered during review
of risk management function (Exhibit-4) and a high-level guidelines to be followed
to manage risk management function (Exhibit-5).
The expected deliverables from BR will be as follows:
(a) A detailed report on financial risks linked with the outlined issues in
Exhibit-3 and suitable approach to manage identified financial risks
(Marks 08)
(b) An evaluation report on impact of newly introduced executive information
system on the management performance (Marks 08)
(c) A report on the benefits, attached with the adoption of integrated reporting
by AA and report on possible value for shareholders measuring
performance in respect of social capital and manufactured capital.
(Marks 09)
Now, you are requested to draft a note to respond AA. (Total Marks 25)
76
Question Bank
Exhibit-1
AA has manufacturing facility in Pakistan, Bangladesh and Srilanka with same capacity.
Performance of each unit is also separately measured; therefore, each unit is free to sale
internally as well as externally. Total external and internal sales for the year ended 30 June
2021 were PKR 900 Million and PKR 200 Million respectively. Operating profit for the year
ended December 2021 was PKR 62 Million. The major operating cost is direct raw material
cost. Another major component of cost is interest cost (currently 40% gearing ratio). In this
regard, AA has a strong supplier base and well manage ordering function to avail bulk
discounts. AA has 30 June year end.
The geographical spread of external customers was as follows:
Asia 10%
Australia 10%
UK 40%
US 15%
Europe 25%
In recent, we have faced major losses due to rapid devaluation of our currency and increase
in commodity prices. The global economic conditions have also affected our business.
Our supply chain adversely effected by the recent COVID-19 surge, resulting in non-
fulfillment of customer orders and ultimately financial losses. In all situation, we didn't have
the appropriate business continuity procedures to manage the situation.
Exhibit – 2 Existing policies & procedures
Audit committee is responsible to manage strategic and operating risk, whereas the finance
department, directly reportable to board committee, is responsible to manage financial risks.
Currently, AA is exposed to number of financial risks including interest rate, exchange rate
and commodity prices.
Exhibit – 3 Financial Risks
In fertilizer business, our major raw material is ammonia, which is one of the basic
commodities and traded in commodity market in USD. A future contract for delivery in
January 2022 is being traded at USD 520/tonne after USD 10/tonne decrease in prices within
one week. The current price of ammonia is USD 500/tonne.
With regards to ammonia, AA has different challenges to manage ammonia. Fluctuations in
exchange rate and market price for ammonia were major challenges for AA. Further, we can't
hold much inventory of ammonia considering it's volatile nature.
In respect of mentioned challenges, AA has plan to purchase 2000 tonne ammonia on spot
prices in next couple of months (may be as on 15 Jan 2022) and intend to hedge financial
risks. However, our treasury department don't have much understanding about hedging
instruments and their impact on financial statements considering fluctuations in exchange
rate and commodity prices.
77
The exchange rate as follows:
Current rate 155
Spot Rate 160
Exhibit – 4 Information system
Each business unit has decentralized operating model and separate system for production,
inventory management, sales, customer service, human resource, admin, and finance. Each
business unit shares departmental reports with head office for consolidation and further
reporting to board for decision making.
Now, board is considering to implement integrated information system to avoid delays and
improve reporting & decision making process.
Exhibit – 6 Important factors to be considered in risk management function
Currently, company is majorly focusing on financial performance in board meeting as well
as in annual reports. Having that, audit committee is responsible for strategic and operating
risk management as mentioned in Exhibit-2, however, their performance is not satisfactory.
Further, we are aware of the importance of non-financial factors for sustainability, even
though it is neglected area in past. However, it needs to be focused going forward.
In view of above facts, board is planning to introduce integrated reporting, but have with
some reservation due to lack of complete subject matter understanding and value proposition
through measure of social and manufactured capital.
78
Question Bank
20 Rabia Limited
A large manufacturing IT equipment company, namely Rabia Limited (RL), is operating in
Pakistan with two major products. The major product is IT related hardware which it mainly
supplies to original equipment manufacturers (OEM). The other product area is IT network
system, which mainly sells to medium and small sized companies.
You are engaged by RL for consultancy services to help in preparation of next 3 years plan.
Hira and Mani are also part of your team for RL as researcher and financial expert
respectively. Your team have prepared following information for business plan:
Exhibit 1: A research report focusing on introduction of company, business models and
external environment
Exhibit 2: Summary of business and financial performance based on performance report
(2018-2021), shared by Chief Financial Officer (CFO) of RL
Exhibit 3: A detailed report on alternative future strategies, to be considered for RL –
prepared by your team
Exhibit 4: Minutes of meeting between you and operational team of RL
Exhibit 5: A recent board meeting notes shared by marketing team, containing strategic
choices and threats for RL
Now, you are in position to prepare report based on the available information.
The scenario requirements are as follows:
(a) Prepare following notes based on the available information:
I. An analysis of IT industry and market in which RL is operating business
(10 Marks)
II. A detailed evaluation based on the financial performance (2018-2021) of
RL (05 Marks)
(b) In recent board meeting notes, new strategic choices for RL including entering in
business of supplying emerging technologies such as big data analytics, cloud-
based products, machine learning etc. In this regard, you need to prepare a
presentation slides along with presentation notes, highlighting the opportunities
and benefits through introduction of big data analytics to RL and their customers.
(06 Marks)
(c) In view of threats highlighted in recent board meeting, you need to prepare
following:
I. Prepare a note to discuss three major risks, faced by RL along with the
appropriate risk management strategy for each risk using heat maps and
risk management framework. (06 Marks)
II. A detailed evaluation report on internally developed report containing
strategic choices for RL in next three years along with related assumptions.
(06 Marks)
III. Prepare a recommendation note for your final report based on the
evaluation in above requirement. Recommendation should include
minimum two strategies along with the supporting evidence for
conclusion, which need to be focused by RL in future for sustainable
growth. (06 Marks)
79
(d) It was also highlighted during the meeting with operational teams that RL is also
facing stakeholder management issues. In this regard, you are required:
I. Evaluate how the relative power and interests of the following three
stakeholder groups and the strategies for engaging with them should have
changed after RL Company became a public limited company.
i. Shareholders;
ii. Employees;
iii. Lenders.
(06 Marks)
II. Evaluate the ethical behavior of CEO and HR director in designing and
reporting of HR satisfaction survey. (05 Marks)
Total 50 Marks
80
Question Bank
Exhibit-1 A research report focusing on introduction of company, business models and

external environment, prepared by your research associate i.e. Miss Hira
Introduction of RL
RL is a public listed company and established as private entity back in 1987 by Mr. Tariq
Malik, master's in computer sciences. Initially, RL managed their finances through equity,
retained profits and short term finance arrangements. For expansion and further growth in
business, RL got listed in 2010 to raise funds. More that 30% shares are held by institutions.
External Environment
RL has its head office in Karachi. in IT infrastructure, resulting in significant growth in
sector. The government is also planning to propose a new carbon tax affecting companies
which deals in IT network services. The electronics and IT industry has recently been
identified as a sector with an increasing carbon footprint. In this regard, RL has not yet
formalized system to manage its carbon footprint.
Business Model
RL has two product/service areas – IT related manufactured hardware/components and IT
network services, including technical support.
RL has diversified nature of technical staff working in production, sales, support department
and research & development. Since the inception of the company, 80% of production
employees in the manufacturing side joined a major trade union. In 2018 Pakistan suffered
an economic downturn which led many companies to postpone technological investment and
by then FCS employed 180 full-time employees.
The main source of revenue for RL is the low-cost IT components and it has 1.2% of the total
market share, which accounts for approximately 70% of RL’s total turnover. FCS mainly
delivers (50%) IT components to original equipment manufacturers (OEMs), 30% of which
are based outside Pakistan on a continent which has a single currency which is devaluing
against the Pakistani Rupees. Success in the data communications components sector comes
from the economies of scale achieved by producing high volumes of reliable components
and keeping prices low. RL Company has achieved this despite producing components in a
country where there is significant employment legislation setting minimum wage rates and
conditions.
The second product area is related to IT network services to small and medium sized
organization, but have high profitability margins in comparison with manufactured IT
products. In this area, the key aspect is provision of services related to installation of cloud
based storage for businesses which allow them to store and analyze more customer/buying
related data to improve business strategy including marketing strategy.
81
Exhibit – 2
Summary of business and financial performance based on performance report
(2018-2021), shared by Chief Financial Officer (CFO) of RL
Financial periods: 2021 2020 2019 2018
Sales revenue (domestic and
international) 6·95 7·40 6·80 4·75
Cost of sales 4·97 4·85 4·25 2·62
Gross profit 1·98 2·55 2·55 2·13
Overhead expenses 1·12 1·51 1·41 1·30
Profit before tax and finance costs 0·86 1·04 1·14 0·83
Finance costs 0·69 0·38 0·37 0·14
Tax expense 0.02 0·06 0·08 0·15
Profit for the year 0·15 0·60 0·69 0·54
Other data: 2021 2020 2019 2018
Number of employees 127 135 143 150
Staff turnover (%) 10% 7% 5% 4%
% of orders delivered late 10% 8% 7% 5%
Forward contract order book
(number of orders) 2,500 3,750 4,150 3,505
Customer complaints as a
percentage of total orders and
existing contracts 3.4% 2.4% 2% 1.5%
Investment in non-current
manufacturing equipment as a
percentage of sales revenue 7% 8% 8% 10%
R&D expenditure as a percentage
of sales revenue 3% 5% 5% 6%
82
Question Bank
Exhibit – 3
Evaluation of different strategies in a spreadsheet is as follows:
Strategy evaluation for FCS, using payback method
2020 2021 2022 2023
Strategy 1: Re-focus strategy:
With total cash contribution

m m m m
maintained:
Data
1·55
communications
Network supply
0·85
and support
(1) Total for

2·40 2·40 2·40 2·40
Strategy 1:
Strategy 2: Re-alignment strategy
Growth: Probability:
Network supply
and support 25% 0·60 1·063 1·328 1·660
(Rs.0·85m)
15% 0·30 0·978 1·124 1·293
10% 0·10 0·935 1·029 1·131
(2) Expected value from

1·024 1·237 1·497
network growth:
(3) Data
communications 10% decline 1·55 1·395 1·256 1·130
(Rs.1·55m)
(4) Total cash contribution from Strategy 2: (2

2·419 2·492 2·627
+ 3)
(5) Incremental cash

0·019 0·092 0·227
contribution (4 – 1):
Additional annual fixed costs based on expected

growth:
83
Growth: m Probability:
Network supply
and support 25% 0·75 0·60 0·450 0·450 0·450
(Rs.0·85m)
15% 0·45 0·30 0·135 0·135 0·135
10% 0·25 0·10 0·025 0·025 0·025
(6) Expected value of additional cash fixed

0·610 0·610 0·610
costs:
(7) Cash fixed cost savings

0·500 0·500 0·500
(Data comms)
(8) Net additional

0·110 0·110 0·110
cash fixed costs:
Incremental cash contribution from Strategy

0·019 0·092 0·227
2: (5)
Incremental cash
0·110 0·110 0·110
fixed costs (8)
Incremental net
cash contribution
from
–0·091 -0·018 0·117
Strategy 2
compared with
Strategy 1
Cumulative payback period = 2 years and eleven months
Exhibit – 4 Minutes of meeting between you and operational team of RL

Although you have a well understanding about our organization based on provided
information, as detailed out in Exhibit – 1, but still you invited to attend meeting with
operation teams to understand ground issues in more effective manner. The key meeting
notes are as follows:
Feedback from one of management staff member from marketing team
In 2020, CEO and HR introduced an annual staff survey as one of the initiatives to improve
employee satisfaction level in organization. It was ensured that survey was completely
confidential, however the generic information like age group, gender, designation will be
captured to evaluate results and trends in effective manner. But it was strange moment when
our immediate manager called me after the announcement of survey results, showed his anger
and quoted my exact comments as written in employee survey form by me. He also implicitly
threatened me by saying that you are free to search for a new job if you have any issues in
organization.
84
Question Bank
Comment from an engineer from technical team

He showed his serious reservation on employee survey results, conducted in FY 2020. He
had view that results were not true representative of actual feelings of employees. He felt
that survey was deliberately designed in such a way to avoid negative feedback and genuine
concerns of employee. Further, results were seemed to be managed in a way to give more
importance on favorable feedback such as visual graphics were more focused on the positive
factors. On the other hand, employee performance related issues were more highlighted,
instead of employee satisfaction with the senior management of company.
Feedback from an accountant in fiancé team
We have a policy to restrict cash flows over a maximum three years for capital investment
appraisal and ignore cashflows beyond the stipulated time to ensure pay back within 3 years.
Feedback from support staff member
We are facing staff shortage due to high turnover, having that our sales are increasing day be
day. In present situation, it is quite impossible for us to satisfy all customers. We are also
facing difficulty to fulfill orders and appointments in time, resulting in gradually decrease in
customer satisfaction and ultimately more complaints from customers.
Exhibit – 5 A recent board meeting notes shared by marketing team, containing
strategic choices and threats for RL
Risks and opportunities for RL which can affect RL in short, medium and long term
We are facing staff shortage due to high turnover in the organization, because many key staff
have been ‘head hunted’ or taken early retirement. Further, we are also facing problem to
recruit & retain staff majorly due to geographical location of our office, although we have
modern workplace. In presence of current situation, our staff is already overstretched and
feeling difficulty to maintain quality service standards. Overtime cost is also drastically
increasing, resulting a major financial cost to the company. On the other side, international
market of manufactured IT component is also decreasing with time.
Considering the current and future financial outlook, banks are also reluctant to provide long
term loans at competitive interest rate and to expand our credit lines. In addition, interest rate
are also increasing in the country, resulting in high finance cost.
In the light of above situation, it quite difficult for us to increase our gearing ratio for further
expansion/investment, so that we need to inject further equity or use internal retained
earnings for further investment. In this regard, board has decided 12% cost of equity for
project evaluation purposes.
Future outlook – challenges and uncertainties for RL
About 50% production of IT components is being used internally by RL. For remaining
finished products, RL has two international suppliers, which are dominating player in market
from last 10 years. In recent past, we are facing delays in supplies from our main two
suppliers due to some technical problems at their end in production. As we have dependency
on the suppliers, we are also facing delays in our production and customer deliveries. One of
our major OEM customer accounts for 45% of our sales in this product area.
Growth indicators in our other product area i.e. IT support and management services, are
more positive in comparison with growth indicators for IT components related products.
Cloud based services and big data analytics are also potential areas for growth in future.
Currently, only few companies are operating in Pakistan in this potential area.
85
Future strategy of RL
As per recent forecast for next three years, we are observing more than 10% decline in our
sales year on year on basis, which is a quite alarming situation. To address the challenge, we
need to prepare, discuss, and decide next three best strategy for us on immediately basis in
our next board meeting.
Currently we have two option in mind as future strategy which we need to decide. (Option
1) Should we re-align our business to shift our focus and resources towards high margin
product area i.e., IT management and support services from low margin product area i.e. IT
manufactured components? Further, we also need to exploit new product areas i.e., services
related to emerging technologies (e.g., big data analytics, machine learning, cloud-based
services) to add more in this product area. (Option 2) Should we re-focus on focus on our
core technical area i.e., IT manufacture components to make it more efficient and profitable?
Now, board need to evaluate risk and opportunities for each stated option for decision
along with implementation and finance strategy for each option.
Future prospective for each scenario is as follow:
A) Following the existing strategy
We have estimate that net cash contribution from IT manufacture product area is Rs 1.55 m
and net cash contribution from second product area is Rs 0.85 m. The number are after
interest and tax. Further, we are also expecting 10% sales decline year on year basis in next
3 years.
B) Re-align our existing strategy
If we re-align our strategy and move our focus towards IT management & support services
(Option-1), our sales for IT manufactured components will decreas 10% year on year basis
for next three years. It will also generate Rs. O.5 m per annual saving for next three years
(0.35 m savings from working capital and 0.15 m savings from carbon tax).
Projected growth, additional investment and cost associated with the state strategy can be
shown in below table (All figures are on forecasted basis:
Annual
Annual savings from
Re-alignment strategy and Probability of
increase in cash decline in data
probabilities for growth growth (%)
fixed costs (m) communications
segment (m)
Additional cash contribution

from the network support
business will grow by 25% 60 +0·75 –0·5
each year for the next three
years from the 2021 level

from network support
86
Question Bank
Annual
Annual savings from
Re-alignment strategy and Probability of
increase in cash decline in data
probabilities for growth growth (%)
fixed costs (m) communications
segment (m)

from network support
C) Re-focus on strategy
It is estimated that we can maintain existing level of cash flow i.e. 2.4 m for next three years
if we focus on our existing strategy through improving our manufacturing side and re
organizing our support staff.
87
21 Kalam Hotels
A listed hotel chain i.e. Kalam hotels located in Funland, having developed economy
along with developed tourism industry and excellent growth from last 20 years. Kalam
hotels started it's business about 50 years ago with three hotels in main cities of country.
Kalam hotels is a successful and leading hotel brand in Fundland due to it's competitive
pricing strategy. Kalam hotels provide basic facilities (e.g. free wifi, complimentary
breakfast, attached washrooms) to their customers at a very competitive and low price.
However, Kalam hotels currently do not provide luxuries facilities (e.g. bars, pool, gym,
cinema) to their customers. Kalam hotels are located in all over country at very strategic
locations i.e. located nearby air ports or city bus stations or national highways.
Currently, Kalam hotels are operating almost 510 hotels (approx.. 46000 rooms) -
largest hotel chain in terms of number of hotels in Fundland. Kalam hotels have highly
trained and committed staff but low in numbers. Kalam hotels also pay above maket
salaries to keep their staff motivated and committed. Kalam hotels have achieved organic
growth within Fundland since it's inception. Having that it is leading hotel chain in
Funland, Kalam hotel chain is facing competition from new international entrants in
market.
In last financial year, more than 75% booking were made through website due to heavy
investment in technology and web marketing by Kalam hotels in last many years.
You are working in Kalam hotels as business analyst, reporting to finance director
responsible to look after financial and strategic matters of company.
Following exhibits will be used to perform your tasks, as directed by fiancé director:
Exhibit 1: Chairman’s Statement: Report on Company Performance for year ended
October 2021
Exhibit 2: Board meeting minutes November 2021
Exhibit 3: Hotel Industry Report 2021
Exhibit 4: Spreasheet relating to Kalam’s proposed acquisition target
Exhibit 5: Funland Daily News article
The scenario requirements are as follows:
(1) Board is considering developing hotel business in Fundunia, a developing
country with great growth potential. Considering it will be a strategic move for
company, finance director wants to evaluate key factors for success in home
country before any strategic decision.
Required
(a) You need to prepare a note having key success factors for Kalam hotels
in home country i.e. Funland, for finance director to be discussed in next
board meeting. (10 Marks)
(b) Board also identified a strategic opportunity to acquire a large hotel chain
i.e. Clifton Hotels, operating in Fundunia. In this regard, you need to
evaluate proposal for acquisition of Clifton Hotels based on the
spreadsheet provided by Finance Director. (15 Marks)
88
Question Bank
(2) As a regulatory requirement, company has also informed their proposed plan of
acquisition to stock exchange. Normally, this kind of news have a good impact
on stock price. However, a negative article having concern on the proposed
acquisition, printed in the national newspaper, which might have negative impact
on the stock price. Considering the situation, the chairman of the company is very
concerned about the possible consequences of the published article. In this
regard, you are required to draft a press release in response of published article.
This response will be addressed to the criticism analyzing the environmental and
social impact of proposed acquisition in Fundunia with intention to maintain high
level ethical standards in acquisition of Cliffton Hotels. (Marks 8)
(3) In recent board meeting, board members discussed the possible threats for Kalam
hotels in future due to emerging technologies. In this regard, further requirements
are as follows:
(a) You need to prepare a draft note for next board meeting, containing the
potential challenges of disruptive technologies for hotel industry and
potential applications of the same for Kalam hotels for growth and
sustainability. (Marks 8)
(b) In last meeting, finance director shared three main concerns related to
existing information system with the board. In this regard, board has
requested him to present further analysis in next meeting. Now, finance
director asked you to prepare a presentation for board (one slide for each
highlighted concern in last meeting) along with presentation notes to
assess potential outcome of each identified concern and recommend action
plan against each one. (Marks 9)
Total 50 Marks
89
Exhibit – 1 Chairman Statement: Report on company performance for year ended
October 2021
Kalam Hotels is a most successful brand in Funland due to our continuous struggle and
commitment. We are continuously striving to provide best in class services to our valuable
customers, which is one of the competitive factor for us in market. Having a network of about
510 hotels, we provide our services to our customers at strategic locations at very compatible
prices (20% more than our competitors). It means that geographical location of our hotels
and pricing strategy are also other important contributor to our success journey.
Financial year 2021 was very successful for our company. We have achieved record growth
and customer satisfaction in this financial year resulting in high profitability and returns for
our shareholders. We have more than 1,100 employees across our network. In this financial
year, we have achieved 9.1% growth in sales with 79.5% room occupancy ratio in the
comparison of previous year sales i.e. $1,072 million. We achieved 9.5% growth in our profit
before tax to $ 236 m.
Through investment in our hotel geographical sites and staff, we are offering best value for
money services to our customers. In this financial year, we invested about $80 m in digital
marketing to improve digital experience of our customers. In response of this, we have
achieved record 80% booking from our website, also giving us a competitive edge.
However, the market is evolving in which we are operating, Customer demands and
competitors dynamics are changing. Disruptive channels like digital marketplace is also
impacting the hotel industry. All these factors are creating pressure on us for better services
and productivity in a cost-efficient manner for sustainability and growth. Further we need to
invest to improve existing capabilities and to build new competitive edge for further growth
and suitability in future times.
Key Performance Indicators for the year ended October 2021
Commitment to shareholders Commitment to staff

Revenue Growth 9.1% (Target 8%) Staff retention rate 52% (Target 55%)
Pre-tax Profit growth 9.5% (Target 9%) 6.2 training days per employee (Target 5.5
days)
Commitment to customers Commitment to the environment

Customer satisfaction 91.6% (Target 90%) 2.4% reduction in CO2 Emissions (Target 3%)
Customer return visits 47% (Target 45%) Re-cycling of 85% of waste ( Target 83%)
For future, we have identified following four key strategic areas to focus to ensure the
ongoing success of our company:
Focus on our strengths
Having excited investment opportunities in developing countries, International expansion is
a new area of growth for Kalam Hotels. We need to focus on utilization of our resources in
best manner on the investment projects, having great profitability while maintaining the
quality standards and customer satisfaction level.
90
Question Bank
Focus on growth and innovation

We must ensure to continue our focus to innovation and best in class services to remain
relevant in market for long term. Further, we also need to improve our digital capabilities to
deal with changing world.
Focus on sustainability
We are motivated to continue sustainable and environment friendly business. We are also
committed to make investment for environment friendly business through reduction in
wastage, decrease in hazards gasses in air and move towards carbon neutral business. In next
five years, we need to upgrade our infrastructure including to improve our sustainable and
environmentally friendly position. Further, we also continue to train our staff to encourage
sustainable behaviour towards environment friendly business.
Focus on investment in technology and staff
We are continuous motivated to build a workplace with strong principles of diversity and
equity. We still need to invest to improve our digital capabilities for sustainable growth in
future. We have almost $10 m budget for each year for training & development of our staff.
We are also happy to mention that we are paying above market salaries to our staff members,
even more than minimum wages as declared by the government.
Exhibit – 2 Board meeting minutes extracts, November 2021
The chairman started the meeting with the welcome note and agenda of the meeting. He
shared the recent developments in information technology along with the challenges faced
by Kalam hotels in their existing information system.
Point – 1 Disruptive technologies
Sales and Marketing Director, Ms. Ayesha shared her concern related to traditional hotel
busines. She said that traditional hotel business is under threat due to new emerging concept
i.e. "Rent a Room". She also sent a detail note to all board members through email in advance
to explain the stated concept. The extract of email body is as follows:
Rent a Room is a virtual marketplace which offers flexible hospitality services to customers
in more quick and convenient way with third party hosts including rental apartments,
homestay, hotel rooms and hostels.
The service provider receives a predefined commission from both parties. Currently, almost
over two million accommodations are registered on virtual marketplace in more than 60,000
towns worldwide.
It is important to mention that many of the listed hosts are providing basic as well as some
of luxusrios facilities like provision of mini cinema services at a very economical rates even
less than our room charges.
In response, operational director said that the stated new concept is not a big challenge for
us considering we have well established business model. As per operational director, Rent a
Room concept is based on an informal business model which is not sustainable in a longer
run. Further, customer are expecting more services than provision of services in the stated
model.
Finance director also expressed his opinion to board and told the audience that technology is
main disruptive factor for the hotel industry going forward. He told that visitors (mostly
91
people in 20-40 age groups) are more focusing on value for money and flexible services
(such as flexible booking, check in and check out services through smart devices). Further,
he also explained some use cases of emerging technologies to show how smart devices can
be used as replacement of physical door keys.
Other technology disruptors like online travel agencies (OTAs), hotel booking sites, blogs
and different smart phone apps were also discussed along with their possible impact on our
business.
Chairman summarized the discussion by saying that we couldn't ignore disruptive
technologies and we should need to assess each threat before any decision.
Point – 2 Information System
The finance director shared his concern for not having clear information strategy, although
we have invested a large amount in our financial management system in last few years and
not experienced any breach of information system. He also raised his concern regarding
control environment of IT/IS environment. In this regard, he also presented following three
main risks to IT/IS environment along with possible reasons for risks, which need to be
addressed on immediate basis:
(1) Lack of focus on IT/IS Strategy: Weak focus on IT/IS strategy and weak strategic
leadership of our IT/IS development and limited support for IT/IS strategy at
Board level.
(2) Cyber and date security breaches: Failure to update our information systems in
line with latest cyber security threats and lack of appropriate internal physical and
access controls.
(3) Business continuity threat: Insufficient planning for business continuity and lack
of awareness at Board level of the importance of critical information systems.
Meeting concluded with following action points to be addressed before the next meeting
(1) Identify possible challenges for Kalam Hotels due to disruptive technologies and
recommend applications for disruptive technologies by Kalam Hotels.
(2) Identify appropriate action plan to control information systems environment.
Exhibit – 3 Hotel Industry Report
Apparently, this financial year is very positive for many hotel chains in Fundunia, but that
does not mean businesses can become complacent.
Despite of recent economic recession, tourism is continuously progressing in Fundunia, with
8% rise in tourists in this year. Fundunia has highly developed hotel and hotel industry. Both
traditional companies and OTAs are progressing in country. Customers are getting more
flexible services at competitive prices due to emerging usage of online booking websites and
prices comparison sites.
Having that, government is also focused to invest in infrastructural development to promote
tourism. Recently, Fundunia inaugurated one of the largest airport in the second big city of
Fundunia. This resulted an additional 2.5 million visitors last year (80% of them visited the
country for tourism purposes). In addition, a huge investment was also injected to improve
road and rail network.
92
Question Bank
Government is also announcing incentives for investors in tourism industry to create job
opportunities for local public. In this regard, education sector is also playing its role in
provision of skilled labour through offering the related qualification.
This led towards the more activities in the economy and created more opportunities for
investors in a highly competitive environment. Recently, two new national brands have
opened their hotels at strategic locations. Due to intense competition in country, two big hotel
brands in country have gone out of business this year. This is an alarming example for hotel
companies, not focusing on changing environment.
It is critical to focus on technology and innovation for sustainability in future. Most of the
hotels are offering digital experiences to their customers in Fundunia (e.g. provision of online
booking in much effective and flexible manner).
Customers are expecting standard services at competitive prices. A recent online survey
indicated that 70% customers would be interested in best deal in the best location. Recent
economic recession has significantly impacted the hotel businesses, resulting a large number
of companies went out of business. However, companies, operating in efficient manner and
focusing on customer satisfaction, survived in recent recession.
Challenges for hotel industry beyond 2021
Customer requirements
In future, the main challenge for hotel industry is to achieve customer satisfaction for that
hotels must need to understand customer needs and prepare their business strategies
accordingly. This is challenging for hotel industry because customer needs are evolving very
rapidly and they are becoming more demanding in presence of disruptive technologies.
Customer are also more focusing on value for money services.
Recruiting the right people
As per recent survey, it was indicated that highest turnover (almost 60%) was recorded in
hotel industry in Funland, which is a alarming situation for hotel companies to retain skilled
staff for provision of highly competitive services to their customers. Companies need to
establish a very effective HR strategy to recruit and retain highly skilled people.
Changing environment
The competitive landscape is also changing. One of the major trends in hotel industry,
companies are focusing on mergres and acquisitions to increase their market share and
vertically integrate their product offerings.
The nature of competition is also chaging through introduction of new business models, For
example, companies following Rent a Room business model, doesn't own one single room.
Instead they are operating and managing a virtual marketplace.
Exhibit – 4 Spreasheet relating to Kalam’s proposed acquisition target Cliffton Hotels
 All 25 hotels in chain are operating from last 20 years and located at strategic
locations in Fundunia.
 Mid range hotels with some luxurious facilities like gyms, pools etc.
 Funduia is 150,000 miles away from Funland. Fundunia has developing economy
with low wage rates and poor employment practices including usage of child
labour.
93
 Fundunia has great potential in tourism industry.
 It is a family business, which has lacked investment in the last 12 years.
Key investment data (All figures used have been converted into Funland’s home
currency ($)):
Year
0 1 2 3 4 5 6
Revenues 48,180,000 48,180,000 53,961,600 53,961,600 53,961,600 53,961,600
Initial 80,000,000
investment
Refurbishment 10,000,000 5,000,000
Environment
1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Investment
Training Costs 3,000,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000
Operating 21,681,000 21,681,000 24,282,720 24,282,720 24,282,720 24,282,720
Costs
Total Costs 90,000,000 30,681,000 24,181,000 26,782,720 26,782,720 26,782,720 26,782,720
Cash Flow 90,000,000 17,499,000 23,999,000 27,178,880 27,178,880 27,178,880 27,178,880
Discount factor
1.00 0.89 0.80 0.71 0.64 0.57 0.51
12%
Present Value 90,000,000 15,624,107 19,131,856 19,345,390 17,272,670 15,422,026 13,769,666
Net Present 10,565,715
Value
Additional Information:
 Some of Fundland’s hotel managers would need to relocate to Fundunia on a
temporary basis to assist in training and staff development in the first year of
operations and will be required to carry out on-going mentoring activities for the
next two years.
 A combination of debt and equity will be used to finance the acquisition.
Exhibit 5: Funland Daily News article
Recently, Kalam Hotels have publicly expressed their interest to acquire a struggling hotel
chain in Fundunia i.e. Cliffton Hotels. The chairman and co-founder of hotel chain admitted
in a recent interview that they decided to sell the hotel chain three months back due to
continuous decline in sales. Further, he also admitted that company were failed to cope with
changing environment not making investment in right direction, which was a main reason in
the recent decline of our hotel chain. However, he was confident that new investor can bring
it back to the right direction through right decision making and investment, having that
Fundunia has great potential in tourism industry. Considering all the factors in mind, is it
right move for Kalam Hotels to acquire Cliffton Hotels?
As per recent statement by Chairman, Kalam Hotels have highest standards of staff values
and employment rights (e.g. holidays, sick leaves, bonuses, increments) . However, staff in
Clifton Hotels are being paid on very low wage rates even after working at extended hours
with low employment rights. Staff at Cliffton Hotels (mostly women staff) have limited
opportunities for training & development. In addition, Cliffton hotels have policy to hire only
men for managerial position in comparison with equality principle of Kalam Hotels.
94
Question Bank
Cliffton Hotels were also fined multiple times by government authorities for breaching the
environmental regulations i.e. polluting the local waterway with the outflow of untreated
sewage due to non-availability of proper facilities and limited resources. In this regard,
Kalam Hotels need to invest heavily to make the hotel chain sustainable and environment
friendly business.
Although Funduia has great potential in tourism industry and government is also taking more
positive measures to attract investors, environmental awareness in the country is at very low
level. National recycling levels are less than 60% in comparison of neighbor countries and
reported emissions of hazards gasses were also at worst in the country.
Considering the all points, it's quite obvious that company is exploiting this opportunity to
maximize their profits due to low wage economy with a large number of poorly educated
and unemployed population. It is definitely a questionable step for organization like Kalam
Hotels to move towards unethical direction.
95
Past exam questions
22 TNS Textiles (June 17)

TNS Textiles (TNS), which was incorporated over 50 years ago, is listed on the
Pakistan Stock Exchange. It manufactures textile products and sells them in Pakistan
(25%) and internationally (75%), with customers in Asia, Europe and the US. This
includes home textile products such as bed linen as well as a wide range of clothes, to
companies which then sell the goods under their own brand names around the world .
TNS is one of the largest textile companies in the country and has steadily accumulated
a significant cash balance, but has been losing market share for several years. Growth in
the industry has also slowed, leading to declining revenue, to the extent that TNS is in a
breakeven situation. Some major shareholders in TNS have been critical of management,
demanding that they formulate a strategy to restore growth.
The board of TNS is now considering two options to achieve this growth, both of which
could be financed from cash reserves:
(1) Launch an aggressive marketing campaign to grow organically, particularly in
export markets. This would be underpinned by a new, more efficient production
process as TNS will replace its existing machines, some of which are outdated,
with modern, innovative machines purchased from Germany. These can be
operated by fewer staff which will allow for reductions in cost, and lower, more
competitive pricing.
(2) Acquire an established competitor, Premium Fabrics, which is also based in
Pakistan and exports 95% of its production.
The board members believe that they must choose between these options as they
do not have the management capability or financial resources to undertake both
of these.
TNS has made a number of acquisitions in the past, always integrating the
acquired company into its existing operations. All acquisitions have been
significantly smaller than Premium Fabrics. In all cases the business and assets
of the acquired companies were transferred to TNS and the newly acquired
subsidiaries were either left dormant or wound up. Success has been mixed. The
most recent acquisition, International Fashions, was acquired in 20X2 and the
management of the acquired business were vocal in criticising the TNS board
following the acquisition, feeling that they were being undermined. Eventually,
most of the management left the company and the operations were integrated into
TNS's existing operations, but the dispute and loss of expertise meant that the
planned benefits resulting from the acquisition were realised two years later than
the original forecast.
96
Question Bank
Potential acquisition of Premium Fabrics

Premium Fabrics is a privately owned company operating from five production facilities
in different parts of Pakistan. It was founded 40 years ago by Mr Ashar Ahmad, who
remains the Chairman and Chief Executive. The shareholdings are (ordinary shares of
Rs 10/each):
Ashar Ahmad 7 million
Rafqat Memon (Finance Director) 4 million
Mst. Ghazala Khan (Operations Director) 3 million Managers and

other employees 6 million
The shareholders of Premium Fabrics have indicated that they are willing to sell the
company if an appropriate offer was made and the board would be willing to make some
limited, non-public information available to TNS in order to enable an initial bid to be
made.
Report required
You are an assistant to the group accountant of TNS, Reema Malik. Premium Fabrics
has provided financial statement data (Exhibit 1) and some accompanying notes (Exhibit
2). Reema has also provided some additional notes to guide you based on a recent
meeting with the TNS board, together with some post-acquisition performance
assumptions made by Reema (Exhibit 3). One of the other members of the finance
department has also supplied some foreign exchange data (Exhibit 4). Reema has asked
you to prepare a draft report which addresses each of the following requests:
(a) Estimate the amount we should offer as an initial bid for Premium Fabrics, based
on the information we have. As a minimum, please provide estimates using free
cash flow and net asset valuation and an explanation of the pros and cons for each
valuation method. Assume a WACC of 15%. (14 marks)
(b) Provide an analysis of the two strategic options the board is considering,
including the strategic and foreign exchange risks involved in each. Recommend,
with reasons, which you think would be a better strategic fit for TNS. (8 marks)
(c) Discuss the key implementation challenges we can expect to see if we choose
either option, with brief recommendations on how we can overcome them.
(10 marks)
(d) Explain how we could manage the exchange risk arising if we go ahead with the
purchase of machinery from Germany, and the expected outcome if we use
forward contracts, assuming the actual rate on 30 June 20X7 for 1 Euro is Rs
116.21/Rs 116.45. Discuss any other ways we could manage this risk. (4 marks)
(e) Examine the taxation implications of the two options followed by a brief
conclusion. (Actual calculations are not required.) (14 marks)
Reema has indicated that she does not require any executive summary, contents page,
etc. She just wants you to prepare the above sections of the report.
Requirement
Prepare the sections of the report requested by the group accountant, Reema Malik.
Assume the current date is November 20X6.
Total = 50 marks
97
Exhibit 1 – Financial information provided by Premium Fabrics
Statement of profit or loss and other comprehensive income for the years ending 31
December
20X6 20X5
Actual
Rs'm
15,764 13,843
(14,114) (12,108)
(702) (561)
948
(23) (30)
(5) (5)
920 1,139
(285) (353)
635 786
20X6 20X5
Actual
Non-current assets
3,965
Total assets 9,553
Issued
capital
1,855 2,372
Non-current liabilities 45 71
2,724 2,089
2,924 2,289
Notes
1 Non-current assets consist of land and buildings, plant and machinery and
office equipment. Some plant and machinery and office equipment are held
under finance leases. All non-current assets are held at historic cost less
accumulated depreciation.
98
Question Bank
Owned Owned Assets

land and plant and held Office
buildings machinery under equipment Total
Rs'm Rs'm finance Rs'm Rs'm
leases
Rs'm
Cost
at 1/1/X6 2,359 4,372 196 768 7,695
Additions 91 26 95 212
Disposals (4) (20) (24)
at 31/12/X6
(forecast) 2,359 4,459 222 843 7,883
Accumulated
depreciation
at 1/1/X6 308 1,472 90 237 2,107
On disposals (3) (15) (18)
Charge for
the year 41 874 59 147 1,121
at 31/12/X6 349 2,343 149 369 3,210
Carrying value
as at 31/12/X6
(forecast) 2,010 2,116 73 474 4,673
Current assets break down as follows:

2
31/12/X6 31/12/X5
Rs'm Rs'm
Stock 3,311 2,570
Trade receivables 761 846
Other receivables 300 282
Cash and bank balances 383 267
Total 4,755 3,965
3 The company has not paid any dividend.
99
Exhibit 2 – Accompanying notes provided by Premium Fabrics
Ashar Ahmad, the founder, Chairman and Chief Executive, is now 65 and looking
to sell his shareholding and retire. The other directors do not have sufficient funds
to buy him out. They are willing to sell their shares in principle, but have indicated
that they would like to remain in post following the company's sale.
Financial reporting
All land, buildings, plant and machinery are depreciated to a zero residual value
over their estimated useful lives. This includes assets held under finance leases, as
they will revert to the company's ownership at the end of the lease term. All
depreciation is charged on straight line basis.
The owned land, buildings, plant and machinery have an estimated total fair value
at 31 December 20X6 of Rs 6.5 billion. It is estimated that the fair value of the
finance lease assets at 31 December 20X6 would be Rs 150 million.
Stock is held at the lower of cost and net realisable value.
The loans are secured by charges over the assets of the business and directors'
guarantees.
Exhibit 3 – Post acquisition performance assumptions From the meeting

between Reema and the TNS board Assume that the acquisition would occur on 1
January 20X7. Operations
The board of TNS believes that there is scope to reduce costs by integrating the
operations of TNS and Premium Fabrics. They estimate that this will result in a
reduction in cost of sales of Rs 0.75 billion in 20X7, and a further Rs 0.75 billion in
20X8. Due to the disruption of the integration, revenue is expected to be static in
these years, but will grow by 20% in 20X9, as will cost of sales. Both are then
expected to increase in line with forecast inflation of 3%.
Operating expenses are expected to reduce by 10% in 20X7 due to the integration and
be static thereafter.
Taxation
Assume that future corporation tax rates will be 30%. Ignore final tax regime (FTR)
and minimum tax.
The machinery at Premium Fabrics is considered to be quite antiquated and in need
of renewal, so TNS plans to invest a total of Rs 0.5 billion in capital expenditure in
each year 20X7 and 20X8. Allowable initial and normal tax depreciation is 25% and
10% respectively. Tax depreciation on existing capital assets is forecast to be Rs 150
million in 20X7 and Rs 100 million in 20X8, while accounting depreciation will fall
by 10% in each year.
100
Question Bank
Capital expenditure is forecast to be Rs 0.3 billion in 20X9 which is approximately

equivalent to total tax depreciation and total accounting depreciation in 20X9, which
is then expected to increase by 3% per annum thereafter, in line with inflation.
From 20X9, no material difference is expected between accounting and tax
depreciation.
Exhibit 4 – Additional notes re purchase of equipment from Germany

Memo prepared by finance department
If TNS goes ahead with purchasing the machinery from Germany, it will place the
order on 1 January 20X7 and make the payment on 30 June. The machinery will then
be delivered in September. The overall cost is expected to be EUR20 million.
Forecast exchange rates as at 1 January 20X7 are:
Spot (EUR/Rs) 112.18 – 112.44
3-month forward 0.67 – 0.61 premium
6-month forward 1.15 – 1.08 premium
101
23 YSJ Chartered Accountants (June 17)
YSJ Chartered Accountants (YSJ) is a firm offering audit, tax and consulting services
from two offices, based in Islamabad and Lahore. It was founded 20 years ago and has
grown steadily in a very competitive market, based on a good reputation for client
service. The Lahore office was opened 10 years ago when a competitor in that city was
acquired and rebranded, with the head of the competitor becoming the office's managing
partner. It has grown rapidly, including by the acquisition of two smaller firms, which
were integrated into the existing offices. The firm has 17 partners, 12 based in Islamabad
and 5 in Lahore. The most recent partners were admitted five years ago. Each office is
headed by a managing partner, and they report to the senior partner, who is based at head
office in Islamabad.
The firm generally earns much higher margins on consulting work than audit and tax,
but they tend to be one-off assignments, whereas audit and tax work recurs each year.
The offices reflect the distinct business environments in their locations and have a great
deal of autonomy. Staff tend to be loyal to their office and the managing partner, rather
than the firm as a whole. Management information systems are different in the two
offices, and use different technology.
The partners do not receive a salary, but divide profits between themselves on a broadly
equal basis, with some adjustments for additional responsibilities. There has been
increasing dissatisfaction with this system and the senior partner has proposed two
alternative approaches for discussion (see Exhibit 2).
You are the Partnership Accountant at YSJ, and the financial controller has asked you
to help her prepare this month's report to the partners by analysing the current financial
position of the two offices. Extracts from the most recent management accounts are
shown in Exhibit 1. She would like you to prepare sections of the report which:
(a) The new system will be an already developed system by a software firm and shall
be customized to meet the needs of YSJ. The system of the two regional offices
by interpreting the data given in Exhibit 1. (6 marks)
(b) Briefly evaluate the likely impact of the current and proposed remuneration
schemes on recruitment, motivation and behaviour of partners. (8 marks)
(c) Suggest two additional key performance indicators which YSJ could use to
evaluate partners and why they are appropriate. (4 marks)
(d) Evaluate the potential benefits which introducing a new database and executive
information system could have on performance management at YSJ, and practical
issues connected with the introduction of the new system (see Exhibit 3).
(4 marks)
(e) Discuss the tax implications of the proposed implementation for tax year 20X7
and for subsequent tax years (assume that entity has a special tax year ending 31st
December). (4 marks)
Requirement
Prepare the relevant extracts for the report to partners as requested by the financial
controller.
Total = 25 marks
102
Question Bank
Exhibit 1 – Management accounts for the two offices of YSJ for the years ended 31
December 20X5 and 20X6
20X6 20X5 20X6 20X5
Staff costs (380,337) (372,730) (227,469) (204,722)

(159,790) (154,996) (76,570) (69,679)
(42,250) (31,688) (25,232) (16,534)
2.8 1.6 1.8
16% 19% 20% 15%
Exhibit 2 – Extract from a memorandum sent by the senior partner

Since its foundation, YSJ has operated on the basis that partners are paid equally,
with adjustments for additional responsibility. This has helped to give everyone a
shared stake in the business. However, now that we have two substantial offices, we
should reconsider this policy. Two alternatives have been proposed:
(1) Starting in 20X7, we set a target for profit before interest and tax for each office,
based on the 20X6 figures. If an office exceeds its target, partners will receive
a 25% bonus on their standard profit share calculations.
(2) Partners are awarded 'points' based on their time served in the partnership,
success in winning new business and additional responsibilities. Profits are then
shared out among partners in proportion to the number of points they hold.
103
Exhibit 3 – Notes from a meeting with the financial controller
The partners are considering making a change to the information systems at YSJ.
Currently, each of the offices has its own systems and, within this, there are separate
systems for time tracking, finance and human resources. The system in Lahore is
based on the one used by the firm before it was acquired, and works in a different
way to the one used by the Islamabad office. Reports are compiled and manually
reconciled by the head office team in order to provide summary information for the
partner information pack which forms YSJ's main strategic information system.
However, the partners are considering the implementation of a new system based
on an integrated, single database that would be accessible via the web at both
offices by all authorised staff. The company network would be upgraded to allow
real-time input and updating of the database, although access rights will be
restricted so that staff can only enter or amend data relating to their own function
or site.
The database would support a management information system with more detail than
is currently available and a high-level executive information system.
The new system will be an already developed system by a software firm and shall be
customized to meet the needs of YSJ. The system will cost Rs 25million. Sales tax at
a rate of 17% shall be levied on its purchase. Customization will cost Rs 5 Million
and implementation team will be paid Rs 2 Million. Customization and
implementation will not attract sales tax.
Installation of the Software was completed on 31st May 20X7.
YSJ is not registered for Sales Tax. The software licence is for a period of 15 years.
104
Question Bank
24 Chromium Mining Ltd (June 17)

You work for the advisory department of the firm Zaheer Khan & Company, Chartered
Accountants (ZK). Chromium Mining Ltd (CML) is a key client of your department.
Your manager has asked you to accompany her to a meeting with Husain, the Finance
Director of CML.
CML is a long-established mining company which began mining chromite, but
subsequently diversified and gradually its main business came to be copper mining. The
price of copper has been in decline for some time and, although it has recently recovered,
it has led to a poor financial performance for CML over a number of years, and now the
company is facing liquidity issues. At the meeting, Husain explained that, in order to
survive the next few months and provide a basis for its recovery plan, the company
urgently needed to restructure its finances.
He went on to say, 'In the latest management accounts, the company has breached its
loan covenants relating to profitability and current asset ratio and so our bank, TBL, has
told us that our current borrowing is repayable in full, although we do not have the cash
to do so. They have given us until the end of the year to come up with a viable plan. The
bank may consider a refinancing package in the form of a loan, but if we cannot obtain
this, or alternative financing, there is a significant risk of bankruptcy. This would be a
tragedy as the board has a credible plan and we believe the company is viable.
We need some cash flow forecasts to present to the bank in support of our refinancing.
Owing to staff sickness I do not have anyone available in the team to do this, so please
could you prepare a five-year forecast based on the information in my forecast (Exhibit
1) and memorandum (Exhibit 2) which sets out two additional options for refinancing.
What I would also like from ZK is a report that compares the financing packages on
offer, including their cost, and provides a clear recommendation regarding the best
approach for CML to take, including the tax implications. Please could you also take
account of a note which our CEO has sent me?' (Exhibit 3)
Following the meeting, your manager asks you to draft a report in response to Husain's
request, in two separate sections:
(a) Section 1: Five-year cash flow forecast to support the loan application
(5 marks)
(b) Section 2: A comparison of the financing packages (14 marks)
(c) Husain would also like you to draft a brief note for him recommending how
the firm should respond to the chief executive's memo. (6 marks)
Requirement
Respond to the instructions from the manager.
Assume the current date is 1 October 20X7. Ignore turnover tax implications.
Total = 25 marks
105
Exhibit 1 – Forecast income statement for the year to 31 December 20X7
Rs'm
Sales 15,875
Cost of sales (11,310)
Gross profit 4,565
Other costs (4,374)
Finance costs (390)
Net loss before taxation (199)
Taxation 0
Net loss after taxation (199)
CML is currently engaged in disposing of loss-making businesses, restructuring and

development of new opportunities. This will require investment (net of cash receipts)
of Rs 800 million each year for the next 3 years, and Rs 200 million per year
thereafter. Turnover is forecast to reduce by 10% in 20X8, then increase by 5% each
year for the next 4 years. Gross margin will improve by 1% for the first 3 years and
then be stable thereafter and other costs will reduce by 10% in 20X8, then increase
by 5% each year for the next 4 years.
Opening cash, apart from the refinancing, is an overdraft of Rs 500 million.
Depreciation is expected to be Rs 350 million in 20X8 and remain constant. Any
changes in working capital are not expected to be material. Assume that there is no
material difference between tax depreciation and accounting depreciation. As at the
end of 20X7, CML is forecast to have brought forward losses for tax purposes of Rs
300 million.
Exhibit 2 – Memorandum from Husain

As we are now in breach of our covenants with TBL, it has indicated that it is not
willing to continue our current overdraft at its interest rate of 12% beyond the end of
this year. It is, however, willing to consider making a loan of Rs 3 billion at a rate of
15%, starting on 1 January 20X8, subject to acceptable cash flow forecasts. The loan
will be repaid in five equal annual instalments, at the same time as annual payments
for interest. This loan would partially replace our current overdraft. Therefore, CML
expects to pay Rs 120 million in interest on remaining amount of current overdraft,
over and above the interest on the new loan.
As an alternative, we have been in discussions with an investment house,
Cosmopolitan. They have provisionally agreed the following financing package:
CML will issue Rs 3 billion of 12% convertible Term Finance Certificates (TFCs) to
Cosmopolitan at par on 1 January 20X8. Cosmopolitan would have the right to
convert each Rs 1,000 of convertible TFCs into 12 ordinary shares in CML on 31
December 20Y3. Issue costs payable to professional advisers would amount to Rs 65
million. Under this agreement no dividends would be paid by CML before 20Y3.
The investors' expectation is that the share price will increase by an average of 5%
each year.
106
Question Bank
We have also had discussions with major shareholders who have provisionally
indicated that they would be prepared to support a rights issue. Rs 3 billion of new
shares would be issued on a 1 for 2 basis and at a discount of 20% on market value.
Note. Assume CML's current debt : equity ratio is 0.4 and will drop to 0.1 if the rights
issue goes ahead. The applicable tax rate is 30%, the risk-free rate is 6%, the market
rate is 13% and CML's current equity beta is 1.7, with a market value of Rs 85 per
share.
Exhibit 3 – Memo from Zohaib Malik, Chief Executive Officer PRIVATE AND
CONFIDENTIAL
Husain,
As you know, the survival of the business could depend on securing one of the
refinancing packages, and they in turn depend on the cash flow forecasts. Please can
you make sure our advisers understand this, and that it is vital that the forecasts
demonstrate we will be able to make all repayments. If need be, they should adjust
growth assumptions to make this work. You are aware that I am currently negotiating
with a major potential client in China and am very confident that we will win the
deal, so I really don't think repayment will be a problem. You can share this with the
advisers if you like but please don't circulate this any further. In particular, I am keen
that we do not bring this to the Board for discussion until we have secured the
financing.
Zohaib
107
25 SGC Construction (December 17)
SGC Construction (SGC) is a private engineering and construction company, based in
Lahore. It is a well-regarded business, with a recognised brand in the construction market
and a reputation for high-quality work with its key government clients. The company's
stated aim is to be the 'solutions provider of choice' in engineering and construction in
Pakistan.
Its growth over the years has been largely due to the efforts of its founder and Chief
Executive Officer, Mohsin Chaudhry. Mohsin Chaudhry is also the company Chairman,
and owns 50% of the company's equity. His daughter, who owns 10% of the equity, is a
qualified lawyer working in Lahore, and his son, who owns 5%, is an ambitious and
recently qualified engineer. The remainder of the equity is in the hands of a private
equity company, which invested in the company two years ago, encouraged by its
historic strong cash generation and perceived growth prospects.
SGC currently operates with a small Board, with the CEO and one other executive
director, the Chief Financial Officer (CFO) Mariam Syed. A representative from the
private equity company and a long standing friend of Mohsin act as the two non-
executive Directors. Another friend of Mohsin is the senior partner in the company's
firm of external auditors, who also perform internal audit functions.
Originally SGC worked on small and medium sized private sector projects, including
residential buildings, but several years ago the board took a strategic decision to change
its focus to larger projects. SGC now specialises as the lead contractor on major
infrastructure projects which it wins through a tendering process, working with a range
of subcontractors on the building of infrastructure, including roads and bridges using
standardised designs. The board still believes that this was an appropriate strategy to
pursue, despite the Pakistan government taking measures recently to stimulate the local
real estate industry with various incentives that have benefited those of SGC's
competitors who have continued to engage in house construction.
The company has a pool of highly-trained and experienced staff who contribute to SGC's
ability to deliver on large, unique and complex projects. The Board believes that its
project tendering, complex and enormous levels of resources planning and management
systems (including monitoring and control of work provided by its sub-contractors and
suppliers) are among the best in the industry and have helped it to do well in a very
competitive market. About two-thirds of its annual revenue, which all arises in Pakistan,
comes from government clients for infrastructure projects. SGC is now one of the
dominant companies in the market for government contracts, most of which are long
term and have a duration of between three and five years.
After several years of strong revenue and profits growth, SGC's business has been
adversely affected by economic slowdown. The board decided to reduce the latest annual
dividend payment, but considers it a top priority to restore dividend payments to
previous levels as soon as possible. Some action has already been taken to investigate
where operating costs could be controlled, but the board acknowledges that more needs
to be done.
The Board has attributed the poor financial results in 20X7 to the following factors:
 A number of projects (and contracts) were completed in early 20X7, and these
have not been replaced with new business.
108
Question Bank
 The government postponed the start of several new infrastructure projects which
SGC had planned to tender for.
 There has been a delay in completing two major projects during 20X7, and as a
result there has been significant over-spending on them.
 SGC lost out on some projects to competitors and it also had to accept lower
margins on certain contracts in order to retain the client
Major competitors (see Exhibit 3) have appeared to perform much better during the
previous two to three years, both because their operations are more diverse in the
domestic market, and because some of them have construction projects in other
countries. However, Mohsin Chaudhry believes that the current problems faced by
SGC's business are short term in nature; he expects a 20% recovery in revenues in the
next financial year, and he has said that he is prepared to increase SGC's prices if he has
to. The Pakistan government is expected to invest in new infrastructure projects to
stimulate the construction sector, and Mohsin Chaudhry is confident that SGC should be
able to win more contracts. There are numerous infrastructure development projects
being proposed, including a large number of flyovers, underpasses, highways, tunnels,
dams, roads and industrial projects.
However, the CFO has cautioned against over-optimism and believes that a return to
profitability might take much longer.
Report required
You are the senior accountant of SGC. You have been reviewing the summary financial
statement data (Exhibit 1) and some additional notes on issues currently facing the
company (Exhibit 2).
The CFO Mariam Syed has asked you to prepare a draft report which addresses each of
the following segments.
(a) The Board of Directors are concerned about maintaining the company's
competitiveness, and it has requested an assessment of the market environment
that SGC operates in, along with an evaluation of the key risks that the company
currently faces. (10 marks)
(b) In addition to the environmental analysis, the Directors have requested a review
of the main features of the company's recent performance to help them understand
where improvements need to be made, or particular strengths developed.
(9 marks)
(c) Various strategic options for growth have been identified for the company in
Exhibit 2. For the options identified, explain the potential for the company's
growth and make a recommendation to the Board of Directors as to which
strategic option should be pursued. (12 marks)
(d) Assume that SGC has decided to opt for the strategic option of overseas markets
(Exhibit 3) and acquire 100% shareholdings of BKM Building.
109
Discuss the taxability of BKM and the tax implications of the acquisition on SGC
(actual calculations are not required). (9 marks)
(e) With regard to the proposed acquisition of BKM that was discussed in part (c),
the CFO has been asked by the board for an estimate of the value of the BKM
brand, and suggestions as to how the company might develop a strategy for the
BKM brand in Pakistan. (Ignore taxation.) (10 marks)
Requirement
Prepare the sections of the report requested by CFO Mariam Syed. Assume the current
date is 30 September 20X7.
Total = 50 marks
Exhibit 1 – Summary financial statements

Summary statement of comprehensive income for the year ended 30 June
20X7 20X6
158,559 227,190
(134,775) (178,142)
(28,541) (37,035)
(4,757)
(2,784) (2,763)
(7,541)
– (2,960)
(7,541)
(1,500) (4,545)
(9,041)
110
Question Bank
Summary statement of financial position as at 30 June
20X7 20X6
Rs'm Rs'm Rs'm Rs'm
Total non-current assets 212,717 200,711
Current assets:
Inventories 6,390 12,779
Due from customers for
contract work-in-progress 31,139 62,277
Trade receivables and 8,969 17,937
prepayments
Cash and cash equivalents 9,501 18,896
Total current assets 55,999 111,889
Total assets 268,716 312,600
Current liabilities:
Due to customers for
contract work-in-progress 1,656 2,208
Trade payables and
accruals 15,750 37,485
Bank loans 23,566 17,742
Total current liabilities
40,972 57,435
Non-current liabilities:
Bank loans 55,980 74,360
Equity:
Share capital and capital 57,595 57,595
reserves
Retained earnings 114,169 123,210
Total equity 171,764 180,805
Total equity plus
liabilities 268,716 312,600
111
Summary statement of cash flows for the year ended 30 June 20X7
Rs'm Rs'm
Cash flows from operating activities
Loss before interest and taxation (4,757)
Adjustments for:
Depreciation 26,830
Operating cash flow before changes in 22,073
working capital
Changes in working capital:
Reduction in inventories 6,389
Reduction in net amounts due from customers 30,586
for contract WIP
Reduction in receivables and prepayments 8,968
Reduction in trade payables and accruals (21,735)
24,208
Net cash inflow from operating activities 46,281
Cash flows from investing activities
Purchase of property, plant and equipment (38,836)
Net cash flows used in investing activities (38,836)
Cash flows from financing activities

Repayment of loans (12,556)
Dividends paid (1,500)
Net cash outflows from financing activities (16,840)
Net change in cash and cash equivalents (9,395)

Cash and cash equivalents 1 July 18,896
Cash and cash equivalents 30 June 9,501
Exhibit 2 – Strategic options for SGC

Extract from a report by the son of Mohsin Chaudhry
Current strategy
Several years ago, the Board of Directors decided to change focus away from small
and medium-sized projects in favour of larger public sector ones. However, the focus
on large projects may have narrowed the business too much in comparison with
competitors.
Having said that, I believe that SGC should continue to strengthen links with the
Pakistan government via tendering for new projects and focussing on its core
strengths: proven experience, engineering and construction expertise and project
management.
112
Question Bank
Overseas markets
The company could aim to pursue sales in overseas markets. SGC should be able to
capitalise on its good reputation by tendering for contracts overseas. One option is to
make an acquisition of a local company that will give SGC access both to overseas
markets and new sectors, and I have been made aware of a retail construction
company based in Pakistan, BKM Building (BKM), which is seeking a buyer. It has
significant experience of building large shopping centres in Malaysia and a strong
management team. Forecast financial information for BKM for the coming year is
attached as an appendix below.
Return to former markets
A return by SGC to small and medium sized housebuilding projects could provide an
attractive avenue for revenue growth. As we know, the Pakistan government has
taken measures recently to provide various incentives that have benefited house
construction companies. With the government moving to stimulate real estate and
residential construction, SGC might even consider acquisition of a specialist firm of
local architects that could enhance its team and provide bespoke consultancy services
to the private residential housebuilding sector.
New technologies
The construction industry has in the past been characterised by strong adherence to
traditional methods, but sustainable development is now on the agenda of many
businesses, including those in the construction industry. Climate action plans (such
as the Paris climate accord) will continue to be a factor in global development.
United Nation member states (including Pakistan) have adopted the 2030 Agenda for
Sustainable Development, which includes a set of Sustainable Development Goals
(SDGs) to tackle climate change by 2030. The modern construction industry is likely
to be increasingly characterised by innovation in materials, technologies and
practices, and this should be recognised in future SGC strategy in order to
differentiate it from competitors.
Appendix
BKM: Forecasted profit and loss statement
Forecast
Rs'000
Revenue 81,356
Cost of sales (all variable) (47,916)
Gross profit 33,440
Fixed costs (12,000)
Depreciation (8,000)
Profit before tax 12,240
Tax (3,060)
Net profit 9,180
113
The BKM brand is well recognised in Malaysia as a builder of large shopping centres.
Surveys show that its brand is trusted in the construction sector and its 'competitively
priced, high-quality' position is one which is generally understood by its clients.
However, the brand is comparatively unknown in Pakistan.
The BKM board has claimed, based on market research, that compared to companies
whose brand is less well known in Malaysia, construction volumes and revenue are
significantly higher at BKM. Specifically, it is estimated that the BKM brand accounts
for 15% of its overall sales volume.
BKM has spent significant amounts in recent years on B2B advertising, which has
been specifically targeted at brand support and promotion in the Malaysian retail
construction sector. It is estimated that for a competitor to establish a similar retail
construction brand from a zero base in Pakistan would require many years' advertising
expenditure, costing around Rs 3.2 million per year, with a present value of Rs 40
million.
A large US construction company, Slab Inc, offered BKM the equivalent of Rs 10
million in 20X0 to acquire the global rights to the BKM brand outside Pakistan. This
offer was rejected by the BKM board.
Exhibit 3 –
Competitors PDY Ltd
PDY Ltd offers a range of construction services ranging from housing to shopping
centres and involvement in government projects. PDY has recently indicated that, as
part of its expansion strategy and following a phase of rigorous cost control, it plans
to increase its participation in government infrastructure contracts and hopes to erode
SGC's market position with planned increase in competitive tender bids.
RTP Ltd
This company specialises in the construction of warehouses and apartment buildings
both in Pakistan and overseas.
IZC Ltd:
Specialises in engineering solutions for skyscrapers and dams around the world, IZC
Ltd has seen its revenues grow during 20X7.
APV Ltd:
This company builds sports centres, educational institutions and shopping centres in
Pakistan.
114
Question Bank
26 TTA Airlines (December 17)

TTA Airlines (TTA) is a Pakistan based scheduled airline, specialising in long-haul
flights from Karachi. It caters for both business and leisure travellers. Established over
30 years ago, when it acquired its initial fleet of aircraft, along with the rights to routes
and landing slots at Karachi's Jinnah International Airport, the fleet has since expanded
through purchasing and leasing additional aircraft.
TTA has always operated in the long-haul, intercontinental market with routes from
Karachi to America, Asia and Africa. Seats on TTA aircraft are arranged by class in
increasing order of price from premium economy to business class and first class. TTA
has always prided itself on the level of service that it provides to its first class passengers,
and its business class service is gradually becoming more highly regarded despite some
recent problems with staff, cabin facilities and food quality on some of its routes.
The TTA board has been considering the possibility of TTA operating a new route from
Karachi to Sydney, Australia. If the company decides to do this, new aircraft will need
to be acquired and these will require financing. The details of the proposal are set out in
Exhibit 1.
The TTA board has also been reviewing the company's long-term business plan. At a
recent meeting, it agreed that the company needed to focus clearly on a limited number
of 'strategy drivers' – aspects of the business that should drive the company's strategy in
the future. These are set out in Exhibit 2.
You are a special projects accountant at TTA, and the financial controller has asked you
to help him by preparing some of the sections for a strategic report for the board. He
would like you to prepare sections of the report which:
(a) Calculate the revenue per week, for one aircraft, expected to be generated by each
of the two proposed seat configurations. Provide a reasoned recommendation as
to which seat configuration would be preferable, taking account of all relevant
factors. (7 marks)
(b) Compare the two methods of financing the new aircraft, providing supporting
calculations and explanations. Provide a reasoned recommendation. State any
further information that would be needed before making a final decision.
(12 marks)
(c) Suggest suitable key performance indicators (KPIs) for each of the strategic
drivers in the board's draft business plan. (6 marks)
Requirement
Prepare the relevant extracts for the report as requested by the financial controller.
Total = 25 marks
Notes
1 Applicable tax rate is 30% payable in the same year. Allowable initial tax
depreciation rate on aircraft is 25%. Tax depreciation is allowable on straight
line basis.
2 As a working assumption, use an annual discount rate of 10%.
115
Exhibit 1 – Details of proposal to operate a new route to Australia Introduction
A new route with landing slots has become available between Karachi and Sydney,
Australia. This route would start on 1 October 20X8.
Operating data
The new route would require the acquisition of two new identical aircraft which are
capable of flying all the way from Karachi to Sydney. TTA proposes to operate the
route with one flight per day in each direction. Each aircraft will only operate one
flight per day.
The proposed prices of seats for a one-way flight are:
Premium economy Rs 80,000
Business class Rs 150,000
First class Rs 300,000
Market research findings
Preliminary market research conducted within the business community in Pakistan
has indicated that the number of passengers per one-way flight between Karachi and
Sydney, based on the proposed prices and the company's current advertising strategy
and brand image, would be as follows:
Day Premium economy Business class First class
passengers passengers passengers
Monday 200 100 15
Tuesday 210 70 15
Wednesday 210 80 15
Thursday 220 80 15
Friday 240 90 15
Saturday 240 90 20
Sunday 240 70 20
The above table represents a typical week between Karachi and Sydney. Flights are
expected to operate every day of the year.
TTA is confident that the forecast level of demand will remain consistent for the next
few years. However, if long-term demand for the new route to Australia is lower than
anticipated, then one or both aircraft could be taken out of service from 30 September
20Y1. It is estimated that the fair value of each aircraft will be Rs 3,400 million at 30
September 20Y1.
116
Question Bank
Configuring the aircraft seating

The two possible configurations for an aircraft are:
 Configuration 1: 15 first class seats, 90 business class seats and 240 premium
economy seats.
 Configuration 2: 20 first class seats, 70 business class seats and 250 premium
economy seats.
The seat configuration will be the same in each of the aircraft, and once installed it
cannot be changed.
Financing the aircraft
The purchase cost, per aircraft, is expected to be Rs 5,500 million, payable on
1 October 20X8. TTA would borrow to finance the aircraft purchase. Each aircraft
would have an expected useful life of 10 years, after which time it is forecast that it
could be sold for Rs 2,000 million.
As an alternative to purchasing, TTA can lease the aircraft for 10 years. Annual lease
rentals for each aircraft would be Rs 700 million and would be payable annually
commencing 1 October 20X8. The lease contract would contain a break clause which
would permit TTA to cancel the lease after five years, if the route does not prove
successful, in return for a penalty payment per aircraft of Rs 1,900 million on that
date.
It is not necessary that both aircraft are required to be financed in the same way.
Exhibit 2 – Strategy drivers

The TTA board has identified three drivers for the business:
(1) Geographic expansion
(2) Promoting the TTA brand
(3) Selling holiday packages (flight plus hotel deals under a new brand 'TTA
Holidays')
A strategic risk for TTA is that competitor airlines will drive their businesses in
similar ways, but more successfully. To counter this risk, the board has asked the
Chief Executive Officer to set performance targets for each of the strategic drivers,
with an appropriate number of key performance indicators (KPIs) for each, to monitor
actual performance over the period of the business plan.
117
27 Paragon Fitness Ltd (December 17)
Paragon Fitness Ltd (PFL) is a company operating in the fitness sector in Pakistan. It
provides training space and equipment to its members through its network of fitness
centres and has two major revenue streams: monthly membership fees and personal
training fees (individually tailored fitness programmes developed for members by
personal trainers).
The business was founded 30 years ago by Kashif Malik, who wanted to take advantage
of the growing interest in health and fitness. Dreams of expansion have never been
realised, largely because of a history of disagreements on the way that the business
should develop. Kashif Malik is now the company chairman. The current CEO is his
brother, Faisal, who is an ICAP chartered accountant. The executive management team
consists of the CEO, CFO Samia Kundi (ICAP Chartered Accountant) and COO Izad
Malik (Faisal's son), who is also an ICAP chartered accountant.
Market conditions
In recent years the fitness centre market has become increasingly crowded and
competitive, and profit margins have been squeezed. The management team at PFL
believes that the current challenges reflected in its latest financial statements are due to
a combination of factors, including less willingness to pay high prices for health and
fitness services.
Accordingly, PFL has maintained its membership base by keeping its membership fees
low, and occupying the lower end of the fitness market when compared with competitors
who offer more modern facilities and innovative exercise programs and classes. The
company is also reviewing costs, having taken the decision at the end of 20X5 to restrict
expenditure on new equipment, keep centre facilities simple and maintain staff numbers
at current levels. There has been some concern about maintenance standards and a recent
incident has highlighted the problems (Exhibit 3).
Membership contracts with PFL require the member to pay monthly membership fees
up front, for a minimum of 24 months. Having signed a contract, members must make
payments for the full period.
Human resources
Following a report from a human resources consultancy on PFL's problems with staff
retention, the company introduced a generous bonus scheme for the achievement of
certain targets, aimed at retaining its centre managers, with the result that some of the
longer serving managers are now on remuneration packages that are above the industry
average.
Each of PFL's 10 fitness centres operates with a centre manager and around 15 members
of staff. Many centre managers are saying that the company needs to provide more
training to help develop a closer rapport between staff and members, which will
encourage members to maintain their memberships. Many members of centre staff have
expressed enthusiasm for training in areas such as motivational psychology, as well as
disciplines such as yoga or pilates.
118
Question Bank
Financial performance 20X7

The company is profitable. However profits have been falling since 20X5, and
performance in 20X7 is reflective of the challenging market. Despite this, there is
optimism that profit growth will be restored if the correct strategy is found, and some
options have been put forward (Exhibit 2). Summary financial statements for PFL for
the three years ended 30 September 20X7 are shown in Exhibit 1.
You are an accountant working in the head office of Paragon Fitness and have been
asked by your manager, the Chief Accountant, to accompany him to a meeting with
Samia Kundi, CFO, at which various issues are to be discussed. Following the meeting,
your manager asks you to draft a report in response to Samia's request for additional
information, in separate sections:
(a) Calculate PFL's working capital between 20X5 and 20X7. As far as the
information allows, analyse the probable impact on working capital of each of
the strategic options that have been identified, assuming that they are mutually
exclusive, and consider how any financing requirements might be met (10 marks)
(b) With reference to the comments made by the CEO, explain the role that human
resources management should play in the acquisition of Prime Performance and
which human resources issues need to be addressed.
(8 marks)
(c) With reference to the ICAP Code of Ethics, what are the issues presented by the
events described in Exhibit 3? In your answer, comment upon the appropriate
course of action to be taken. (7 marks)
Requirement
Respond to the instructions from your manager.
Total = 25 marks
Exhibit 1 – Summary financial statements for the three years ended 30 September
20X7 for Paragon Fitness Ltd
Year ended 30 September 20X5 20X6 20X7
211.0 208.0
Staff costs (24.6) (26.4) (26.5)
(20.3) (21.4) (19.9)
(98.6) (99.0) (98.4)
(39.0) (49.0) (43.0)
(182.5) (195.8) (187.8)
119
20X5 20X6 20X7
Profit before interest and tax

(1.0) (1.1) (1.1)
0.2
Profit before taxation
(4.5) (3.7) (3.1)
Profit after taxation
(14.2) (11.6) (11.6)
Retained profit
Summary statement of financial position

Rs'm Rs'm Rs'm
Non-current assets
Leasehold improvements 87.0 91.7 95.9
Fixtures, fittings and equipment 9.3 6.3
11.2
Total non-current assets 98.2 101.0 102.2
Current assets
Inventory 1.8 2.1 2.0
Receivables 3.5 3.2 3.4
Cash 8.6 16.0 16.7
Total current assets 13.9 21.3 22.1
Total assets 112.1 122.3 124.3
Current liabilities
Payables 16.5 15.2 14.0
Advance membership income 9.0 9.5 10.0
Total current liabilities 25.5 24.7 24.0
120
Question Bank
20X5 20X6 20X7

Rs'm Rs'm Rs'm
Borrowings 25.0 28.0 26.0
Total non-current liabilities 25.0 28.0 26.0
Total liabilities 50.5 52.7 50.0
Equity
10.0 10.0
Share capital 10.0
Reserves 51.6 59.6 64.3
Total equity 61.6 69.6 74.3
Equity and liabilities 112.1 122.3 124.3
Note. Borrowings represent a Rs 40 million revolving credit facility from PFL's
bankers which has been agreed until 20X9.
Extracts from statement of cash

flows
Rs'm Rs'm Rs'm
Cash generated from operations 38.1 32.1 28.4
Net interest paid (0.6) (0.9) (0.8)
Dividends paid (14.2) (11.6) (11.6)
Income tax paid (4.5) (3.7) (3.1)
Net cash from
operating activities 18.8 15.9 12.9
Cash flows from investing activities:
Acquisition of property,
plant and equipment (25.5) (11.5) (10.2)
Net cash used in investing
activities (25.5) (11.5) (10.2)
Cash flows from financing
activities:
Increase/(decrease) in
borrowings 2.0 3.0 (2.0)
Net cash from
financing activities 2.0 3.0 (2.0)
121
20X5 20X6 20X7
Rs'm Rs'm Rs'm
(4.7)
Cash and cash equivalents at

30 September
Exhibit 2 – Strategic options

The three cases below describe significant strategic options which PFL is considering.
1. Opportunity to manage in-house gyms: Maira Shah, a friend of the Malik
family who is a successful property developer, has offered PFL the opportunity
to manage six gyms located within one of her company's newly built apartment
complexes. The business model for these gyms would involve PFL managing
and operating them in exchange for a fixed monthly fee, receivable six monthly
in arrears. PFL would have no responsibility for capital investment, but would
need to employ additional staff. Each gym would be approximately half the size
of the average fitness centre currently operated by PFL.
2. Accelerated investment program: Impact Fitness, a very large and successful
international fitness chain has announced that it will enter the Pakistan market.
In order to protect PFL's market position against this competitive threat, the
COO, Izad Malik, has argued that there is an urgent need to accelerate
investment in new equipment in order to maintain profitability and improve the
potential for growth in the business.
3. Acquisition opportunity: Prime Performance Ltd is a rival fitness centre
operator in Pakistan. PFL has been contacted by an investment bank acting as
adviser to Prime Performance regarding the sale of its network of premium
fitness centres. It is estimated that the cost of these fitness centres would be in
the region of Rs 45–55 million.
Faisal Malik the CEO has said: 'Although I like the idea of the acquisition of
Prime Performance, I am a bit concerned about the employment issues which it
appears to be having at the moment. Following new investment, costs have been
reduced at Prime (as redundancies were made following the introduction of
some new operating methods) but not to the extent that management expected.
There are ongoing disputes in response to new working patterns for centre staff,
and proposed further changes to working practices that staff believe will
undermine the premium position that Prime occupies. I don't want an acquisition
which makes financial sense to be undermined by human resources issues, and
therefore I think we need to give careful consideration to the 'people' side of the
acquisition as well as the 'numbers' aspects of it.'
122
Question Bank
Exhibit 3 – Ethical concerns

One of PFL's most successful fitness centres is extremely popular with local office
workers, who visit the centre early in the morning, at lunchtimes and after work. The
building in which it is located is relatively old, and PFL is the sole owner and
occupier. The board of PFL have been aware for some time that this building (along
with other PFL centres) is in need of refurbishment and minor structural
improvements, but it has never been regarded as unsafe.
This centre has also had staffing problems. Its previous manager left PFL for a
competitor, and while a replacement manager was being sought the centre was being
managed by Izad Malik's daughter, Laila. She was appointed by Izad with very little
assessment of her suitability, as there was pressure to put an interim manager in place.
Unfortunately, due to the pressures of the role and having to deal with a backlog of
customer complaints, Laila failed to tell PFL head office that a neighbouring business
had informed her that there was a risk to the structure of the building in which the
fitness centre operated, following building works that took place next door. By the
time a formal letter on the matter was received at head office, advising of the possible
need to vacate the building until it could be investigated, nearly a month had passed
without any adverse incident. Without consulting Kashif, the Chairman, and while
Izad was on leave, Faisal Malik, the CEO, decided not to take any action. On his
return to work, Izad was surprised to hear of this decision, but went along with it on
the grounds that the centre concerned had the highest number of visits per week of
any of its branches, and so it was important that it be kept open. In any event, nothing
had yet happened to indicate that the building was unsafe.
Several weeks after Izad's return to work, part of the ceiling collapsed in the centre,
breaking both arms of a member who was using a rowing machine and injuring many
others. The neighbouring business has used social media to point out that PFL was
warned. In response, PFL has denied that it received sufficiently detailed
communication about the potential damage to the building, or any firm indication that
there was anything seriously wrong. Laila has been told by Izad not to make any
public comment for the time being.
The denials by PFL have limited the damage, with most public anger directed towards
the building contractor who undertook the works that appear to have caused the
problem. For its part, the building contractor has denied any responsibility for
structural damage, suggesting that PFL should be held responsible for not maintaining
its properties to a sufficient standard.
A full review has been launched into the affair, and a complete report given to Faisal
and Kashif Malik which details exactly what occurred. Faisal and Kashif are
considering their next actions; the report is highly critical of PFL's approach to
building safety in this instance, and the brothers intend to suppress it as they believe
that this portrayal is unfair. Izad Malik has told Faisal and Kashif that he does not
agree with them, saying that the best approach is to publish the report and forcefully
deny that PFL ever knowingly compromised safety. He has also decided to conduct
his own internal review of conditions at each of the fitness centres with a view to
proposing a programme of improvements.
123
28 XYZ Industries (June 18)
XYZ Industries Ltd (XYZ) manufactures, repairs and services equipment for mining
companies. Its only factory is in Hyderabad, and all of its sales are made in Pakistan. Its
CEO is Farukh Dawar.
Some of the equipment supplied by XYZ is standard across the industry, and can be
supplied without any additional customisation. Other items must be manufactured on
receipt of specific customer orders, and the manufacturing process can take anywhere
between a few days and six weeks for more complex products. While customers usually
plan their purchases many months in advance, some orders may be unplanned, for
example, when a broken piece of equipment such as a drill or pump has to be replaced
at short notice. XYZ also operates a network of depots throughout Pakistan, providing
both planned maintenance services and all emergency repairs for the equipment that it
sells.
The equipment made by XYZ is generally too heavy to be transported economically by
air, so it is normally distributed via road or rail links within Pakistan.
In the year ended 31 December 2017, trading conditions for XYZ were challenging, as
mining companies in Pakistan were reluctant to expand their operations or invest in new
equipment in a climate of continued economic and political uncertainty. The XYZ board
has decided that in order to promote revenue growth, the company needs to expand
geographically. Malaysia, where there is significant mining activity, has been identified
as a suitable location. A base in Malaysia could supply customers located in Malaysia,
and other customers in the south-east Asia region. Two alternative strategies are being
proposed:
(1) To establish a subsidiary in Malaysia with its own manufacturing capability
(known as 'Strategy 1')
(2) To establish a division in Malaysia which distributes equipment manufactured in
Pakistan (known as 'Strategy 2')
Strategy 1
This would involve setting up a Malaysian subsidiary to manufacture equipment at a
new factory, for distribution to customers in Malaysia and south-east Asia by sea.
Malaysian Equipment Inc (MEI), would be incorporated in Malaysia where the currency
is the Malaysian Ringgit (RM). The new factory would be built in Malaysia for an
estimated initial cost of RM 195 million. This would be financed partly by an issue of
shares, but mainly by debt. The XYZ treasurer recently left the company, but had already
identified two alternative methods of debt finance (Exhibit 1).
Much of the equipment manufactured by MEI would be similar to that manufactured in
Pakistan, but there would need to be variations to accommodate the different activities
of Malaysian and south-east Asian mining industries, and the different commodities that
are mined in the region. The capacity of the Malaysian factory would be about one-third
of the existing factory in Hyderabad. Skilled staff, supply chains and production
facilities would need to be developed.
Components and materials for the new factory would be sourced from Malaysian
suppliers. Staff would be recruited locally, and would include engineers responsible for
repairs and maintenance of the equipment sold across the region.
124
Question Bank
Strategy 2
Under this strategy, a distribution centre would be built in Malaysia, at a cost of RM
12.5 million, which could be financed from XYZ's operating cash flows. Standard
equipment would continue to be manufactured in Pakistan, and transported to the
distribution centre by sea, from where it would be sent to customers in Malaysia and
south-east Asia. Made to order items would be sent directly to the customer from
Pakistan.
Under Strategy 2, the Malaysian operation would be a division, managed from the
Pakistan head office. A group of engineers based in Malaysia (comprising about half the
number required for Strategy 1) would be responsible for repairs and maintenance of the
equipment sold.
Under either strategy, construction work and other preparation would commence on 1
January 2019, and would then take one year to complete. Trading in Malaysia and south-
east Asia would then commence on 1 January 2020. The former treasurer provided
summary forecasts of operating profit for both strategies (Exhibit 2).
The XYZ board has not yet made a final decision on which of the strategies to adopt,
and no information on its intentions, or either of these options, has been made public.
No risk assessment of either strategy has been carried out.
Report required
You are an accountant reporting to Saira Kundi (FCA), the Chief Financial Officer of
XYZ. You have been reviewing the information prepared by the treasurer – the finance
methods for Strategy 1 (Exhibit 1) and the summary forecasts of operating profit under
each strategy (Exhibit 2).
You have been asked by Saira Kundi to prepare a draft report for the XYZ board which
addresses each of the following segments.
(a) For the two alternative strategies:
(i) Determine the net present value (NPV) in Pakistan rupees at 1 January
2019. (5 marks)
(ii) Evaluate and explain the risks of exchange rate fluctuations, including
calculations of the sensitivity of the NPV to future exchange rate
movements. (10 marks)
(iii) With specific reference to the products and services that XYZ offers,
evaluate the benefits and risks associated with each strategy, and
recommend the preferred strategy to adopt. (10 marks)
(b) Compare the two proposed debt finance methods for Strategy 1 and give a
recommendation on which method to use. (10 marks)
(c) Discuss the income tax implications if XYZ opts for Strategy 2.
Note. Actual calculations are not required (8 marks)
125
(d) Saira is concerned about some ethical issues for XYZ. She has passed you an
email from Farukh Dawar which details a proposed collaboration with AUG Inc,
a large Malaysian mining company (Exhibit 3). As part of your report, provide
notes explaining any ethical issues for XYZ arising from this proposed
collaboration and how these should be addressed. (7 marks)
Requirement
Prepare the sections of the report requested by Saira Kundi.
Total = 50 marks
Exhibit 1 – Finance methods for Strategy 1, prepared by the XYZ treasurer

The XYZ board estimated that the financing needed for Strategy 1 would be RM 195
million. Our initial working assumption is that the exchange rate will be RM 1 = Rs
25.
The board decided that the level of equity finance for Strategy 1 will amount to RM
25 million, with the remaining RM 170 million needing to be debt financed, using
one of the following alternative methods:
Finance Method A
On 1 January 2019, the Malaysian subsidiary, MEI, would raise a 15-year loan of
RM 170 million from a Malaysian bank, at an annual fixed interest rate of 5%. XYZ,
as the parent company, would provide guarantees to the Malaysian bank for the
repayment of the loan.
Finance Method B
On 1 January 2019, XYZ would raise a Rs 4,250 million, 10-year loan from a
Pakistan bank, at an annual fixed interest rate of 4.8%. XYZ would then immediately
make a loan to MEI of RM 170 million. This would be a 15-year loan, at an annual
fixed interest rate of 5%.
Exhibit 2 – Summary forecasts of operating profit and working assumptions

XYZ staff travelled to Malaysia to undertake market research, investigate proposed
operations and estimate costs. The following forecasts were then prepared:
Strategy 1
It is anticipated that it would not take long for the reputation of MEI's new factory to
become established, so MEI would spend the year 2020 growing its share of the
market. The sales figure for the year ending 31 December 2021 would then remain
at that level in subsequent years.
126
Question Bank
Summary forecasts for MEI are as follows for the years ending 31 December
2020 2021 and onwards
59,000
(13,140) (19,125)
(29,350) (29,750)
(16,815) (17,100)
(10,000) (10,200)
(10,305)
Strategy 2
(290,500) (11,620)
(75,000) (3,000)
(270,000) (10,800)
(35,000) (1,400)
127
Working assumptions
 For both strategies, all construction and other preparation work will commence
on 1 January 2019 and all initial cash outlays will be made on that date.
 For both strategies, trading will commence on 1 January 2020.
 The risk-adjusted annual weighted average cost of capital for Strategy 1 is
estimated at 10%, and that of Strategy 2 has been estimated at 8%.
 The exchange rate will be constant at RM 1 = Rs 25.
 For Strategy 1, all costs incurred, and all revenues earned, are in RM.
 For Strategy 2, all operating costs are incurred in Rs and all revenues are earned
in RM.
 Operating cash flows will arise at year ends.
 All cash flows will be remitted to the parent company in Pakistan.
 Ignore tax.
Exhibit 3 – Offer of collaboration from AUG Inc – email from Farukh Dawar to
Saira Kundi
Good morning Saira,
As you know, last week I received an email from AUG Inc in Malaysia, offering to
collaborate with XYZ. I include an extract below:
'The AUG board is aware that XYZ is considering opening a new factory in Malaysia,
operating through a newly-formed subsidiary, MEI. As you will be aware, AUG is a
major mining company, with Malaysia being our main market. We are always
interested to hear about new suppliers, and would like to discuss whether MEI could
become AUG's preferred equipment supplier for its Malaysian and south-east Asian
operations, on terms that we hope can be discussed in the near future. We are sure
that a mutually beneficial arrangement could be made, if AUG were to make certain
assurances in regard to the amount of business that it could give to MEI. We would
welcome a meeting with all members of the XYZ board to take this proposal further.'
Saira, I understand that you have today declared a conflict of interest, in that your
brother lives in Malaysia and is on the board of AUG. The XYZ board has expressed
concern about any ethical issues that may arise from this relationship when we enter
into any negotiations with AUG. I would like you to draft some notes for the board
addressing these issues that will put their minds at rest.
I look forward to your response,
Farukh Dawar
128
Question Bank
29 KIT Solutions (June 18)

KIT Solutions (KIT) is a listed IT company based in Pakistan which operates through
three divisions: Software, Hardware and Training. It sells its products and services to
both individual and business customers, but the company has performed poorly in recent
years. A significant proportion of KIT's ordinary shares are still held by the private
equity firm, PPZ, and pressure from PPZ about the poor share price performance has
resulted in the recent appointment of a new Chief Executive, Masood Khan, who has
been tasked with improving performance.
KIT's Software division (which sells hundreds of types of software package, as well as
hundreds of different games) and the Training division (which offers training courses in
software applications and general computer use) have performed reasonably well, but
both of their divisional heads believe that these two divisions have suffered because most
of the company's available funds have been provided to the Hardware division, in an
attempt to help it to become established after it was first set up.
The Hardware division was set up with a purpose-built factory in Pakistan to diversify
into the manufacture of items such as computer cases, motherboards, central processing
units, monitors and disk drives, but it has struggled to compete with established, multi-
national suppliers. It has continued to perform below expectations, and KIT's board has
agreed to sell the Hardware division on 31 March 2019 for net cash proceeds of Rs 3,000
million, and withdraw from the hardware market completely. The board is still deciding
how to use the net cash proceeds in the longer term.
Report required
You are a newly appointed senior accountant at KIT, and you report to the chief financial
officer (CFO). With the CFO currently away from the office, you have been asked by
Masood Khan to review the forecast information in Exhibit 1, along with some notes on
alternative uses of the net cash proceeds from the sale of the Hardware division (Exhibit
2). Masood Khan has asked you to prepare a draft report which addresses each of the
following segments:
(a) (i) Analyse the financial and strategic implications of the KIT board's decision
to close the Hardware division, including key ratios. (9 marks)
(ii) Explain the likely effects on the risk profile of KIT, and on its share price,
of each alternative use of the net cash proceeds from the sale of the
Hardware division. (7 marks)
(b) Masood Khan has drawn your attention to notes that he made soon after his
appointment (Exhibit 3). With reference to the Code of Corporate Governance,
identify improvements that could be made in the governance structure of KIT.
(4 marks)
(c) You have also been given an extract from management accounting information
related to the Software division (Exhibit 4). Identify and justify the additional
information that should be made available at divisional management level to
assist future decision making for sales and customer management in the Software
division. (5 marks)
Requirement
Respond to the instructions from Masood Khan. Total = 25 marks
129
Exhibit 1 – Forecast performance
Forecast performance for the year ending 31 December 2018
Training Hardware Software
690 6,290
650 95 700 1,445
100 75 200 375
550 20 500 1,070
11,950
19,000
5,000
500 550 2,050
Exhibit 2 – Alternatives for use of the net cash proceeds from the sale of Hardware
division
Alternative 1
Purchase new production equipment for the Software division in order to improve its
productivity and product quality. It is estimated that this new investment would
generate a 9% annual return.
The cost of new production equipment for the Software division would be Rs 6,000
million. To finance this amount, KIT would use the net cash proceeds of Rs 3,000
million from the sale of the Hardware division and borrow a further Rs 3,000 million.
Alternative 2
Use the whole of the Rs 3,000 million net cash proceeds from the sale of the Hardware
division to reduce some of KIT's existing borrowing.
Exhibit 3 – Governance arrangements and data management – notes prepared by

Masood Khan
Governance
The board consists of seven directors, out of which four are executive directors who
have each held these posts for over 10 years, and myself. Before I was appointed, the
chair also acted as the chief executive. At board level, all major functions are carried
out by the main board, with no subcommittees. The internal audit department is
headed by Sami Ahmed, a certified Internal Auditor who served the company in
various positions prior to his appointment as Head of Internal Audit.
130
Question Bank
Exhibit 4 – Financial and operating data – Software division
Quarterly summary management accounts for the year ended 31 December 2017
3 months to 3 months to 3 months to 3 months to
31 March 30 June 30 Sept 31 Dec
2017 2017 2017 2017 Total
Operating data for the year ended 31 December 2017

3 months to 3 months to 3 months to 3 months to
31 March 30 June 30 Sept 31 Dec
2017 2017 2017 2017
Sales and customer data

All of our customers (whether individual or business customers) order products and
training courses online. Both businesses and individual customers can return products
to KIT, for any reason at all, within 14 days of purchase. We do not record the reasons
for these returns.
There are hundreds of businesses on KIT's customer database, but many of them have
not made a purchase for many years. Individual customers are asked to provide details
about themselves when they place an order, and this information is held on a database
along with the history of the customer's transactions. Little use appears to be made of
this information; I have been told that there is far too much detailed data to be useful.
131
30 Farid Textile
Farid Textiles Ltd (FT) is a manufacturer of clothing based in Lahore. The company was
started by Farid Farooqi twenty years ago with just one sewing machine. Over the years,
Farid has taken on additional employees, expanded the factory and gained some
prestigious customers throughout the world. The company is still privately owned by
Farid and members of his family. Farid is an ambitious man who is prepared to take risks
where necessary in order to expand the business.
FT’s customers are fashion retailers. They provide FT with designs for the clothing that
they require. FT makes the clothing, dyeing the materials to the required colour, sewing
the clothes and embroidering the customer’s brand name onto them. Typically, the work
is performed in batches and stored in FT’s warehouses until the customer requests
delivery.
FT employs 50 staff members. Factory staff include loom operators, sewers,
maintenance and warehouse staff. In the office, the company has a sales department, an
accounting department, an export department (which deals with the paperwork
associated with sending products abroad), a procurement department and a small IT
department that deals with the maintenance of FT’s office computers.
The sales director has suggested that the company should set up an online store to sell
clothing directly to customers. He points out the high profit margins that FT’s customers
enjoy, often selling clothing for more than twice the wholesale price that they pay to FT.
He has suggested that if FT can sell directly to end customers then it could enjoy the
benefit of these higher margins. Farid is excited by this idea and is keen to investigate
further.
The online store would require an initial investment of approximately Rs. 110 million.
The Farooqi family do not have additional capital to invest, and Farid does not wish to
take on debt. Instead, he is considering listing FT on the Pakistan Stock Exchange in
order to raise the finance. The shares to be issued would represent 20% of the share
capital of FT. Extracts from a business plan, along with a forecast NPV for the online
business, are included as Appendix 2.
Textile companies already listed on the Pakistan Stock Exchange trade at a price
earnings ratio of six on average. A comparable listed company to FT has an ungeared
cost of equity of 15%. The free cash flows to equity from the existing business operations
(not including the proposed online retail business) are expected to remain at the same
level as for the year ended 30 September 2020 in perpetuity.
Requirements
(i) Evaluate the net present value calculations for the online business in Appendix 2. (08
marks)
(ii) Evaluate the proposed strategy of diversifying into online retail and recommend
whether FT should go ahead with the investment. (10 marks)
(a) Calculate a fair value for the new shares that will be issued on the Pakistan Stock
Exchange using the price earnings ratio and free cash flow to equity methods, and
briefly evaluate each method in this case. (09 marks)
(b) Explain how big data could be used to improve the competitiveness of FT. (06
marks)
132
Question Bank
(c) (i) Discuss the ethical stance of Arish Clothes based on the newspaper article
about the documentary 'Ghost workers in Pakistan’s Textiles industry' described
in Appendix 3, and discuss the impact that this stance may have on its future
performance. (06 marks)
(ii) Recommend two actions that FT should take in the light of the documentary
'Ghost workers in Pakistan’s Textile industry.'(06 marks)
(d) Discuss the sales tax implications on FTL if it decides to set up an online store.
(05 marks)
133
APPENDIX 1 – FINANCIAL INFORMATION OF FARID TEXTILES LTD
Statement of profit and loss for the year ended 30 September 2020
2020 2019
------ Rs. in million ------
Sales 1,605 1,364
Cost of sales (1,452) (1,240)
Gross profit 153 124
Admin expenses (27) (25)
Distribution costs (22) (21)
Operating profit 104 78
Tax at 29% (30) (23)
Profit after tax 74 55
Note: Included in cost of sales is depreciation of Rs. 139 million.
Statement of financial position as at 30 September 2020

2020 2019
------------- Rs. in million -------------
Land and buildings 450 499
Plant & machinery 320 321
Office equipment 40 38
Total non-current assets 810 858
Inventories 289 246

Trade receivables 230 205
Cash 50 22
Current assets 569 473
Share capital (Rs. 1,000 each) 100 100

Retained profits 1,137 1,100
Total equity 1,237 1,200
Trade payables 112 95

Tax payable 30 36
Total current liabilities 142 131
Total liabilities & equity 1,379 1,331
Note: Rs. 91 million was spent on acquisition of property, plant and equipment to maintain
the existing operating capacity of the company.
134
Question Bank
APPENDIX 2 – EXTRACTS FROM THE BUSINESS PLAN RELATING TO THE

ONLINE RETAIL PROJECT
The online retail project would require the setting up of a new warehouse where inventories
of finished goods would be held for despatch to customers. IT infrastructure would also need
to be developed, with a website offering the products for sale, and supporting databases that
can receive orders from customers, take payments via credit cards or other payment methods,
and monitor stock levels. Existing IT staff have no experience of e-commerce systems, so
additional IT staff would be required to set up the new systems.
The following is a forecast of the net present value of the project:
At year ending 30 September
2021 2022 2023 2024 2025 2026
------------------------------ Rs. in million ------------------------
------
Sales 50.0 75.0 112.5 123.8 130.0
Cost of sales (20.0) (30.0) (45.0) (49.5) (52.0)
Gross profit 30.0 45.0 67.5 74.3 78.0
Expenses
Marketing (1.5) (1.5) (1.0) (1.0) (1.0)
Rental (4.0) (4.4) (4.8) (5.3) (5.8)
Staff costs (7.6) (11.2) (13.3) (14.0) (14.7)
Other costs (0.8) (1.2) (1.9) (2.0) (2.1)
Pre-tax cash flows 16.1 26.7 46.5 52.0 54.4
Tax at 29% (4.7) (7.7) (13.5) (15.1) (15.8)
Investments
New IT equipment (75.0) (0.5) (0.5) (0.5) (0.5) (0.5)
Machinery (30.0) (2.1) (2.2) (0.3) (2.7)
Working capital (5.0) (2.5) (3.8) (1.1) (0.6) 0.0
Total cash flows (110.0) 8.4 12.6 29.2 35.5 35.4
Discount factor at 15% 1.000 0.870 0.756 0.658 0.572 3.813

PV (110.0) 7.3 9.5 19.2 20.3 135.0
NPV 81.3
The investment would take place on 30 September 2021. It has been assumed that total cash
flows from the year ended 30 September 2026 would be Rs. 35.4 in perpetuity. Staff costs
relate to additional marketing staff who would decide on the product offerings and prices,
and keep the website updated. Also included is a small number of warehouse staff, who
would manage the inventories and package the goods for delivery to the customers. FT would
use third party delivery companies to deliver the products and customers would pay the costs
of delivery.
The sales manager has pointed out the possibility of analysing big data to help predict trends
in the industry. This data would include new data obtained about the buying habits of
customers who use the new online business.
The finance director of FT has determined that an appropriate cost of equity for the project
would be 15% per annum based on the cost of equity for similar companies.
135
Free cash flow to equity for the existing business would be unaffected by the decision of
whether or not to proceed with the direct sales project.
APPENDIX 3 – NEWSPAPER ARTICLE
The Pakistan textiles industry has been receiving international attention following an
undercover documentary made by a UK broadcaster into employment practices at a
well-known textiles company, Arish Clothes.
The documentary 'Ghost Workers in Pakistan’s Textiles industry' highlighted practices

at Arish Clothes’ factory in Lahore, which uses contract workers rather than employing
staff directly. The workers are contracted on one-month contracts. Usually the workers
are contracted again at the start of the following month. This practice avoids the legal
requirement that staff who work for more than three months are automatically
considered by the law to be employees.
If workers are not officially employed, the company saves costs such as holiday pay,
sick pay, social security, and pensions contributions. One worker who was interviewed
in the documentary reported that he had been injured during an accident at work and had
to take a month off to recover. He asked the company for sick pay but was told that since
he was not an employee, he was not entitled to it. Another worker was fired, allegedly
because his supervisor did not like him. When he tried to appeal to an employment
tribunal, he was told that the court could not hear his case because he was not an
employee.
The documentary has attracted considerable interest in the UK. The British interest in
the case relates to the fact that some well-known British retailers, such as Trendy
Fashions, buy clothing from Arish Clothes. After the documentary was aired, Trendy
Fashions issued a press release stating that they had been unaware of such practices, but
they would be reviewing their contract with the company as a result of the practices
uncovered by the documentary. Another British retailer, which buys clothing from
factories around the world, stated on the documentary that it requires all its suppliers to
adhere to its corporate code of conduct. This code of conduct includes provisions
relating to the fair treatment of employees and requires all employees to have a fair
contract of employment.
The documentary could harm the reputation of all textiles companies in Pakistan, as
retailers may assume that these practices are common. It is important that the industry
in Pakistan reacts to the criticisms made collectively, rather than seeking to brush these
issues under the carpet.
136
Question Bank
31 Faisalabad Surgical
Today is 1 January 20X1.
Faisalabad Surgical Supplies Limited (FSSL) is a manufacturer of high quality surgical tools
that listed on the Pakistan Stock Exchange six years ago. FSSL has one main manufacturing
site in Faisalabad. The main head office is located on the same site as the factory, with a
second office in Islamabad used primarily for meetings. FSSL sells surgical tools all over the
world, with 90% of items being exported, and invoiced in the customer’s domestic currency.
FSSL has a world class reputation for the quality of its surgical tools, commanding a 30%
premium over the market average as a result.
The board are reviewing their formal risk management processes, and have identified some
new risks, but a course of action to address this is currently outstanding. The draft risk
register containing these new risks may be found in Appendix 3.
The company has historically favoured a ‘hollowed out’ structure, where many aspects of
operations have been outsourced – including outbound logistics. FSSL has a strategic
partnership with a global logistics business that transports inventory from the factory in
Faisalabad to the customers’ premises on a just-in-time basis. There have been several
complaints in recent months from customers about slow deliveries. An internal investigation
by FSSL revealed that to manage their costs, the logistics service provider has been holding
FSSL inventory until sufficient deliveries could be gathered from elsewhere to justify the
cost of delivery vans and plane freight costs. Given the premium FSSL charges their
customers, FSSL has decided to investigate bringing logistics in-house to ensure tight control
over delivery times.
Despite higher than average sales prices, FSSL has relatively low margins due to the high
quality manufacturing process it uses. In a bid to improve margins, the board is considering
outsourcing manufacture of most of its product range to a reputable manufacturer in
Myanmar. The Myanmar provider will be required to invest in machinery and training, but
FSSL have agreed in principle to lend them the money (Rs. 500 million) to enable them to
invest. Further details of the proposed outsourcing arrangement are provided in Appendix 1.
A significant amount of funding will be required for both the in-house logistics and outsource
manufacturing proposals – approximately Rs. 950 million in total. FSSL intends to borrow
the funds from a bank, repayable over a ten-year term at an annualised rate of 7.042% per
annum. The directors are concerned about the impact this increase in gearing could have on
their cost of capital. Details of current finances are provided in Appendix 2.
137
Required
(a) Assess the risks identified in the draft risk register and recommend and justify a
suitable response to those risks. No calculations are required. (05 marks)
(b) (i) Calculate the weighted average cost of capital now and after the proposed
increase in borrowing. Explain the assumptions implicit in calculating the impact
of the borrowing on the WACC. (09 marks)
(ii) Recommend a hedging strategy for the regular amounts payable to / receivable
from the Myanmar outsource partner. No calculations are required. (04 marks)
(c) Identify and explain the key change management issues FSSL face as a result of
the decision to outsource some manufacturing to Myanmar. Recommend and
justify key aspects of a change management programme in response. (04 marks)
(d) Briefly discuss the income tax implications of outsourcing the products to the
manufacturer in Myanmar. (03 marks)
Total: 25 marks
138
Question Bank
APPENDIX 1 – MYANMAR OUTSOURCE PROPOSAL (KEY FACTS)

Potential provider Myanmar Precision Engineering
Scope 75% of current product range by value
Initial term Five years
Notice period 1 year after initial term, either party.
Start date 1 January 20X2
Set up FSSL to lend Rs. 500 million, 8% per annum interest, capital
repayable in monthly equal installments over three years.
FSSL headcount impact 60% of Faisalabad factory workers to be made redundant, with
the option for 5-10% of those at risk of redundancy to
relocate to Myanmar for the initial five-year contract.
APPENDIX 2 – FAISALABAD SURGICAL SUPPLIES LIMITED ANALYST

REPORT EXTRACTS
Balance sheet extract at 31 December 20X0:
Note Rs. in million
Non-current assets 1,245
Net current assets 330
1,575
Share capital 1 250

Total equity 950
5% TFCs 2 625
Total equity and long-term debt 1,575
Notes:
(1) Share capital consists of shares with a nominal value of Rs. 100 and a market
value of Rs. 375 cum div at close of business 31 December 20X0. A dividend of
Rs. 25 per share is due to be paid on 3 January 20X1. Share price is expected to
grow at the same rate as historical dividends.
(2) The TFCs have a nominal value of Rs. 10,000 each, pay interest on 31 December
each year and are irredeemable. They are currently priced at Rs. 7,100 per TFCs
ex interest.
Other key facts:
Dividend per share history
Year 3 Jan W6 3 Jan W7 3 Jan W8 3 Jan W9* 3 Jan X0 3 Jan X1
Rs. 31 32 35 20 22 25
* There was a share split of 2 for 1 in early W9
139
 Industry average gearing level (debt/(debt plus equity)) = 30% by market values
 Debt beta = zero
 Corporate tax rate = 29%
APPENDIX 3 – DRAFT RISK REGISTER
Risk Probability Impact Action

(high or low) (high or low)
Being sued by a customer

for faulty equipment
supplied. This has not
happened to date but has
happened to our
competitors’ recently.
The price of steel, which is

a key raw material in our
production process,
fluctuates significantly.
Myanmar operation may

not work as expected. We
have experience of
outsourcing but we have
not outsourced
manufacturing specifically
before.
140
Question Bank
32 Karachi Pharmaceuticals Limited (KPL)

Today is 1 January 20X1.
Karachi Pharmaceuticals Limited (KPL) is a listed pharmaceuticals researcher and
manufacturer. The board of directors is undertaking a strategic review as a result of
recent concerns about cash flow. KPL’s overdraft is reaching unsustainable levels while
their competitors are paying large dividends and have significant cash reserves.
In order to prepare for a board meeting to discuss this crisis, you have been asked to
examine the portfolio and benchmarked performance of KPL. More information to help
this process is provided in Appendices 1, 2 and 3.
KPL has historically marketed its products by launching them at trade shows and press
events, advertising in trade magazines and via the established network of face-to-face
salespeople who visit hospitals and medical practices to speak to medical professionals
directly. Often large intermediaries buy drugs in bulk for a discount, that they then sell
on. The board is concerned that the company is not making the best use of technology
through this traditional approach and is considering a more digitally-based approach to
marketing and sales.
One of KPL’s key products, tradename ‘Pleuromol’, is particularly effective in the
treatment of otherwise often fatal respiratory illnesses. It is an expensive drug at Rs.
100,000 per day for a typical 14 day treatment. The marginal cost of manufacture is
closer to Rs. 1,000 a day. Following a recent cybersecurity incident, this information has
been leaked to the press. The class of diseases treated with Pleuromol is common in
children in poorer, developing nations who cannot currently come close to affording the
treatment. There is mounting pressure to make the drug available either free of charge
or at a drastically reduced cost to these locations.
The marketing director is keen to make the drug available through a revised Corporate
Social Responsibility Programme (Appendix 4). However, the finance director claims
this would be a waste of shareholder’s funds, neglecting the director’s moral and
fiduciary duty to the shareholders, and would reduce the funds available for future
research.
Requirements
(a) Analyse the financial position and product portfolio of KPL in relation to its
competitor and conclude on the position and prospects of KPL. (13 marks)
(b) Explain how the ‘six Is’ of e-marketing could be used to improve the current
marketing mix. (06 Marks)
(c) Respond to the claim that the proposed Corporate Social Responsibility
Programme is potentially a waste of shareholders’ fund. (06 marks)
Total: 25 marks
141
APPENDIX 1 – ANALYST REPORT EXTRACTS
Background on KPL’s product portfolio, including industry growth and market share
information
Pharmaceutical products are typically one of three types:
 Class 1 – Those under development. These are not yet saleable until fully developed
and approved by regulators.
 Class 2 – Those being sold under patent. These enjoy a 20-year period of exclusivity.
 Class 3 – Those being sold out of patent and ‘generics’. When a drug is outside its
patent period, the drug is available to be made by any pharmaceutical companies.
Often the original brand name still commands a premium due to customer familiarity
with the name, but it is usual for there to be ‘generics’ – less expensive, essentially
less branded versions of the product manufactured by others.
KPL’s portfolio mix is as follows:
Class 1 Class 2 Class 3
By number of products 174 15 40
By revenue (% of total revenue) n/a 40 60
By gross margin (% of total gross margin) n/a 65 35
The majority of the Class 2 and Class 3 products are in high-growth markets.
By definition, Class 2 products are effectively 100% market share. Of the Class 3 products,
KPL is the largest provider by revenue for around 75% of the products in that class.
APPENDIX 2 – SUMMARISED FINANCIAL STATEMENTS OF KPL
Statement of profit or loss extracts
20X0
Rs. in billions
Revenue 200
Gross margin 180
Depreciation and amortisation (80)
Other expenses (30)
Operating profit 70
Finance charges (50)
Dividend 0
Retained profit for the year 20
142
Question Bank
Statement of financial position extracts

20X0
Rs. in billions
Tangible non-current assets 245
Intangible non-current assets 1,000
1,245
Current assets 48
1,293
Share capital 100

Total equity 753
Long term borrowings 245
998
Current liabilities excluding overdraft 40
Overdraft 255
1,293
APPENDIX 3 – INFORMATION ABOUT MUMBAI PHARMACEUTICALS
KPL views Mumbai Pharmaceuticals Ltd (MPL) as a direct competitor of comparable

size and with similar target markets. Using the same Class 1/2/3 as KPL use themselves,
MPL’s portfolio mix is as follows:
Class 1 Class 2 Class 3

By number of products 40 30 50
By revenue (% of total revenue) n/a 90 10
By gross margin (% of total gross margin) n/a 95 5
The majority of the Class 2 and Class 3 products are in low growth, stable markets.
By definition, Class 2 products are effectively 100% market share. Of the Class 3
products, MPL is the largest provider by revenue for around 40% of the products in that
class.
143
The following are financial statement summaries of MPL:
Statement of profit or loss extracts
20X0
Rs. in billions
Revenue 220
Gross margin 210
Depreciation and amortisation (40)
Other expenses (30)
Operating profit 140
Finance charges (30)
Dividend (110)
Retained profit for the year 0
Statement of financial position extracts
20X0
Rs. in billions
Tangible non-current assets 199
Intangible non-current assets 350
549
Current assets excluding cash 48
Cash 225
822
Share capital 100

Total equity 547
Long term borrowings 245
792
Current liabilities 30
822
APPENDIX 4 – PROPOSED CORPORATE SOCIAL RESPONSIBILITY

PROGRAMME
The current corporate social responsibility programme extends to, for example:
 Sponsorship of key sporting events
 Supplier labour practices due diligence
 Local community support around our manufacturing facility
 University sponsorship and research fellowship support
However, the current programme does not extend to the charitable provision of products,
as highlighted in the recent coverage concerning Pleuromol.
144
Question Bank
33 RhanaPharm
RhanaPharm Ltd (RhanaPharm) is a pharmaceutical company based in Lahore. The
mission of the company is as follows:
We exist to provide essential medicines in Pakistan at affordable prices to all, while
providing a good return on investment to our shareholders.
The board has developed the following corporate objectives to support this mission:
 To develop and grow a diverse portfolio of products
 To continuously achieve efficiency in production
The company was founded in 1993 by Mustafa Sharif, a qualified pharmacist. It
expanded quickly and, in 2010, obtained listing on the Pakistan Stock Exchange (PSX).
Mustafa is now the CEO of the company. The Sharif family still own 51% of the shares
in the company.
The company manufactures and markets generic drugs and drugs under license at two
factories in Pakistan and sells them to hospitals, doctors' surgeries and pharmaceutical
retailers. Some research and development costs are also incurred in developing generic
drugs and obtaining approval from the Drug Regulatory Authority of Pakistan. These
costs are capitalised and amortised over the expected useful life of the products, which
is usually between 5 to 15 years.
At the start of the year 2020, the company recruited a new Finance Director, Shahid
Nawab. Shahid had previously worked as a manager for a large international accounting
firm. He believes that the performance management and measurement systems at
RhanaPharm need improvement. He has already prepared a draft balanced scorecard. He
also suggests that the existing remuneration scheme for executive directors and structure
of the board need to be improved.
Your employer, Blue Horseshoe consulting, has been engaged by the directors of
RhanaPharm to review the suggestions made by Shahid, and propose any changes to
these.
Shahid has provided you with a file containing following Appendices:
Appendix 1: Management accounts of RhanaPharm
Appendix 2:
Key performance indicators of AsilPharma, a pharmaceutical company based in Dubai
Appendix 3: Proposed balanced scorecard for RhanaPharm prepared by Shahid
Appendix 4: Details of the current board structure
Appendix 5: Existing remuneration scheme for executive directors
Required
(a) Evaluate the financial and non-financial performance of RhanaPharm based on
the information provided in Appendices 1 and 2 (16 marks)
(b) Evaluate the proposed balanced scorecard prepared by Shahid (08 marks)
145
(c) Assess the effectiveness of the current board structure at RhanaPharm and explain
its possible impact on the performance of the company (10 marks)
(d) Evaluate the current remuneration scheme for executive directors (06 marks)
(e) The board of directors are considering acquiring 50% to 60% shareholdings in
HPL, a company engaged in discovery, development and commercialisation of
prescription medicines. Mustafa has been proactively advocating the acquisition,
as he believes that this acquisition is in line with the company’s mission, and the
existing and future losses of HPL would also be available to be set off against the
income of RhanaPharm.
Prepare a briefing paper for the board of directors of RhanaPharm outlining the tax
implications of acquiring HPL. (10 marks)
Total: 50 marks
146
Question Bank
APPENDIX 1 – MANAGEMENT ACCOUNTS OF RHANAPHARM

Statement of profit or loss for the year ended 31 March
2021 2020
------- Rs. in '000 -------
Revenue 178,712 175,207
Cost of sales (86,643) (85,478)
Gross profit 92,069 89,729
Selling, general and admin expenses (37,373) (37,200)
Operating profit 54,696 52,529
Interest expense (4,800) (4,800)
Profit before tax 49,896 47,729
Tax (14,470) (13,841)
Profit after tax 35,426 33,888
Gross profit margin 51.52% 51.21%

Operating profit margin 30.61% 29.98%
Statement of financial position as at 31 March
2021 2020
------- Rs. in '000 -------
Non-current assets
Intangible assets 45,623 43,388
Property, plant and equipment 75,240 74,762
120,863 118,150
Current assets
Inventories 21,661 14,246
Trade and other receivables 29,785 29,201
Cash and cash equivalents 10,156 2,345
61,602 45,792
Total assets 182,465 163,942
Equity
Share capital (shares of Rs. 1,000 each) 100,000 100,000
Retained profits 18,763 1,050
118,763 101,050
Long-term bank loan 40,000 40,000

Current liabilities
Trade payables 9,232 9,051
Tax payable 14,470 13,841
23,702 22,892
Total dividends (Rs. '000) 17,713 16,944

Dividend per share (Rs.) 177.13 169.44
Share price (Rs.) 4,723 4,548
ROCE 34.5 37.2
147
Non-financial performance indicators
Number of new products launched in most recent year 2
Employee engagement 50%*
*Employee engagement is the percentage of employees that feel valued and supported
by the company, according to an employee survey carried out by an independent
company.
APPENDIX 2 – KEY PERFORMANCE INDICATORS OF ASILPHARMA

AsilPharma is a pharmaceutical company based in Dubai. The company is a similar size to
RhanaPharm and has a similar business model.
Growth in revenue vs previous year 6%
ROCE 17.3%
Gross profit margin 45%
Operating profit margin 19%
Gearing (debt ÷ equity plus debt) 13%
Total shareholder return for most recent financial year 5%
Number of new products launched in most recent year 10
Employee engagement 65%
148
Question Bank
APPENDIX 3 – PROPOSED BALANCED SCORECARD FOR RHANAPHARM
Financial perspective
 Revenue growth
 Return on capital
employed
 Total shareholder
return
Customer perspective Internal business processes

 Net promoter score*  Time to gain approval
 Average prices compared for new products to
competitors  Number of rejected
batches
Learning and growth

 Number of new products
 Training days per
employee
*Net promoter score is the score given on a scale of 1 to 10 to the question "would you
recommend RhanaPharm to other buyers of pharmaceuticals?" Customers would be
surveyed twice per year.
149
APPENDIX 4 – DETAILS OF CURRENT BOARD STRUCTURE
The following is taken from the annual report of RhanaPharm.
Director Career at RhanaPharm
Mustafa Sharif (Age: 62 Mustafa founded RhanaPharm in 1993. He
years) Chief Executive became CEO when the company listed on PSX in
Officer 2010. Mustafa holds a doctorate in pharmacy
from the University of Karachi.
Shahid Nawab (Age: 32 Shahid joined RhanaPharm in 2020 after working
years) Finance Director for 11 years for an international accounting
practice in Karachi. Shahid is a member of the
Institute of Chartered Accountants of Pakistan.
Asif Awais (Age: 60 years) Asif has been working for RhanaPharm since
Production Director 1994. He joined the company as a research
scientist. He was appointed head of production in
the year 2001 and became production director in
2004. Asif holds a BSc degree in pharmacy.
Dr Abdul Khan (Age: 58 Dr Khan joined the board of RhanaPharm as
years) Independent Director chairman in 2013. He has enjoyed a successful
career working and teaching at the Jack Beecham
Chairman
School of Pharmacy in Lahore.
Famida Sharif (Age: 60 Famida, wife of Mustafa, joined the board as a
years) Non-executive non- executive director in 2010 at the time of the
Director company's listing. She had previously worked for
RhanaPharm on a part-time basis as office
manager.
Muhammad Mujahid (Age: 59 Muhammad joined the board in 2015. Prior to
years) Independent Director joining the board of RhanaPharm, he was the head
of research for one of RhanaPharm's competitors.
He now runs his own consulting firm.
Dr Ali Tariq (Age: 65 years) Dr Tariq joined the board in 2018. He has had a
Independent Director distinguished career as an orthopaedic surgeon,
and still works as a consultant for several
hospitals.
Dr Yasmin Tokhi (Age: 55 Dr Tokhi joined the board of directors in 2010 at
years) Independent Director the time of the company's listing. She had a
distinguished career in the pharmaceutical
industry including five years working in a senior
position for the Drug Regulatory Authority of
Pakistan.
Muhammad Suri (Age: 68 years) Muhammad joined the board in 2018. He worked
Independent Director for many years for a global investment banking
firm. He retired from this in 2009 and is now an
independent director of several listed companies
in Pakistan.
150
Question Bank
APPENDIX 5 – EXISTING REMUNERATION SCHEME FOR EXECUTIVE

DIRECTORS
Executive directors receive the following remuneration:
(1) A fixed salary element, which would be equivalent to 62.5% of the directors' total
remuneration if maximum bonuses are achieved.
(2) A bonus as a percentage of the fixed salary element, which is awarded for the
achievement of the following targets:
 10% if revenues grow by 2% or more compared with the previous years
 20% if return on capital employed is greater than 24%
 20% if operating profit margins are more than 30%
 10% if the gross profit margin is more than 50%
The bonuses paid for achieving a particular target are independent of the achievement
of the other targets. For example, if return on capital employed is greater than 24%, the
20% bonus will be paid regardless of whether the other targets have been achieved.
151
34 Razaport
Razasport is an international manufacturer and distributor of sports equipment since last 40
years. As market leader, Razasport is proud of its ability to innovate and incorporate the latest
sports science into its products. Razasport currently owns a production facility in Lahore
which also serves as a warehouse. The company also owns a fleet of vehicles used to perform
local deliveries.
During the last year, the company has suffered from cancelled orders and falling sales as a
result of the coronavirus pandemic. For the first time in its history, the owners and managers
are concerned about the profitability of the business. Consequently, Farooq Ali, the Chief
Financial Officer, is reviewing a range of different approaches to try and improve business
performance.
Big Data and digital marketing
Farooq is aware of the benefits that using data can bring to an organisation. In response to
declining sales, Farooq is considering to investigate how Razasport can better use the data
they have by developing a digital marketing strategy. He has recently engaged the services
of Gem Consulting to advise further on this which can be seen in Appendix 1.
Supply chain management
Until recently, 90% of Razasport's products were sold in either Pakistan or Iran and delivered
using Razasport's own fleet or by using local couriers. In 2015, Razasport developed its e-
commerce capability, with the majority of these sales being shipped to the United Kingdom.
To avoid the current high shipping costs and long lead times, the Logistics Manager, Adnan
Baig, is proposing a third-party logistics (3PL) strategy involving a purpose built e-
commerce warehouse in Poland. Shipping and warehouse costs can be seen in Appendix 2.
Razasport would co-share the warehouse with other businesses, making use of the specialist
inventory management and logistics tracking technology supplied by the 3PL provider.
Factoring of trade receivables
Officially, payment terms are 30 days but due to its long-term relationships with many
customers, Razasport does not enforce this. However, bad debts are minimal and Razasport
has confidence that the majority of customers will eventually pay. Until now, Razasport has
seen the delay in cash collection as a necessary cost of doing business and part of the
customer service for which they are known. In order to improve the liquidity, Hamza
Bukhari, Financial Controller has prepared a proposal to factor trade receivables which can
be seen in Appendix 3.
Requirements
(a) Explain how the use of big data and a new digital marketing strategy could
improve long-term financial performance for Razasport. (08 marks)
(b) Evaluate the proposed supply chain strategy and recommend whether Razasport
should outsource its warehousing, in light of recent business performance.
(08 marks)
(c) Advise Razasport on whether to proceed with the proposal to factor trade
receivables, providing supporting calculations where appropriate. (09 marks)
Total: 25 marks
152
Question Bank
APPENDIX 1 – EMAIL FROM CONSULTANT ON DIGITAL MARKETING

STRATEGY
To: Farooq Ali, Chief Financial Officer
From: Gem Consulting
Subject: Big Data and digital marketing
Date: 1 June 2021
Further to our discussions, please find enclosed a summary of the key findings from our
review. The full report will be made available to you by the end of next week, per our initial
discussions.
Big Data
A customer database is already in existence containing a wealth of untapped data,
including: customer demographics, preferred sports, contact details and transaction
history.
Digital Marketing
 Razasport is reliant on traditional marketing to promote its products, for example,
billboards and sports magazine advertisements. Razasport also maintains a simple
website.
 Industry average data suggests that the ROI of print marketing is approximately 5.5%.
With current data, it is currently not possible to assess Razasport's marketing ROI.
 Approximately 63% of Razasport's sales in a year come from 20% of its customers.
 Approximately 76% of Razasport's sales in a year come from repeat customers who
have made purchases in the last two years.
Recommendation
Gem recommends the introduction of a customer relationship management (CRM) system
to extract the most value from the data currently available. Gem also recommends the use of
digital marketing tools to significantly improve the ROI of marketing campaigns.
We would like to take this opportunity to thank you for using Gem Consulting and we
look forward to working with you again in the future.
Regards,
Noor Abbas
Digital Marketing Consultant
153
APPENDIX 2 – SHIPPING AND WAREHOUSE COSTS
To: Farooq Ali, Chief Financial Officer

From: Adnan Baig, Logistics Manager
Subject: Shipping and warehouse costs
Date: 3 June 2021
Per your request, please find attached an extract of average parcel sizes and shipping
costs from Lahore and Poland’s warehouse to UK based customers.
Assumptions underlying the data are as follows:
 Parcels up to 29 kg in weight are always sent by air freight from Pakistan and
this will also apply to shipments from Poland.
 Parcels of 30 kg or more are sent by sea freight from Pakistan. Similar sized
parcels will be shipped using road transportation from Poland unless a
customer is willing to pay extra for air freight.
 Customers can pay €0.8 per kg for faster delivery on large (30 kg+) orders.
 Lead times from Lahore to the Poland’s warehouse (sea freight) are 19 days
and the bulk shipping cost to replenish the Poland’s warehouse is, on average,
€2 per kg.
 One euro equals Rs. 200
Also please note the lease terms associated with the warehouse:
 The initial rental term is five years. Early termination requires four months'
notice and an exit fee equivalent to six months' rental.
 An additional payment of €12,000 is payable annually in advance for e-
commerce support. These fees are non-refundable.
Please do not hesitate to get in touch if you require further clarification. Regards,
Adnan Baig
Attachment to letter received from Adnan Baig on 3 June 2021:

Courier shipping cost per kg to UK
Poland Lahore
up to 5 kg €7 €21
6-29 kg €3 €18
30-100 kg €1 €12
Lead time to customer (days)
Air 1 6
Road 4 N/A
Sea N/A 25
Average shipment weights % of shipments Average net revenue per kg

Small (10 kg) 48 €6
Regular (35 kg) 36 €12
Oversize (145 kg) 16 €14
154
Question Bank
APPENDIX 3 – PROPOSAL TO FACTOR TRADE RECEIVABLES

Proposal
Falling sales are currently putting profitability and liquidity under pressure. This
proposal examines the use of debt factoring to improve liquidity and profitability.
Trade receivables
Razasport has traditionally maintained a high trade receivables balance. Although there
is a 30-day credit policy, this has been overlooked for the vast majority of customers due
to the longstanding relationships in place. Many customers tend not to pay for 90 days
and Razasport finances trade receivables using the overdraft facility (interest rate of 12%
p.a). There are very few bad debts to be written off.
Factoring
The factor will pay 70% of the trade receivables when a credit sale is made and the
remaining 30% when the cash is received from the customer. This is estimated to be 45
days after the debt is factored.
The factor will charge interest at a rate of 10% per annum on cash advanced plus a fee
of 2% of annual credit sales revenue. By reducing the administrative burden associated
with managing the aged debtor list, it is estimated that we can rationalise the Trade
Receivable department, reducing credit control costs by approximately Rs. 1.5 million
each year if the factor is used.
Razasport currently has annual credit sales of Rs. 1.3 billion and trade receivables of
Rs.320.55 million which represents 90 days of sales (based on a 365-day year).
155
35 A2Z
A2Z is a listed company providing data analytics and digital business solutions. The business
is structured on divisional lines with one division specialising in data analytics whilst the
other division focuses on digital business solutions such as artificial intelligence (AI). Clients
are predominantly in the bricks and mortar retail sector and are located across Pakistan, India,
Singapore and Australia.
Since its inception, A2Z has grown organically but the board is now looking to expand the
business through acquisition. The Finance Director, Saeed Afridi, has identified Logical, a
small, unquoted data analytics company specialising in online retail. The owner of Logical
is planning his retirement and is therefore seeking an exit route within the next year. He has
asked to meet with Saeed to discuss the valuation of Logical, with a view to selling the
business to A2Z (Appendix 2).
During the last year, the board have become increasingly concerned about the risks A2Z is
exposed to as a result of its rapid expansion. As part of this risk focus, the board has engaged
the services of a data security consultant after several high profile cyber-attacks on
supermarkets in Pakistan. The consultant has identified that one of A2Z's clients has exposed
A2Z to malware, which has potentially infected A2Z's data and processes (Appendix 3).
A2Z has 50 million shares in issue, with a current share price of Rs. 37. A2Z had earnings of
Rs. 66 million in 2020.
Requirements
(a) Identify and evaluate the key risks facing by A2Z. Recommend suitable
mitigating strategies.
Note: Include an analysis of the data provided in Appendix 1 to identify risks and ignore
cyber security risk. (12 marks)
(b) Estimate the value of the entire ordinary share capital of Logical for the purpose
of A2Z making a bid. Explain any key concerns you have with your valuations.
(07 marks)
(c) Explain the possible causes and consequences of cyber security incidents, such as
the one highlighted by the data security consultant. Recommend actions that A2Z
should take to prevent future cyber-attacks. (06 marks)
Total: 25 marks
156
Question Bank
APPENDIX 1 – COMPANY BACKGROUND

A2Z has been operating in the industry which is growing rapidly but having an intense
competition. A2Z has always had a high turnover of client but with their reputation for client
service, innovative technology and speed of response, they have always been able to win
new client without any difficulty.
Data Analytics division

The Data Analytics division uses a cloud-based platform to capture, analyse and store high
volumes of raw data, including publicly available data as well as data provided by clients.
Client specific raw data remains the intellectual property of the client, but ownership of data
becomes complex once it has been processed by A2Z, resulting in extensive legal issues
when client change providers. All clients are invited to upload data from their own systems
to A2Z's cloud. A2Z is then able to provide analysis to client, often within a few minutes of
receiving their data.
Digital Solutions division

The Digital Solutions division specialises in providing retail clients with artificial
intelligence (AI) solutions. This is a growth business and the speed of innovation is rapid, so
much of the division's work involves research and development. The Digital Solutions
division currently makes use of generic technologies, so any innovation is easily copied by
competitors.
Divisional operating data – Years ending 31 December

Data Analytics division Digital Solutions division
2020 2019 2020 2019
Number of:
New customers in year 26 21 12 8
Customers lost in year 17 14 15 4
Customers at 31 December 121 112 37 40
---------------------- Rs. in million ----------------------
Revenue 156 148 86 71
Operating profit 38 41 18 17
Total assets less current liabilities 220 220 148 144
Revenue from largest customer 95 82 26 26
Forecast growth rates 17% - 36% -
157
APPENDIX 2 – EXTRACTS FROM LOGICAL'S FINANCIAL STATEMENTS
Extract of statement of profit or loss for the year ended 31 December

Notes 2020 2019
--------- Rs. in '000 ---------
Revenue (i) 335,200 296,150
Cost of sales (117,320) (103,653)
Gross profit (ii) 217,880 192,497
Operating costs (iii) (120,000) (120,000)
Operating profit 97,880 72,497
Interest expense (22,000) (22,000)
Profit before tax 75,880 50,497
Tax (22,005) (14,644)
Profit for the year 53,875 35,853
Extract of statement of financial position as at 31 December

2020 2019
--------- Rs. in '000 ---------
Total assets 150,197 142,460
Total liabilities 76,797 72,600
Notes:
(1) Revenue – growth of 14% is expected next year.
(2) Gross profit margins will remain the same in 2021.
(3) Operating costs include salaries. Logical has recently recruited three new IT
administrators at a cost of Rs. 30,000 per month. Two employees started in
January 2021 and one joined at the start of April 2021.
158
Question Bank
APPENDIX 3 – DATA SECURITY ISSUES
To: Board of directors URGENT AND

CONFIDENTIAL
From: Sobia Shamin, InfoSec Data Security
Subject: Data Security issues
Date: 1 June 2021
Further to our review of A2Z's data security, testing has revealed a data
breach in one of A2Z's clients, Bestbuy Supermarkets.
A2Z uses an in-house designed software application to identify breaches

in the cloud-based storage. Our testing to date has revealed that the
malware reached A2Z's systems via Bestbuy and remained undetected
by the software for a period of six weeks, giving rise to potential
infection of other clients' data and systems. InfoSec is currently
undertaking further testing and scanning to establish the extent and
severity of the attack. In the meantime, InfoSec requests authorisation
to install our bespoke malware detection application 'Rapid Spy' to
verify the integrity of all client data and to prevent similar breaches of
A2Z's system.
With kind regards,
Sobia Shamin
159
36 Jazeera Machinery Ltd (June 18)
Jazeera Machinery Ltd (JML) sells new and used agricultural machinery (including
ploughs, harvesters, forklifts, drills and tractors) through a network of dealerships across
Pakistan. It sells equipment acquired from both private sellers and a range of
manufacturers, many of whom have enjoyed long trading relationships with JML.
Teela Ltd (Teela) is another company that deals in agricultural equipment, concentrating
mainly on fertilising and pest control systems. It has performed poorly in recent years
after it diversified unsuccessfully into the sale of tractors under a franchise agreement
with a newly established manufacturer. This new brand of tractor has struggled in a
market that is dominated by more established brands. With promotional efforts diverted
towards tractor sales, Teela's management's attention became fully taken up with the
struggling franchise, and it began to miss sales targets for its other products.
Teela's sales and cash flows have been declining in 2018, and it has recently entered into
liquidation. The liquidator is attempting to sell Teela as a going concern, and has been
in discussion with JML as a potential purchaser. The directors of JML believe that Teela
could be a useful acquisition, as some of its dealerships are in valuable locations and
JML has been wanting to expand its activities to include other types of equipment.
In 2016, an offer was made to acquire the Teela brand for Rs 300 million by another
agricultural equipment dealer. The offer was given serious consideration at the time but
was eventually refused. In 2017, one of the new tractors sold by Teela crashed as a result
of steering problems, injuring several farm workers. As a consequence, Teela is being
sued for a substantial sum.
Report required
It is June 2018. You are the chief accountant at Jazeera Machinery, reporting to the CFO.
You have been reading through the notes describing the directors' strategy for Teela
(Exhibit 1) and Teela's latest forecast financial statements (Exhibit 2). The CFO has
asked you to send him a memorandum that can be used to report to the board on the
proposed Teela acquisition. This memorandum should include the following elements:
(a) A discussion on the valuation of Teela's business assets for the purpose of the
acquisition. Discuss any key areas of uncertainty involved in the valuation and
indicate any further information that may be required. Based on the available
information, determine a plausible amount which JML may quote for acquiring
Teela's business. (11 marks)
(b) With reference to the forecasts about Teela's future performance in Exhibits 1 and
2, construct a cash flow valuation and discuss the importance of the successful
implementation of JML's proposed strategy for Teela. Outline the risks to the
proposed strategy that arise with the particular circumstances of this acquisition.
Note. Ignore tax. (10 marks)
(c) Discuss the impact of income tax if it is taken into consideration while
constructing the cash flow valuation in (b) above.
Note. Actual calculations are not required. (4 marks)
Requirement
Prepare the memorandum required by the CFO. Total = 25 marks
160
Question Bank
Exhibit 1 – JML's intended strategy for Teela Ltd

Due to the pending litigation, the directors of JML would prefer to acquire the Teela
business as a whole, but not to acquire its shares. JML's plan for Teela is to re-launch
the business, continue to sell fertilising and pest control equipment and also, if
feasible, operate an alternative tractor manufacturer's franchise. Implementing this
strategy, it is expected that it will turn Teela's fortunes around.
Forecast annual results under this new strategy, assuming that a new franchise
arrangement can be set up successfully, include a 100% increase in revenue in 2019
compared to 2018, with cost of sales increasing accordingly. Administrative and
distribution costs are fixed costs, but synergistic savings of Rs 20 million should be
achieved in 2019. From 2019, annual profits are expected to be constant.
The annual depreciation amount will stay constant at the 2018 charge, and annual
capital expenditure to sustain the business should be around Rs 75 million.
JML's cost of capital has been estimated at 10%.
Exhibit 2 – Forecast financial statements for Teela Ltd

Statement of profit or loss for the year ended 31 December
Unaudited Actual
forecast 2018 2017
Rs'm Rs'm
Revenue 3,519 4,223
Cost of sales (Note 1) (3,060) (3,672)
Gross/profit 459 551
Depreciation (335) (335)
Administrative and distribution costs (Note 1) (93) (93)
Profit from operations 31 123
Finance costs (138) (110)
(Loss)/profit for period (107) 13
Note
Retained earnings at 1 January 428 415
Retained earnings at 31 December 321 428
161
Summary statement of financial position at 31 December
Unaudited Actual
forecast 2018 2017
Rs'm Rs'm
Assets
Non-current assets
Property, plant and equipment (Note 2) 2,480 2,815
Current assets
Inventories (Note 3) 1,685 1,408
Receivables (Note 4) 75 122
1,760 1,530
Equity and liabilities
Issued capital 765 765
Revaluation reserve 153 153
Retained earnings 321 428
1,239 1,346
Non-current liabilities – loans 2,234 2,142
Current liabilities 767 857
Notes
1 Cost of sales are 90% variable, with the other 10% being fixed. Administration
and distribution costs are all fixed.
2 The estimated fair value of property, plant and equipment at 31 December
2018 is Rs 3,400 million, of which Rs 2,300 million relates to property. Selling
costs would amount to Rs 75 million. There have been no acquisitions or
disposals of property, plant and equipment during 2018.
3 Inventories at 31 December 2018 consist of Rs 615 million of tractors, and
Rs.1,070 million of fertilising and pest control equipment. The administrator
claims that the total estimated net realisable values (at full retail price) are
Rs.690 million and Rs 1,300 million respectively at 31 December 2018.
4 Within receivables, there is a large debt that is more than a year old and
amounts to Rs 15 million. The administrator has pressed this customer for
payment and has expressed some confidence that it will be paid in a few weeks'
time.
5 Teela had recently estimated its annual cost of capital as 10%.
Note. The solution missed tax credit available for investment in plant & machinery. This
may be added in the option 1 solution as follows and five marks may be awarded for it.
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Question Bank
Proposed Addition to Solution 5 marks Tax Credit for investment:

(1) Section 65B provides that tax credit is allowed to companies in respect of
extension, expansion, balancing, modernization and replacement of plant and
machinery already installed therein.
(2) The tax credit is allowed equal to 10% of the amount of investment.
(3) The tax credit is allowed against minimum tax & final tax as well.
(4) The plant & machinery is required to be installed between July 01, 2010 to June
30, 2021.
(5) The tax credit in excess of tax payable is allowed to be carried forward for two
subsequent years.
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Answer Bank
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Answer Bank
Answers to preparation questions

Question 1 - VisionPak
Marking scheme
Section Detailed Marking Guidance Marks

(a) Identify a strength of the company – up to 1 mark 2
each
Explaining why it is a strength – up to 1 mark each 2
Identify a weakness of the company – up to 1 mark 2
each
Explaining why it is a weakness – up to 1 mark each 2
Identify an opportunity for the company – up to 1 2
mark each
Explaining why it an opportunity – up to 1 mark each 2
Identify a threat to the company – up to 1 mark each 2
Explaining why it is a threat – up to 1 mark each 2
Identify a key strategic challenge – up to 1 mark each 2
Discussing key strategic challenges – up to 1 mark 2
each
Maximum for this section 16 marks

(b) Identifying a suitable strategy for the company – up to 3
1 mark each
Explaining why the strategy is suitable – up to 2 6
marks each
Total 25 marks
(a)
TUTORIAL NOTE
Look inside the questions for the elements of a SWOT, and balance your
observations e.g. 2 x S, W, O and T. For each briefly describe why something is
a strength etc.
Remember there is a secondary requirement in part (a) – identify key strategic
challenges. There are numerous you can choose from, as there are lots of hints
in the scenario e.g. outdated technology and approaches to marketing. Again
for each explain why something is challenging.
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Strengths – (Internal)
Reputation
The company has an excellent reputation for quality products. This will enable
the company to launch new products with confidence that existing customers will
have faith in their products and services, thus increasing market penetration.
Financial strength
The company is on a sound financial footing, including large cash reserves. This
is advantageous as it will allow VisionPak (V) to make investments in new
technologies such as those used by Specs4less, (S) without the need to secure
external finance.
Weaknesses – (Internal)
Technology
The technologies employed by V appear dated, as the company cannot match the
one hour service of S. This has resulted in a lack of competitive edge, resulting
in lost customer loyalty and declining market share, as well as a higher cost base
seen in falling gross and net margins in Exhibit 2.
Poor internal control
The company produces internal information that shows variable profitability and
lack of control over job roles. The failure to act upon this information means that
the company has continued to trade from shops that are not very profitable and
hence drag down the company's results. The lack of control over job roles may
lead to confusion amongst staff, creating inefficiency and lower levels of
customer service.
Opportunities – (External)
New technologies
The technologies that V has not yet utilised may be acquired using V’s cash
reserves and Adiba’s knowledge gained in her employment with S. For instance
Adiba will have intimate knowledge of S’s processes, services and products, so
V may learn a lot from her about how S has out-competed V in recent years. This
will allow the company to compete more effectively against S and stem the tide
of lost customer loyalty. Additionally, the new technologies should lower the
production costs which are currently relatively high and allow company to offer
efficient services to the customers.
Youth market
Although there is a predicted slowdown in the economy, we are told customer
spending will rise in the 18–30 year olds market segment. V could target its
product development and marketing approaches to this segment to gain market
share in a demographic that is known to contain high spending and image
conscious consumers. This could be aided by the having endorsements of the star
players from cricket teams, or other popular sports stars.
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Answer Bank
Threats – (External)
Competition
V faces increased competition from companies such as S, employing superior
technologies. The intense competition that V faces will cause problems such as
a falling customer base, which will result in lower repeat custom and falling
economies of scale. The V brand may also suffer in comparison to successful
industry rivals.
Market slowdown
If Pakistan’s economy were to slow down this could adversely affect V’s sales.
Even though consumer spending amongst younger people is predicted to be
strong this will primarily benefit the stronger competitors with differentiated
products and services. As V is currently uncompetitive it stands to miss out on
any increase in spending.
Key strategic challenges
Uncompetitive technologies
In order to become competitive V needs to invest in newer technologies. Its
current technologies make its production methods slow and expensive. Failing
to invest will make it hard for V to regain market share and cut costs.
Outdated marketing
Letting 'the product speak for itself' is an outdated marketing concept. A failure
to research, understand and supply customer needs, and to align them with
promotional activities, undermines V attempts to be more competitive. As such,
V needs to adopt a more customer-focused approach to marketing. In addition, it
also needs to use the internet digital marketing platforms as a promotion channel,
which it is not currently doing.
Disjointed structures
The lack of cohesion over pay and job roles is undermining V's ability to provide
a consistent service offering. Failure to do so will confuse staff which may impact
upon customers and harm the brand. Therefore, the company faces a challenge
to introduce more a coherent and co-ordinated structure around job roles and
remuneration.
(b)
TUTORIAL NOTE
Here you are looking at how to derive strategies from a SWOT. The key here
is to think:
How to exploit a strength/How to neutralise a weakness/How to exploit
opportunities/How to combat a threat. For instance if new technologies are
a threat, then the company ought to consider how it raise the finance
necessary to invest in updated technology.
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Invest in new technologies
Developing the technology to prepare and dispense common prescriptions within
one hour will solve a number of the issues discussed above. It will enable V to
use its strengths, being it brand and cash, to take advantage of the opportunity
presented by new technologies. Additionally, the weaknesses of uncompetitive
technologies resulting in slow and expensive production costs, will be reduced
or eliminated. This measure will also allow V to compete on an equal footing
with S and other potential competitors, and if it invests in even more recent
innovations perhaps out-compete S in the growing youth market too.
Marketing Campaigns
V could attempt to arrange celebrity endorsements with sports, music or film
stars in order to enhance their brand. The cricket captain’s endorsement appears
to have been a fortunate accident, but the benefits of an official endorsement by
him and/or other sports stars could be huge in terms of brand exposure, customer
loyalty and maybe premium pricing.
Particular emphasis could be placed on the growing 18–30 year olds market
segment. There will be a cost in terms of payments to the celebrities and
marketing campaign. Marketing, however is an area that is currently both a
weakness of V that can be eliminated and an opportunity that can be exploited.
The use of digital marketing, using platforms such as Facebook, Instagram,
YouTube, Snapchat and Twitter would be particularly appropriate when
targeting the youth segment.
Focus on profitable locations
V appears to operate some stores that are profitable whilst others are less so,
which drags down overall group profitability. V should conduct a review of each
site's historic and potential future profitability and focus its resources where it is
most likely to make maximise returns for shareholders.
For example those sites with very high rental should have their leases reviewed
to see if they can be broken or notice served to either look for alternative premises
in the town or to close the store. In this way V will be maximising its returns in
respect of a key constraint (e.g. cash invested in retail floor space).
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Answer Bank
Question 2 - BMG
Marking scheme

(a) Explain the meaning of ethics in the context of 1
business
Identify an ethical issue – up to 1 mark each 3
Explaining the nature of the ethical issues identified 3
– up to 2 marks each
Identify a conflict – up to 1 mark each 1
Explaining the nature of conflicts identified – up to 2
2 marks each
(b) Using an appropriate framework e.g. Mendelow’s 0.5
Matrix – up to 0.5
Identify and classify a relevant stakeholder – up to 1 2.5
mark each
Explaining how to manage each stakeholder – up to 2 10
marks each
(c) Accelerated depreciation for alternate energy projects 1.5
up to 0.5 mark each
Benefit of accelerated depreciation for alternate 0.5
energy projects
Carry forward and use of accelerated depreciation in 3
subsequent years
Total 25 marks
(a)
TUTORIAL NOTE
Ethics is an area of subjectivity, so, when discussing your thoughts on this
topic you must justify your observations. In this case the ICAP’s Code of
Ethics may be a useful resource e.g. objectivity, confidentiality etc apply to a
range of situations, not just those involving accountants.
When thinking about stakeholder conflict you need to map the
needs/desires/interests to each group, then, consider when are working in
opposing directions e.g. shareholders want high dividends, but, staff want
higher wages.
Ethics is 'the science of morals' and is concerned with doing the ‘right things’
and maintaining expected standards of behaviour in the conduct of business.
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ICAP have their Code of Ethic’s which impose obligations on both ON as an
advisor providing advice to a client company, and ON as a company, as it’s
finance employee’s must act in line with the code. For instance ON’s advice to
BMG must be objective, and made with due care. At the same time ON must
avoid placing themselves in a conflict of interest. From an internal perspective
decision making with BMG’s finance function must be made with integrity and
objectivity. For example BMG should be careful when placing reliance on
Faisal’s cousin in Denmark. There is a potential conflict of interest here and
BMG should satisfy themselves that this supplier really is the most suitable for
BMG in the current circumstances, rather than being engaged because of the
family relationship.
The Provincial Assembly (the Assembly) has a duty to exercise fairness in
decision making of this type, and will need to balance the interests of various
stakeholders when deciding whether or not to grant planning permission for
BMG to undertake wind turbine electricity generation. Any decision is likely to
have to take account of a number of political considerations, notably the power
of the various interest and pressure groups, and of course, the upcoming
elections, as each representative of the Assembly will need to bear in mind the
view of their local constituents.
The key ethical issues can be summarised as follows.
(i) Ownership of national resources
One of the arguments raised by the 'anti-capitalism groups' is likely to be
that corporations should not be given private ownership and/or
exploitation rights over resources that could be regarded as under
'common ownership', such as the land required to site the turbines. There
is, however, the contrary ethical argument of 'stewardship': that is, that
since natural resources belong to the nation, there is a duty to exploit them
in the public interest, rather than 'wasting' them in their undeveloped state.
From the Assembly’s point of view, this is an on-going ideological
conflict (unresolved within the global political system) but there is also a
more focused conflict between the claims of economic sustainability and
environmental sustainability.
(ii) Economic sustainability
One of Assembly’s key priorities is to secure the sustainability of
economic activity and the increase of prosperity, particularly in under-
developed areas of the region. This is an 'ethical' issue in that it addresses
the basic economic welfare of local citizens: should rights to work and a
share of economic benefits be compromised by environmental
considerations (which may not have been raised by local people)? Aside
from this, there is the desire to address the power outages, something that
will have a beneficial impact on the local (and potentially) national
population, dependent upon the amount of electricity that can be generated
and added to the national grid. Mr. Faisal hinted at some tax benefit
available in the form of extra deprecation but he was not sure about the
details. Tax savings will add to the economic arguments in favour of this
proposal.
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Answer Bank
(iii) Environmental sustainability

This is the primary argument against the turbine operation. It addresses a range
of ethical values such as stewardship of the environment (the duty to preserve it
for future generations), the protection of habitats and biodiversity (e.g. the risks
to the endangered Greater Spotted Eagles and Laggar Falcons), community rights
to 'amenity' (preservation of living conditions and enjoyment of the environment)
and compliance with national and international law and regulation on
environmental protection. Against this arguments however are the facts that wind
turbines are a sustainable energy source that ultimately may do less harm that
other forms of energy generation e.g. burning more fossil fuels to plug energy
shortages.
The Provincial Assembly will have its own policy guidelines in regard to
environmental protection and sustainability, within which the decision to grant
BMG permission should be made.
(iv) Secondary stakeholder interests
The purpose of democratic government is to represent stakeholders in society –
and the process of application for wind farming rights is designed to ensure that
stakeholder voices are heard and taken into account. By definition, a 'stakeholder'
has a legitimate interest in a process or outcome, but there is a particular concern
that stakeholders which might otherwise be voiceless or powerless should be
fairly heard: the needs of the local communities and the claims of the (supremely
voiceless) flora and fauna.
There is also a justice or equity issue involved in the concept of 'externalities.'
Environmental and other impacts/costs of corporate activity need to be taken into
account – if not formally accounted for within the economic model – since they
are borne by secondary stakeholders who may not reap the benefits; for example,
the damage to the birds’ habitats.
Conflicts between main stakeholder groups
The issues discussed above account for the main sources of conflict between the
stakeholder groups.
(i) Conflict between BMG and environmental pressure groups
This conflict is focused between BMG and the demonstrators. This is a
systemic conflict, arising from competing ideologies and priorities in
regard to social responsibility.
BMG’s focus on maximising its financial returns is legitimate within its
own terms, because BMG has a duty to maximise the value it generates
for its shareholders, which includes securing the company’s future. It may
also be supported (although this is not stated in the scenario) by
community groups on the grounds of creating employment, and benefiting
the community through taxes paid, investment and the 'trickle down'
effect of economic activity, alongside the ability to sustain more local
commerce through the alleviation of power outages.
Environmental pressure and interest groups, however, focus on a different
set of priorities: the need to protect rare species from extinction, the need
to preserve scenic beauty for future generations, and so on. Wind farms
are a worldwide target of such groups, because of their aesthetic impact
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on environments, and impact on local wildlife via the destruction of
habitats and fears that birds will fly into the turbines. The pressure groups
may or may not be representative of local community interests: supporting
the 'bigger picture' of the environment at the expense of local economic
sustainability.
(ii) Conflict between local residents and BMG
A second conflict arises from the local residents’ fear of loss of residential
amenity as a result of the required construction activity. This may partly
be legitimately focused on the risk of traffic congestion and noise, but
there may also be an underlying fear of change and cultural erosion.
Economic progress and development (although desirable to some) may
represent the loss of an agricultural way of life and indigenous cultures
that have endured for many years.
While BMG may agree that congestion and noise should be minimised as
part of its social responsibilities, it is clearly committed to industrial
development and resource exploitation, and would presumably argue that
such a position benefits not only its shareholders, but the local community
as well through the creation of jobs and related investments in the local
economy e.g. reducing power outages may encourage inward investment
in the regions brining more jobs to the local economy.
(b)
TUTORIAL NOTE
The framework required here is Mendelow’s matrix. Avoid the temptation to
draw the matrix, instead, focus on the sources of power (how these groups can
be disruptive) and interest (why they care about the organisation’s strategy).
Understanding the level of power and interest different stakeholder groups have
should help BMG decide how to manage its relationships with those groups. The
key stakeholder and pressure groups identified in the scenario might be placed in
a power/interest matrix as follows.
(i) Anti-capitalist groups/Environmentalists
These are likely to have relatively low power (with relatively low numbers
and credibility in relation to more directly affected stakeholders)
– and at the moment high interest. There is a however a high likelihood
that a number of protestors will move on to the next ‘thing’ that they can
protest against, so, with some patience this group may become ‘low’
interest as they find something else to protest about.
However, within this group, BMG could distinguish between the concerns
of local stakeholders and the more ‘professional anti- capitalists’ who are
likely to move onto the next site of concern to further their cause. Local
stakeholders might have a more deep-seated interest in the development,
in which it may be appropriate for BMG to keep them informed.
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Answer Bank
(ii) Local residents

Local residents have a high legitimate interest in BMG’s plans, both
positive, in terms of improved power supplies and development, and
negative, in terms of loss of amenity. They have relatively low power:
although they may have more influence over the short-term as voters in
the upcoming elections. We do not have the figures to hand, but unless
that the local voters are able to sway the balance of power in the Assembly
after the upcoming elections their influence will be weak. However,
because of their high interest, there is a risk that they will co-opt more
influential stakeholders (such as the media and interest/pressure groups).
BMG should show its willingness to take local residents' concerns into
account by open consultation with them, and should try to promote the
economic and social benefits of the project – trying to convert (at least
some of) this group into supporting the development rather than resisting
it.
(iii) Provincial Assembly
The Assembly has a high official interest, as the approver of planning
grants: it also has an interest as beneficiary in the economic/social benefits
to the area – and in the concerns of voters who pose a political risk. It has
high power to revoke permissions and to monitor and enforce
environmental and local legal regulations. As it seems likely that public
money will need to be invested in the project, then the Assembly must
also weigh the public interest in contributing towards the costs of the
project. This could be assessed using an NPV analysis, though given the
environmental concerns then some form of non-financial analysis would
also be needed.
As a key player (with high interest and high power), BMG should ensure
it has regular communications with the Assembly, to try to maximise the
chances of its proposed development being acceptable to them. For
example, BMG should try to be proactive in its relationship with the
Authority by an environmental audit and impact statements, and making
plans to protect the endangered bird species, and minimise the disruption
caused to local residents.
(iv) BMGs shareholders and directors
These groups have a high degree of power over BMG’s strategy; the
directors as the strategic decision makers, and the shareholders as those to
whom the directors are accountable. Normally, they may have relatively
low interest in the specifics of an individual project: as their interests are
more generally in the performance of the company. However, in this
instance, Faisal appears to be viewing this as a turn-around strategy so
therefore this project is likely to be viewed as of being of the highest of
importance. As such, it is important that the directors and shareholders
support the project, and communication between the BMG’s directors and
major investors could be particularly significant here.
Mendelow's would classify Faisal as a key player, and therefore he should
dedicate all of his short-term energies into this project.
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(v) BMG’s bank
As a general rule, a company’s lenders have low interest in its affairs. As
long as interest payments and covenants are met they have little interest
in the day-to-day operations. However, in this instance the bank may
already be aware of BMG’s financial difficulties (and the risk that it may
breach its loan covenants) and therefore may be monitoring its
performance more closely. At the moment, the bank they will be
somewhere between low and high interest, depending on their knowledge
of BMG’s operations. If the project goes ahead then BMG may need to
secure additional finance, at which point the bank will definitely be ‘high
interest’.
As long as BMG continues to service its debts, and is able to demonstrate
compliance with banking covenants, then it is likely the bank can be kept
supportive of the project.
(c) Accelerated Deprecation for alternate energy projects
(1) The alternate energy projects are provided with benefit of accelerated
depreciation in the form of first year allowance in lieu of initial allowance.
(2) The first-year allowance is available in respect of plant, machinery and
equipment installed for generation of alternate energy by an industrial
undertaking.
(3) The industrial undertaking can be set up anywhere in Pakistan however it
shall be owned by a company.
Benefit of accelerated Deprecation for alternate energy projects
(4) The benefit of accelerated depreciation is that in the early years of
operation the taxable income is likely to be reduced by the amount of
depreciation considerably hence resulting in lower impact of taxation.
Carry forward and use of accelerated depreciation in subsequent years
(5) Since the investment in plant, machinery and equipment is likely to be a
very huge amount therefore the accelerated depreciation is likely to ensure
availability of tax loss to the company.
(6) The tax loss due to depreciation is termed as unabsorbed deprecation and
such loss is allowed to be carried forward for indefinite period of time
hence it will also reduce taxable income of future periods leading to tax
savings in future as well till all the deprecation is fully set off against
income.
(7) The brought forward unabsorbed depreciation in subsequent years can
however be adjusted only against 'income from business' and not any other
income.
(8) In the first year, the depreciation is adjusted last against the income of the
company and remaining amount is carried forward for adjustment against
business income of the company for the subsequent years and always
adjusted last.
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Answer Bank
(9) However, during year subsequent years, the unabsorbed depreciation

brought forward can only be adjusted up to 50% of balance income arising
from 'income from business' after adjustment of brought forward losses.
The remaining unabsorbed depreciation is carried forward till fully
adjusted.
(10) The limitation as to adjustment up to 50% of business income does not
apply if taxable income for the year is less than Rs 10 million.
Question 3 - Elite Clothing

Marking scheme

(a) Explain the meaning of forward integration 2
Explain how EC’s strategy has made it more 4
competitive – up to 2 marks each
Explain how EC’s strategy has made it less 4
competitive – up to 2 marks each
(b) Identify strategic opportunities and risks – up to 0.5 3
mark each
Discussing the opportunities/risks – up to 0.5 mark 3
each
Identify the competencies required – up to 0.5 mark 2
each
Explaining the competencies required – up to 0.5 2
mark each
(c) Conditions for surrendering for the year loss of 5
the subsidiary company to the holding company
Total 25 marks
(a)
TUTORIAL NOTE
When evaluating a strategy the approach can be fairly generic, but remember
you then need to use the scenario to ensure that your analysis is tailored to the
client:
Approach 1 – discuss the advantages/disadvantages of each strategy
Approach 2 – discuss the Suitability (strategic sense), Acceptability (to
stakeholders – including the financial returns for shareholders) and Feasibility
(can it be done).
In this issue the first approach is more useful as you can discuss how the
move into dress design has helped/hindered EC’s ability to compete.
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Forward integration back into dress design and manufacture and its effect on
competitive ability
Forward vertical integration is often justified as it enables the firm to do three
things.
(a) Earn more of the profit available in the value chain
(b) Control marketing and pricing strategy – the firm can ensure it maintains
the image of quality and exclusivity
(c) Control usage of the product
EC's main motivation has been to earn more profit. In this, the incorporation of
an in-house clothing design team has enabled it to increase its profits in the short-
term (up Rs 16 million from 20Y6 – Y7). However, what is not clear from the
analysis provided is whether these profits were in fact driven by the expansion,
or, whether this was more connected to higher margins on the European business.
Anecdotally, it appears that the extra volumes and increased utilisation of the
factory initially contributed to the increase in profits.
EC has thus extended its Value Chain. Previously, the process of adding value
was simply a matter of turning a design into a garment. The European retailers
were therefore taking the profits from both the design and retail aspects of the
operation, leaving EC with the profit to be made on the manufacturing only.
However, for the clothes EC designs, it can capture the value (margin) from both
the design and manufacturing activities.
An additional consequence of designing clothes for the domestic market is that
it gives EC a new customer base – its domestic retailers as well as its European
customers. This should make the company more competitive in price as the
greater volumes will allow it to spread its fixed costs across more garments as it
starts to utilise some of its spare capacity. To some degree this has had little effect
on its own Value Chain, as EC is still required to deal with inbound and outbound
logistics, operations, sales and marketing. However, its operations have now
been expanded to take account of the need to design as well as manufacture, and
thus its secondary activities such as HRM and IT will also have needed to change
to accommodate the skills and technology required to design clothing for the
domestic market.
EC’s initial success may have lead Mahood and the senior management team to
consider that vertical integration has no drawbacks, hence their suggestion to
enter retailing.
The drawbacks of EC's approach include:
(a) EC has restricted its market to the middle aged and middle income market.
This may be a sensible strategy for a clothing design company, but, in
reality more market research would be needed to validate this approach.
For instance the strong economic growth in Pakistan in recent years will
have spawned a larger middle-class. However, perhaps EC’s expertise in
fast-fashion may have allowed it to cater for the indigenous youth market
as well.
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Answer Bank
(b) EC has focused rather narrowly on the Punjab region. Whist this is the
largest province in the country this has left more than half of the
population unserved, and, given the regional variation in women’s dress-
ware, it has somewhat limited the company’s sales scope.
(c) EC has to support two different production operations – fast-fashion
production for European clients, and undoubtedly higher quality garments
for the domestic market. Whilst it is believed that greater economies of
scale have been driven by higher utilisation, as sales have fallen back gross
margins have shrunk to 9.0% in 20Y8, compared to 10.5% in 20Y6.
(d) There is some confusion as what EC is trying to achieve, as noted above.
Fast-fashion relies upon relatively inexpensive garments that are
expendable. (Because the clothes are sold at lower prices, the wearer feels
comfortable disposing of items in favour of newer fashions.) This level of
quality is not likely to be compatible with the garments being designed
and manufactured for sale in Pakistan. It may be that Mahood’s desire to
expand the company, mixed perhaps with some nostalgia for the
company’s origins may have resulted in this somewhat unusual mix of
activities.
(e) There are few obvious synergies between these activities. The success of
EC as an off-shore manufacturer was based around its ability to efficiently
produce items to specification, quality and time targets. The move into
design may have made more sense if EC had attempted to produce designs
for its European customers, though it is appreciated that this may not have
been possible at the time as Asian companies are still better regarded for
their manufacturing prowess than their creative talents.
Forwards vertical integration has potentially made it harder for EC to compete
with other manufacturers as its diversification may have confused potential
European consumers, or, reduced its own economies of scale, which are vital
when competing on cost, as most outsourced manufacturing companies have to
do.
(b)
TUTORIAL NOTE
There is a lot to do in this question – the key is to split out the various sub-
requirements:
Identify opportunities (detailed within the scenario)
Identify risks (detailed within the scenario)
Explain the consequences of this strategy (good and bad)
Assess change in competencies (what skills are needed in retailing – which of
these do they have, or, need to acquire)
Forward vertical integration into retail outlets
EC is proposing to move into retailing, with the intention to earn more of the
value in the value system e.g. combing the value chains of design, manufacture
and retailing.
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Opportunities
(a) EC would have total control over production, pricing and marketing. It
could develop a precise marketing strategy that further differentiates its
domestic products, enabling a targeted focus on its desired customer base.
Moreover, it will have more freedom to develop marketing messages and
integrate its marketing strategy.
(b) EC will also be able to ensure that its products are available and visible,
and are not competing in the same clothes racks as other domestic
competitors – thereby avoiding price comparisons. In other words, EC will
not depend on retailers' professional buyers to order or display its
products.
EC will become fully informed of its target market. It may be able to make
clothes to order, if customer measurements can be transmitted electronically to
the factory: this would be an example of mass customisation.
Risks
(a) EC will acquire a range of retail properties, with management problems
of their own. Any additional debt that may be taken on via the acquisition
will incur additional interest that will eat into any extra profits that are
made on clothing sales.
(b) Higher risk. If EC's clothes go out of fashion, the stores will become an
expensive liability. Owning a chain of retail outlets involves a much
higher proportion of fixed costs than design and clothing manufacture.
Much of this risk depends on the location of the shops, as well as any
negative impact that internet shopping may have on traditional ‘bricks and
mortar’ shops.
(c) If EC’s products are exclusively sold in its own shops, EC may forgo the
sales it would have made at independent stores. In these circumstances EC
might be subject to higher customer bargaining power with its existing
retail customers.
(d) EC will need to produce a wide enough range of products to encourage
customers to enter the stores. Alternatively EC may have to supplement
its own wares with others by other suppliers – will it be able to do so cost-
effectively?
Competencies
(a) EC’s competences are currently in manufacturing, rather than retail, so it
will need to develop its competencies in retail if the new venture is going
to be successful. However, as EC is acquiring the chain, it will inherit the
many of the competences needed, providing both that it can keep the staff,
and that EC’s managers integrate the acquisition in a sensitive way. For
instance, this will be the first time EC will need to market directly to the
end consumers of its products (the women who wear the clothes) rather
than to trade buyers.
180
Answer Bank
(b) Inventory management for many small retail stores will be quite
complicated. EC may well inherit systems currently employed in the
acquired company. EC will need to ensure that it has a suitably responsive
distribution system to ensure well-selling items are available to meet
demand.
(c) EC needs to understand shop-based retailing, display, and merchandising
e.g. ensuring a suitable range of clothes is available in the right volumes
and at the right time.
(d) If it makes the acquisition, EC would be running three different types of
business. To benefit from economies of scale, it may need a performance
monitoring system for each business. For instance there will be different
CSFs in each part of the business, so, an appropriate range of KPIs will
need to be developed to ensure management are controlling each part of
the business.
Question 4 - First Bank
Marking scheme
(a) Discussion on size of Board 1
Commentary on actual size of Board at the bank 1
Balance between independent and other directors 1
Size and composition of Risk Committee 1
Position of CEO/Chairman 1
Comment on balance of Board 1
(b) Reduce size of Board – up to 2 marks 2
Splitting role of Chairman/CEO – up to 2 marks 2
(c) Consider the case of fraud – up to 3 marks 3
Determine the influence independent NEDs had on 3
these issues – up to 3 marks
(d) Carried out by independent consultants 1
If no external consultant, then look at NC carrying 1
out reviews
NC prepare aspects of performance to be reviewed 1
Directors invited to give views about their 1
performance
Measures to ensure NC members not reviewing their 1
own performance
181
(e) Review size and structure: 1
Membership of board committees 1
Membership of RC 1
Succession planning 1
New Board candidate recruitment 1
Induction and training needs of directors 1
Total 25 marks
(a)
TUTORIAL NOTE
There question requires a good knowledge of the Code of Corporate
Governance. This highlights the need to be familiar with the main themes of
the Code e.g. composition of the Board, role and responsibilities of NEDs,
role and responsibilities of the committees (audit, remuneration,
appointments, risk), evaluating Board performance.
This knowledge will help you identify the weaknesses in the Bank’s corporate
governance, making it relatively straightforward to give advice on improving
procedures and assessing the performance of their board.
Size and composition of the Board
The Code of Corporate Governance does not specify an optimum size for the
Board, but it recognises that the size of the Board may have an impact on its
effectiveness. The Board should not be so large that it becomes unwieldy.
Conversely, a Board should not be too small. Collectively the Board members
should have sufficient knowledge of the business, skills and experience to lead
the business effectively. There should also be a sufficient number of directors so
that any changes to the membership of the Board can be made without causing
undue disruption.
A Board of 18 members seems large, and so may be unwieldy. This too may
seem an excessive number for large board. Eight directors are either executive
directors or non-executives who are not considered to be independent so the
balance here may need to be tilted so that in a reduced board the independent
member comprise at least a third, and preferably a majority of a slimmed-down
board.
Balance between independent directors and other directors
The Code of Corporate Governance states that companies should have at least
one, and preferably one third, of the total members of the board as independent
directors, and independent directors should make up at least one half of the
Board. The company complies with this provision, since at least ten and possibly
11 out of 18 directors are considered independent.
182
Answer Bank
The Risk Committee

Committees of the Board should consist of members who have a diversity of
skills, experience and knowledge of the company (and risk). There is currently
only one member on the Risk Committee, and his suitability has been called into
question by the sizeable shareholder revolt against his re-appointment.
Positions of Chairman and CEO are held by the same individual
The Code states that: The Code also states that the Chairman and the Chief
Executive Officer (CEO), by whatever name called, shall not be the same person
except where provided for under any other law.
It seems likely that Ms Umar’s dual role is in breach of this requirement, unless
there is any law which expressly allows this.
(b) Reduce the size of the Board.
One suggestion is to reduce the size of the Board by asking some directors to
resign, but of course still maintaining at least 50% of the Board as independent
directors. The Chairman and/or the Nominating Committee should possibly
identify individuals who should be asked to resign.
Split the roles of Chairman and CEO.
The role of the Chairman and CEO should be split. It is up to the Board to decide
which role Ms Umar should continue in. If Ms Umar wishes to remain actively
involved in the management of the bank then she could remain as the CEO. The
Chairman should be responsible for leadership of the board and ensuring that the
board plays an effective role in fulfilling all its responsibilities.
The CEO should be accountable to the Board, and therefore the Chairman’s role
(in leading the board) prevents the holder from exercising executive decisions in
terms of running the bank (as CEO).
(c) NEDs should of sufficiently strong character so as to be able to express their
independent arguments in Board meetings, and so that they might hope to
influence decision-making by the Board.
Non-executive directors (both independent and non-independent) should protect
the interests of minority shareholders, and other stakeholders, against the self-
interest of majority shareholders or management, voting down proposal where
they feel this is the correct course of action.
The Code of Corporate Governance states that:
They (NEDs) are expected to lend an outside viewpoint to the board of directors
of a company and do not undertake to devote their whole working time to the
company.
These functions can be performed by NEDs even when independent NEDs are in
a minority on the Board.
Incidence of fraud
The fraud seems to have been a deliberate act by senior members of the company's
board (the Chief Finance Officer and the Audit Committee Chairman) to report
the company's financial performance incorrectly.
183
The independent NEDs on the Audit Committee did not identify the fraud, and
any influence they might have on decisions by the Board would be in response to
the fraud after it became known.
The Risk Committee did not identify the fraud, and this is because of its historical
problems, and the current two-person structure. The one member of the Risk
Committee who was previously on the Committee had a strong vote against him
(42%) at the AGM, but was reappointed to the Board and the Committee despite
this. The other member is new to the Board, and is the former Chief Risk Officer
of the Bank. This may explain their failure to intervene in the decision making
that lead to this problem.
Investment in the Middle East
The independent NEDs argued against the investment because of the risk
involved, but were persuaded by the rest of the Board. They accepted the majority
view, which may seem to be the democratic outcome, but, the job of NEDs is to
be strong enough to speak out even when they are in a minority. Consensus among
the Board members is preferable to continual disagreement. Although they 'lost
the argument', the independent NEDs will be able to monitor the progress of the
investments, and may wish to discuss the matter again at Board level if the
investments are affected by political events.
In conclusion, although the independent NEDs cannot 'win the argument' in Board
meetings by having a majority of votes, they should still be capable of
contributing to discussions and decision-making; and should also be able to
monitor management to prevent excesses in their behaviour.
(d) The performance review may be assisted or carried out by independent
consultants. This will reduce the problem of directors being involved in a review
of their own performance. This is particularly important with the history of the
Board at First Bank of Punjab up to now.
If an external consultant is not used, the performance evaluation should be
conducted by the nominating committee (NC), or should be conducted according
to procedures determined by the NC. However, in the case of First Bank, using
an external consultant should be the preferred option.
The NC may prepare a list of aspects of performance that should be reviewed, for
the Board as a whole, for each Board committee and for each individual director.
Directors may be invited to give their views about the suggested performance
measurement, using questionnaires or interviews where the items discussed
should be recorded.
Members of the NC should not be allowed to evaluate their own performance,
external independent consultants should be used. The committee may also decide
that the performance of the Board Chairman should be evaluated in consultation
with all other non-executive directors, and possibly also take in the views of the
executive directors. This is particularly important because of the recent case of
fraud within First Bank and the resulting issues and changes with the Board.
After the evaluation has been made, the NC should consult with the Chairman
about the results. Where appropriate they should discuss the need for changes in
the composition of the Board.
184
Answer Bank
(e) The NC should consider the following criteria with regards to evaluating the
Board of Directors:
(i) Review the size, structure and composition of the board – it is currently at
18, with 10 (a majority) independent NED. A Board of 18 members seems
large, and the number of independent directors too minimal.
(ii) Recommend membership of board committees for the individual directors.
(iii) Examine the membership (1) of the Risk Committee, and the
independence of the one member (ex-CRO)
(iv) Undertake succession planning for the Chairman, CEO, CFO and other
directors.
(v) Search for candidates for the board, and recommend directors for
appointment.
(vi) Determine the independence of all directors – this will be improved of the
roles of Chairman and CEO are separated.
(vii) Assess whether directors are able to commit enough time for discharging
their responsibilities.
(viii) Review induction and training needs of new directors.
Question 5 - Fresh ‘n’ Frozen
Marking scheme

(a) Define Big Data 1
Define each of the 3Vs of Big Data – up to 1 mark 3
each
(b) Identify relevant aspect of Big Data/Data Analytics 8
for FF – up to 1 mark each
Explain the relevant aspect of Big Data/Data 8
Analytics for FF– up to 1 mark each
(c) Identify a practical issue for FF – up to 1 mark each 4
Explain practical issue for FF – up to 1 mark each 4
Total 25 marks
TUTORIAL NOTE
The 4 V’s of Big Data are key to defining it in detail e.g. large volumes of
unstructured data, meaning that volume, velocity, veracity and variety are the
challenges that must be overcome in harnessing it.
185
Big Data
(a) Big Data
Data analytics firm SAS define Big Data as 'the exponential growth and
availability of data, both structured and unstructured. Big data may be as
important to business and society as the internet has become.'
Doug Laney at Gartner defines Big Data through the consideration of three V's:
volume, velocity and variety.
Volume – Volume refers to the amount of data which is now available for
organisations to access, store and use. The widespread use of the internet, smart
phones and social media by businesses and individuals have increased the volume
of data produced.
Velocity – refers to the speed at which 'real time' data is being streamed into and
processed by modern organisations. Many online retailers compile records of
each click and interaction a customer makes while visiting a website, rather than
simply recording the final sale at the end of a customer transaction. The speed at
which such retailers are able to utilise this data about customer clicks and
interactions can be used to generate a competitive advantage.
Variety (or variability) – Big data is associated with the diversity of source data.
In many cases big data may come in unstructured form (i.e. not in a database).
For example, keywords from conservations of people have on Facebook or
Instagram, and content they share through media files (tagged photographs, or
online video postings) could be sources of unstructured data. This presents
modern businesses with new challenges in how best to capture, store and process
such data.
(b)
TUTORIAL NOTE
This is a tricky requirement, as, although big data is clearly a technological
topic it actually helps companies by allowing them to deal with operational
issues and processes. Therefore the key here is to identify weak processes,
then, think about having more real-time information (derived from Big Data)
could help the company overcome practical issues e.g. if trucks are getting
stuck in traffic jams, then the solution may be found in real-time traffic routing
via GPS units.
Big Data at Fresh 'n' Frozen Freezer units
Install sensors
The Head of Delivery has identified that a number of freezer units fitted in the
company's older vans are not working well, and are requiring extra power in
order to keep the products suitably frozen, resulting in increased fuel costs. This
issue could be addressed through the installation of sensors in FF's fleet of vans
which could measure and monitor the temperature of the freezer units. Large
retailers have taken to placing sensors into in-store refrigeration and freezer
cabinets to assess whether such equipment is functioning correctly.
186
Answer Bank
Saves staff time

The temperature of individual units could feedback 'real time' performance data
to a central computer accessed by the Head of Delivery and his team. Any
discrepancies could then be identified between the desired temperature and the
actual temperature recorded by the sensors. This would remove in part, the need
for regular physical inspections to be carried out on the vans and would save the
time of the driver and depot workers, freeing them to undertake other tasks. Time
saved may allow FF to raise its targets for deliveries per day above the current
level of 15.
Reduce costs
Installing sensors should also allow the Head of Delivery to identify those units
which require fixing immediately. This is a priority, as during the recent
management meeting it came to light that in some vans the freezers were barely
functioning at all in extreme heat. Obtaining this data sooner would have helped
to ensure that these vehicles were not being used for deliveries until either
repaired or replaced. There may even be scope to install more advanced sensors
which not only record the temperatures in the vans, but automatically adjust the
freezer units settings to maintain the required temperature.
As this illustrates, the use of sensors could assist FF in reducing vehicle running
costs, cut down on fuel usage and help to improve the company's financial
performance.
Logistics and deliveries Traffic congestion
It is evident that congestion on the roads is creating problems for FF's delivery
drivers when completing their daily rounds. Heavy traffic congestion is
increasing the frequency with which drivers miss their agreed delivery slots. This
has led to an increase in the occurrences of no-one being at home to accept the
goods when the driver eventually arrives. This necessitates the need for the
deliveries to be rearranged the following day. As the Head of Customer Services
has highlighted, this is having a negative effect on customer satisfaction, as well
as on driver pay and morale. One disgruntled customer commented that they had
now switched to using an alternative retailer, and it is likely that they will have
shared their experience with friends and family, face-to-face, and maybe online,
harming FF’s reputation. Additionally if less time is lost in traffic jams then the
number of deliveries per day could be raised above the current target of 15, and
the number of deliveries made first time may reach or exceed the target of 95%.
Tracking deliveries
Big data analytics could be employed by FF to relay up to date travel information
from the delivery van back to the depot to assist the Head of Delivery ensure all
customer delivery time slots are met. This could be achieved through the
installation of tracking devices which feedback 'real time' data about the driver's
progress and the likelihood of meeting the delivery time. By capturing and
relaying this data to the depot team, it should be possible to plot alternative routes
to those regularly used by the drivers while they are still out on their rounds – or,
to use modern satellite navigation devices so that the driver can do this from the
cab. However, more fundamentally, the use of such data should allow the Head
of Delivery to re-design the drivers’ current routes to make them more realistic.
187
The delivery routes currently used are evidently no longer viable, as they are
based on historic and outdated data – which is a particular issue given the growth
in Lahore’s population. Improving FF’s route planning should help to increase
the number of deliveries successfully made and reduce the need for return visits.
Customer care
In the event that the driver is unable to meet the required time slot, relaying the
driver's progress will allow the customer service team to contact the customer
and inform them of the delay. In some cases it may be possible that the delivery
is arranged at a later point on the same day, as opposed to a number of days later.
Such an approach should contribute to improving customer satisfaction when
buying from FF.
Poor route management
In addition to road congestion it could be argued that FF's approach to route
management has significantly increased the scope for busier drivers to miss their
designated time slots. As those drivers with fewer deliveries to make on their daily
rounds are potentially sitting around with little to do while their colleagues struggle
to make their designated deliveries. As mentioned earlier, the current situation has
been compounded by the fact that historic delivery patterns were used in
conjunction with an online distance calculator to determine the delivery routes
used. It is evident that this approach to route management has not been updated
since the previous Head of Delivery retired. Better route management may reduce
time wasted by staff, with the benefit of reducing overtime payments, which attract
a premium of 50%, these costs savings will be welcomed by FF.
Active data base management
The current situation could be improved if the company actively manages the
data it receives about its customers. Enhancing the company's systems for
analysing customer data, such as customer order details (e.g. delivery addresses)
would allow FF to build up a historic pattern of the busiest day of the week for
deliveries and those towns and cities where demand for the company's services
is greatest. This could prove particularly beneficial for the Head of Delivery
when planning the daily deliveries as more drivers could be assigned to make
deliveries during busy times. This would overcome the current situation where
drivers only make deliveries on their pre-assigned route and should ensure that
customers receive their goods at the correct time.
Customer relationship management Basic website
At the current time, FF operates a very basic website which is capable of
accepting customer orders. To place an order, customers are required to only
provide limited details, including their name, address, contact and payment
details. The company's management should look to collect greater quantities of
better quality customer data with a view to maximising sales. In the modern
world FF should also consider creating a mobile app so that customers can place
orders, pay and track deliveries on their phones.
188
Answer Bank
Market segmentation and customisation

Data analytics software could be used to analyse the type of purchases individual
customers make, assess the frequency of purchases and the amounts typically
spent. This data could be used to identify hidden patterns and trends in customer
purchasing behaviour. This approach would allow FF to customise its marketing
message by sending emails/alerts with special offers to customers based on their
regular purchases. Complementary products to those purchased could also be
promoted to appeal to individual customers when returning to the website.
Furthermore, if data can be captured which covers the age of customers, spend
per shop as well as the areas in which existing customers live, then this should
help FF to better direct its marketing efforts. It is likely that clusters of existing
high spend customers identified as living in a particular neighbourhood or region
may live near other individuals with similar needs. In such cases FF could benefit
from targeting adverts promoting its services in local newspapers/billboards that
cover these areas. Equally, there may be scope to purchase from a reputable
source the names and addresses of people living in a target area to facilitate
direct marketing.
Data analytics also help companies today by providing customers with
recommendations of items to purchase based on the tastes of similar customers.
Providing shoppers with recommendations while visiting the website may help
to expand the range of products customers purchase.
Decision making
Data analytic tools could be used to improve decision making at FF. For example,
trends (including seasonal trends) identified in online sales in real time could be
used to determine inventory and pricing strategies. Decisions could be made
using this analysis by management or even through the use of automated
software. For example in the event that a particular line is not selling very well
automated software using algorithms could be linked to the company's website
to make decisions about inventory levels and pricing in response to current and
predicted sales data.
Feedback
FF could also look to interact more closely with customers by providing them
with the opportunity to leave feedback on the experience of shopping with the
company (feedback could cover issues covering the quality of the company's
products and delivery service). Capturing and analysing such feedback using
sophisticated data analytic tools whether in structured or unstructured form (e.g.
feedback from Twitter or Facebook) would allow FF to respond quickly to
customer complaints. Analysing customer feedback may also prove insightful in
identifying changes in the types of products customers demand from the
company.
(c)
TUTORIAL NOTE
Big data clearly requires the capture and processing of lots of personal data in
this instance. This will create issues around creating the technological
infrastructure, cost, expertise and security. These are generic issues that will
be relevant to any organisation deploying big data technologies.
189
Practical implications Cost
Increasing the amount of data that FF captures and processes about its customers
would require the company to improve its existing IT architecture and software
applications (such as creating a mobile app). The associated costs of undertaking
such an overhaul would most likely be significant, and would need to be fully
considered against the benefits it is expected to deliver. The management at FF
would need to give careful consideration to the scope of the IT project required.
The scope of the project is concerned with the determining the desired project
outcomes e.g. to capture more meaningful customer data, and the necessary work
needed to achieve this. Where the scope of the project has not been determined
in advance there is a serious risk that the project will fail to deliver the intended
result.
Important consideration must also be given to FF's ability to pay for an
investment in a new IT system. Given the company's recent dip in performance,
coupled to problems with some of the older delivery vans, there may not be
sufficient funds available to fully enhance the existing IT infrastructure at the
current time.
Time
Closely connected to the issue of cost is the amount of management time that
will be required to establish the necessary databases and the analytical software
tools. This process is likely to consume a significant amount of the Customer
Service Director's time (and the time of the IT and Marketing Directors, if FF
has them) in determining the types of data needed to be captured. Furthermore,
if capturing customer data is to be facilitated by upgrading FF's website, then
consideration will need to be given to any potential disruption that this may cause
the company. This is likely to be of significant importance, given that customers
need to use the website to make their orders.
Specialist skills
Consideration needs to be given to whether the FF management team have the
required skills to be able to extract meaningful insight from the data they capture
and process. As FF is a relatively small entity it seems highly unlikely that any
of the existing managers will have any experience in analysing large data sets.
Employing additional experts with the required skills will increase costs.
Limited experience of using technology
Increasing the amount of customer data captured and analysed will make data
management more of a strategic issue at FF. This focus is likely to require a
change in the attitude of the management team towards the use of technology.
Based on the fact that the company presently operates a basic website this may
indicate that the management are somewhat reluctant to increase FF's
dependency on the use of IT systems. Given the required investment needed to
improve FF's IT infrastructure it is important that all members of the
management team support the initiative. Failure to understand the benefits of
capturing increased quantities of customer data increases the scope that this is
simply viewed by some as following the latest 'fad'.
190
Answer Bank
Data overload
Careful consideration needs to be given to which customer data sets are likely to
be of use to FF. There is an inherent danger with data collection that too much
of the wrong type of data may be captured if the needs of the business are not
determined in advance. Too much data may lead to 'data overload'.
Data security
Holding increasing amounts of customer data raises some interesting questions
including; the issue of who actually owns the data held? Whether customers
consent to their data being held? What data is held? These points clearly raise
legal and security concerns over the data held. The management team at FF will
need to ensure that adequate measures are put in place to stop customer data
falling into the wrong hands. Clear company policies on data handling and
adequate password protection over systems holding personal data will need to be
introduced if they are not already in place.
Question 6 - Ali & Co.
Marking scheme

(a) Any TWO from:
Asset based: Do not reflect future earning potential 0.5
Asset based: Do not include intangible assets 0.5
Income based: History cannot predict future earnings 0.5
Income based: Difficult to determine discount rate and 0.5
P/E
(b) Venture capitalist approach 1.5
Top-down approach 1.5
(c) Conduct net asset valuation or calculation 0.5
Assess value of net asset method 0.5
Conduct P/E ratio method calculation 0.5
Assess value of P/E ratio method 0.5
Assess present value (PV) of future cash flows calculation 1
Show workings of PV future cash flows calculation 1
Discuss findings 1
191
(d) Advantages of using VC finance 1
Disadvantages of using VC finance 2
Advantages of seeking a stock market listing 1
Advantages of seeking a stock market listing 1
(e) Explaining how an earn-out clause would work – up to 2 2
marks
Explaining how deferred consideration would work – up 2
to 2 marks
Describing exit strategies – up to 1 mark each 1
(f) Commentary on which offer to accept 2
Calculations for offer 1 2
Calculations for offer 2 1
Total 25 marks
(a)
TUTORIAL NOTE
Company valuations are a common requirement. You need to (i) be able to
perform a range of valuations ranging from Net Asset value, to Present Value
of cash flows including perpetuity (ii) discuss the suitability of each method
used. For instance the Net Asset approach is generally only suitable in a
liquidation scenario, and the dividend valuation model when acquiring a
minority stake in a company.
The subjects in this question are small, start-up companies. As they have little
trading history, and are unlisted valuing them is very subjective and fraught
with risk. Any valuations must therefore be made with a number of
assumptions. In these circumstances you must be able to state your
assumptions, and, discuss the effect that these assumptions will have on the
valuation if they are wrong.
The conventional valuation techniques are either asset-based or income-based
valuations.
Asset-based valuations do not reflect future earning potential. They do not
include the value of intangible assets – almost all of C2C's value is likely to relate
to the intellectual property it has developed. In this case, therefore, the asset
valuation presented of Rs 16,665,911 can effectively be ignored.
192
Answer Bank
With income based valuations, history does not reflect future earning potential.
In this case, C2C has only made losses to date, and it has not yet earned any
revenue. However, this does not mean the business has no value, or, a negative
value. It is also difficult to predict future earnings. As C2C’s product is brand
new, it is difficult to research the company’s future earning potential, and
consequently valuing future free cash flows is likely to be problematic.
(b) Venture capitalist approach
Under the venture capitalist approach it is suitable to estimate future earnings in,
say, three years' time. (This can be difficult but ASS could make assumptions,
based on a share of the high-end cycle computer maker, and produce a range of
values based on this). The next step is to value those earnings using a proxy P/E,
from a similar listed company for example. Then discount the earnings heavily to
today's value, using a high discount factor to represent risk – say 35–50%.
Although these rates may seem arbitrary they are typical rates for a venture
capitalist to use given the risk profile of the start-up companies they typically
invest in.
OR
Top-down approach
Under the top-down approach it is suitable to estimate the total market size for
cycle computer equipment (e.g. by reviewing industry analysis of listed
competitors). This will need to build in the global growth of cycling as a mode of
transport and sport.
The next step is to estimate C2C’s market share, given market reactions to
innovative products in the past. This should produce forecast revenues – and
these could be extended over a reasonable period e.g. annual revenue for the next
five to ten years.
Then it is time to deduct estimated costs based on these implied volumes, leaving
incremental net cash flows (remember the additional capital expenditure required
to manufacture and update the intellectual property).
The final step is to discount the incremental net cash flows to give an NPV. The
discount rate should be based on equally high risk businesses – although, in
practice, this information may be difficult to find.
(c) Range of values for the company Valuation methods
A company can be valued in terms of the underlying value of its assets and its
ability to generate future profits and cash flows (economic value).
Asset based valuation: net assets
Asset values are mainly of relevance if the company is to be broken up for
disposal. BiOs net asset value is Rs 34 million, which, we are told, reflects the
realisable value of its assets. This gives a 'floor level' value for the company, but
is far too low to be of relevance to negotiations with the investment bank, because
the company is a going concern and is not about to be broken up. Equally
importantly, as BiOs is a software developer, most of its assets (know-how, skills,
and contacts) are intangible and their value is not included in the net asset value.
193
It is more relevant to estimate the economic value of BiOs, which can be done in
a number of ways.
Earnings based method: Price/earnings (P/E) ratio method
In this method, which gives a quick approximation to economic value, equity
earnings are multiplied by a suitable P/E ratio taken from quoted companies in
the same industry.
BiOs' earnings in 20X3 = 653 cents x100,000 shares
= Rs 65.3 million
P/E ratio 12 18 90
Valuation Rs million 784 1,175 5,877
The problem with P/E ratios is that they are affected significantly by the expected
growth rate of the company. In the industry examined, P/Es vary between 12 and
90. Given that BiOs is predicted to grow fast, we would expect its value to be in
the top half of this range, at least, but the P/E ratio method does not adequately
allow for the growth rate in the computation.
Note that any reasonable estimate can be made using the P/E ratio of comparable
companies and/or other transactions in the biotech sector. The Directors are
advised to apply the P/E ratio of a close competitor with a similar revenue, market
share, risk, and product range to its own to determine the most relevant earnings-
based valuation. However, we acknowledge the problems of finding a suitable
benchmark given the niche market in which BiOs operates.
This approach to valuation is therefore relevant but simplistic and subject to large
margins of error (for example, due to the range in possible ratios (between 12
and 90).
Free cash flow valuation: present value (PV) of future cash flows
This method estimates a stream of future cash flows rather than just one profit
figure and discounts the cash flows at a cost of capital (earnings and cost of
equity) suitable for the risk of the company's operations.
Using the assumptions that profit after tax equals cash flow, that this will grow
in Years 2 and 3 at 30% per annum, followed by 10% per annum after that, and
that the industry average cost of capital is suitable, we can estimate the company's
value as follows:
20X3 = Year 0, 20X4 = Year 1 etc.
12% mid-year PV
Rs'm discount factor Rs'm
20X4 earnings (Rs 367 × 50% × (1 126.6 0.945 119.6
– 31% tax)
20X5 earnings: 30% higher 164.6 0.844 138.9
20X6 earnings: 30% higher 214 0.753 161.1
20X7 to perpetuity: 10% growth
(W1) 235.4 (W1) 8,828.9
PV of future cash flows: 9,248.6
194
Answer Bank
Working: PV (at 20X6) of the perpetuity from Year 4 onwards, growing at 10%
per annum = 235.4/(12% – 10%) = 11,725. To find the PV as at Year 0, discount
by the 3-year factor: 11,725 × 0.753 = 8,828.9
Comment on valuation using present value (PV) of future cash flows The value
of BiOs by this method is Rs 9,248.6 million.
Although there is a substantial margin of error on this valuation estimate, the
method is considerably more useful than the P/E approach because it allows for
the estimated earnings growth. However, the company's growth projections are
dependent on the ability to find skilled software engineers, who appear to be in
short supply.
A significant uncertainty is the estimated growth of 10% into perpetuity from
Year 4 onwards. This may be unrealistic, as double-digit growth will be hard to
sustain once the company starts to mature, and this assumption substantially
increases the value of BiOs. It is recommended that the directors re-evaluate the
expected growth rate using due diligence processes and if necessary, apply a
lower growth rate to revise the estimated value.
Conclusion
On the basis of the figures given, the company's cost of equity is probably in the
range of Rs 1,175 to 9,249 million (P/E ratio of 18, and the free cash flow
methods). Further information is needed, in relation to the assumptions on which
earnings forecasts are based, in particular the assumption that staffing resources
can deliver the predicted growth rates, and the company's cost of capital would
help to make a more accurate assessment. This can be achieved by appointing
independent advisors to complete due diligence procedures prior to acquisition.
(d)
TUTORIAL NOTE
Venture capital is generally thought of as the lender of last resort e.g. they will
invest in start-up or young companies when traditional lenders such as the
banks will not. This is due to the levels of risk involved. As such it is natural
than venture capitalists will demand (i) a very high rate of return – typically
35%+ annually and (ii) a medium-term exit route e.g. 3–5 years. This makes
VC very different to other sources of funds as explore in the final two parts of
this question.
Advantages of using venture capital
Venture capital funds specialise in financing early-stage, risk-oriented ventures
like BiOs. They will offer finance and assistance once a company has started to
generate revenue and shows that it has high growth prospects.
The funds offered by venture capital are typically for five to seven years, and the
bank has stated that they would want to exit between five and six years' time. At
the end of this period it is presumed that the company will have grown and will
be looking for more permanent sources of funds, at which point the venture
capital fund will seek an exit route.
195
Disadvantages of using venture capital
(i) High cost
Venture capital firms tend to demand large equity stakes in exchange for
advancing loans. In effect once the loss of equity is added to the debt
interest this can be a very expensive way to raise funds. At the point that
the VC firm looks to exit the Safraz brothers could be left with a much
reduced equity stake to sell themselves.
(ii) Participation of venture capitalist
The venture capital fund becomes an equity participant in the company
through a structure typically comprised of a combination of a substantial
proportion of shares, warrants, options, and convertible securities. It also
provides a representative who sits on the company's board, offers strategic
advice to the management team and assures that the fund's interests are
considered. If the directors of BiOs would not welcome this level of
investor involvement, they should not consider venture capital.
(iii) Advantages of obtaining a stock exchange listing
Existing owner directors can realise some or all of their investment, and
new equity finance is easier to raise. Also, the company's status is raised,
and the company's shares can be used as consideration for an acquisition.
(iv) Disadvantages of obtaining a stock exchange listing
Accountability is increased – Directors must be seen to be accountable to
outside shareholders and there is more scrutiny over the company's
activities. Costs are incurred for the initial flotation and as ongoing annual
fees. There is also likely to some delay in arranging this, by which time
the opportunity to acquire C2C may have gone.
(e) Other issues re: venture capital finance
Structuring, earn-out clauses and deferred consideration
Venture capitalists are more likely to invest in BiOs if they are offered a deal
which makes the investment appealing from their perspective.
This may include structuring in an earn-out clause or deferred consideration to
make investing initially a viable option.
An earn-out arrangement means that the venture capitalist could make an initial
investment of funds at the beginning of the project to seed investment and growth.
It could then structure in a guaranteed minimum amount of deferred consideration
to be given to the Safraz brothers at a certain point in the future – say in two years'
time.
The most appealing structure for the venture capitalist is to then add in an extra
layer of deferred consideration which is based solely on performance – so,
additional funds will be paid only if the company meets a projected target based
on performance indicators and/or profitability.
Separate to an official earn-out clause, the Safraz brothers could be given specific
Key Performance Indicators (KPIs) by the venture capitalist company which they
must meet for funding to be ongoing. If the KPIs are not met, then the agreement
is broken and the venture capitalist can exit as determined by the agreement.
196
Answer Bank
Exit routes for a venture capital company

The most profitable exit route for a venture capital company is when the company
in which it has invested achieves a stock exchange listing (see below).
Alternatives are to sell their shares to another investor (which might be another
venture capital fund, but could be a potential acquirer of BiOs) or back to the
original owners.
Stock market flotation
An alternative for BiOs is to continue with existing sources of funds and to go for
a stock exchange flotation within two to three years. To achieve a listing, the
company needs to demonstrate that, in addition to good growth prospects, it has
a strong management team, strong financial controls and good management
reporting systems. These last factors will probably need improvement, as most of
BiOs' administration systems are currently outsourced, and Ali and Wasim are the
only directors.
(f) Offer 1 made to Sarfaraz brothers provides a lot of certainty about the amount that
they will get during the five year period. The assumption of salary and tax rates
staying constant is a bit vague but there is a certainty in the amount that they will
received.
Total amount to be received over a period of five years equates to
Rs.12.427million.
Under offer 2, the total amount received is Rs 15.388million which is
approximately Rs 2.961 million in excess of the amount received under offer
Although the amount receivable under Offer 2 is higher, but it involves a great
amount of uncertainty and hence is a risky offer to accept.
Acceptance of the salary offer will depend upon the risk appetite of Sarfaraz
brothers. Incase if they are have a risk seeking attitude, offer 2 is more preferred
and incase if their risk appetite is low, offer 1 is a better offer to accept.
Offer 1
Year 1 2 3 4 5 Total
Taxable Income 2,940,000 2,940,000 2,940,000 2,940,000 2,940,000 14,700,000
Tax Payable
Tax on Rs 2.5m 344,500 344,500 344,500 344,500 344,500
Tax on Balance @ 25% 110,000 110,000 110,000 110,000 110,000
(454,500) (454,500) (454,500) (454,500) (454,500)(2,272,500)
Net Benefit 12,427,500
Offer 2 Year 1 2 3 4 5 Total
Sales Commission 367,000,000477,100,000 620,230,000682,253,000 750,478,300 21,727,960
Income @ 0.75% 2,752,500 3,578,250 4,651,725 5,116,898 5,628,587
Tax Payable
Tax on Rs 2.5m/4m 344,500 344,500 719,500 719,500 719,500
Tax on Balance @
25%/30% 63,125 269,563 860,690 1,046,759 1,251,435
(407,625) (614,063) (1,580,190) (1,766,259) (1,970,935)(6,339,071)
Net Benefit 15,388,888
197
# of
Offer 1 (Workings) Monthly Taxable
Months
Basic Salary 100,000 12 1,200,000
Travel Allowance 20,000 12 240,000
Cost of Living Allowance 30,000 12 360,000
Bonus 100,000 4 400,000
Conveyance
(2m X 10%) 200,000
Rent Free
Accommodation
Fair Market Rent 40,000 12 480,000
45 % of Basic 540,000
Higher 540,000
2,940,000
Question 7 - PJ
Marking scheme
(a) Using correct cash flows – ½ mark for each scenario 1
Allocating PJ’s share – ½ mark for each scenario 1
Allocating correct cash repatriation figures – ½ mark 1
for each scenario
Applying the correct exchange rates – ½ mark for 1
each scenario
Discounting at 16% – ½ mark for each scenario 1
Calculating NPVs – ½ mark for each scenario 1
Making a recommendation based upon NPV own 1
figures
(b) Question 1 - Discussion of forward rates 2
Question 1 - Discussion of spot rates 2
Question 1 - Discussion of forward rates as a predictor 2
Question 2 - Discussion of using a higher DF re: 2
exchange controls
Question 2 - Risks faced by owners of a private 2
company
Question 2 - Concluding on the point of double- 2
counting the risk
Question 3 - Discussion of terms of the swap 2
Question 3 - Discussion of risks of the swap 2
Question 3 - Discussing use of forward contracts as an 2
alternative
Total 25 marks
198
Answer Bank
(a)
TUTORIAL NOTE
Part (a) is perhaps not as tricky as it looks. In essence you are being asked to
perform who short NPV with basically the same structure in terms of cash
inflows and outflows. The key here is take account of the differing timing of
cash inflows due to the exchange control restrictions. As a quick check you
should expect a worse return under the exchange control option as it has the
effect of delaying cash returns, hence they will be more heavily discounted.
PJ: Joint venture NPV
Assumption 1: exchange controls in operation
Project PJ's 50% Cash Exchange rate Discount PV
Year cash share repatriated Rs million factor Rs
Bs million Bs million Bs million R1 = B 16% million
0 (220) 1 (220)
1 80,000 40,000 20,000 550 36 0.862 31
2 125,000 62,500 31,250 575 54 0.743 40
3 165,000 82,500 133,750 600 223 0.641 143
185,000 185,000 (5)
Assumption 2: Exchange controls are removed
Project PJ's 50% Cash Exchange rate Discount PV
Year cash share repatriated Rs million factor Rs
Bs million Bs million Bs million R1 = B 16% million
0 (220) 1 (220)
1 80,000 40,000 40,000 550 73 0.862 63
2 125,000 62,500 62,500 575 109 0.743 81
3 165,000 82,500 82,500 600 138 0.641 88
185,000 185,000 12
Based solely on these calculations, the joint venture should only proceed if
restrictions on repatriation of profits are lifted, because the JV will not deliver a
positive NPV outcome if the restrictions are not lifted.
(b)
TUTORIAL NOTE
Here you need to tackle each of the statements in Exhibit 3 in turn. In each
instance you should (i) assess the veracity of the statement – the degree or
truth/falseness in each and (ii) apply any relevant theory, for instance
forward rates are calculated using PPP/IRP, so explain the underlying
theory, and any assumptions within will lend credence to your analysis.
199
(i) Reliability of forward rates as predictors of spot rates in the future
Forward rate
A forward rate is a rate agreed today at which currency will be exchanged

on an agreed future date. Forward rates offered by banks are calculated
from today's spot exchange rate and the fixed interest rate in each currency
for the period in question. Because these rates are known with certainty,
the forward rate can be fixed with accuracy: any variation from the
computed rate would allow speculators to engage in risk-free arbitrage
between the money markets and currency markets.
Spot rate
In a floating exchange rate system, however, the spot rate in the future is
dependent on many economic factors affecting supply and demand for the
currency. These may not only be factors we are currently aware of,
because the rate might also be influenced by new events that arise between
now and the future date. Factors influencing supply and demand for
currency include balance of trade, capital investment cash flows, interest
rates, inflation rates, and actions by speculators. The future spot rate is
therefore subject to significant uncertainty. This is especially true of
Venezuela given the new report about the uncertainty over the national
economy, and tendency for government intervention into the market.
Forward rate as predictor
If consistent patterns emerge, forward rates will be adjusted to take
account. The forward exchange rate will be as likely to be above the
eventual spot rate as below it. This is, however, completely different from
saying that the forward rate is a reliable or accurate predictor of the spot
rate. It clearly is not a reliable predictor because of the uncertainty in
events which might arise between now and the future date. This is
particularly likely to be true in a volatile currency such as the Venezuelan
one in this question, especially in light of the factors mentioned above,
and in the news report on the Venezuelan economy.
(ii) Should a higher discount rate be used when there are exchange controls?
The discount rate of 16% is assumed to allow for the time value of money
and the normal business risk of the investment, but not for the risk of
exchange controls being retained. Since the company is not a public
limited company and shareholders are probably undiversified, they are
assumed to be concerned with total risk, not just systematic risk. Exchange
controls are therefore a relevant risk which must be accounted for.
Allowing for the uncertainty of exchange controls
(1) Risk-adjusted discount rate
The cash flows are evaluated assuming there are no exchange
controls (Assumption 2) and the discount rate is increased to allow
for the uncertainty in the timing of the cash flows because of
exchange controls.
200
Answer Bank
(2) Two scenarios

Two scenarios are postulated, one with exchange controls and one
without, as in the question. Both are discounted at 16% to allow for
business risk, but the discount rate does not need to be increased to
allow for exchange control risk, which is already being allowed for
by the delayed cash flows in Assumption 1. This method, used in
the question, is valid and more detailed than the alternative
method.
What is not valid is to postulate the scenario with delayed cash flows and
in addition to increase its discount rate. This would be double- counting
the exchange control risk.
(iii) Can a currency swap help to minimise the exchange rate risk?
In a currency swap, two parties lend each other agreed amounts of
different currencies for a given time, the loans being repaid at the end of
this period. This has the effect of fixing the exchange rate in advance for
the repayment date and therefore reduces currency risk.
Terms of swap
Of course there are no 'free gifts' in foreign exchange and the interest paid
on PJ's loan in Bs will probably be significantly higher than the interest it
receives on its rupee denominated loan. In addition, the swap exchange
rate may well be higher or lower than the 550-600 currently forecast.
These factors are subject to negotiation between the parties.
Risks of swap
PJ must also consider the risk that its swap partner defaults on repayment
or that exchange controls prevent the receipt of interest on its rupee
denominated loan. There will also be commission to pay to the
intermediary which arranged the swap.
Forward contract
Given that there is a forward market for the B then currency risk can be
hedged sufficiently without using a swap. As this is PJ's first venture into
South America, forward contracts may be easier to manage.
Question 8 - PRT
Marking scheme

(a) Calculation of the finance mix – ½ mark for each 2
component figure
Identify feature of the proposed finance mix – up to 1 4
mark each
Discuss pros and/or cons proposed finance mix – up 4
to 1 mark each
201
(b) Calculate operating profits for years 1 – 4 1
Calculate service costs from PRT years 1 – 4 1
Calculate reducing balance of mezzanine debt years 1
1–4
Calculate interest on mezzanine debt years 1 – 4 1
Calculate taxation 1
Calculate gearing each year 1
Calculates impact of warrants being converted 1
Identity that gearing ratios will not be met 1
Identify assumptions made in calculations – up to 1 2
mark each
(c) Identify further information required – ½ mark each 3
Describe why the information would be required – ½ 3
mark each
Total 25 marks
(a)
TUTORIAL NOTE
This is a complex requirement. To begin with you will need to model the
finance mix being suggested e.g. existing shares, new equity, existing debt and
new debt. Once you have done this you can assess any issues that may arise
from this e.g. is there a serviceable level of debt, what impact will exercising
warrants have on the value of the owners’ equity.
Financing mix
If the airport can be purchased for Rs 4,200 million, with ordinary shares at par
value of 60 rupees each the financing mix is proposed as:
Rs'm
8 million shares purchased by managers and employees 480
2 million shares purchased by PRT 120
NBB Bank: secured floating rate loan at KIBOR + 3% 2,400
AV: mezzanine debt with warrants (balancing figure) 1,200
Total finance 4,200
Up to Rs 1,800 million of the mezzanine debt is available, which could be
used to replace some of the floating rate loan. However, this possibility has
been rejected because its cost is 14% compared with 9% and the warrants, if
exercised, could dilute the manager/employee shareholding.
202
Answer Bank
Leveraged buyout
A leveraged buyout of the type proposed allows managers and employees to own
80% of the equity while only contributing Rs 480 million out of Rs 4,200 million
capital (11%). However, it is important that the managers and employees agree
on the company's strategy at the outset. If the shareholders break into rival
factions, control over the company might be difficult to exercise. It would be
useful to know the disposition of shareholdings among managers and employees
in more detail.
Gearing
The initial gearing of the company will be extremely high: the debt to equity ratio
is 600% (Rs 3,600 million debt to Rs 600 million equity). Clearly one of the main
medium-term goals following a leveraged buyout is to reduce gearing as rapidly
as possible, sacrificing high dividend payouts in order to repay loans. For this
reason NBB Bank, the major creditor, has imposed a covenant that capital
gearing (debt/equity) must be reduced to 100% within four years or the loan will
be called in.
Repayment of mezzanine finance
The gearing will be reduced substantially by steady repayment of the unsecured
mezzanine finance. This carries such a high interest rate because it is a very risky
investment by the venture capital company AV. A premium of 5% over secured
debt is quite normal. The debt must be repaid in 5 equal annual instalments; that
is, Rs 240 million each year. If profits dip in any particular year, PA might
experience cash flow problems, necessitating some debt refinancing.
Warrants
If the warrants attached to the mezzanine debt are exercised, AV will be able to
purchase 1 million new shares in PA for 100 rupees each. This is a cheap price
considering that the book value per share at the date of buyout is 420 rupees (Rs
4,200m/10 million shares). The purchase of these new shares will increase the
total number of shares in issue to 11 million, meaning that ownership by
managers and staff will be diluted from 80% to approximately 73%, with PRT
holding 18% and AV holding 9%. However, this should not affect management
control, provided that managers and staff remain as a unified group.
(b)
TUTORIAL NOTE
This is a complex requirement. To begin with you will need to model the
finance mix being suggested e.g. existing shares, new equity, existing debt and
new debt. Once you have done this you can assess any issues that may arise
from this e.g. is there a serviceable level of debt, what impact will exercising
warrants have on the value of the owners’ equity.
Gearing in 4 years’ time
PA’s forecast statements of profit or loss for the next four years, and associated
gearing ratios are shown in Exhibit 1, along with the assumptions using in
calculating the forecasts.
203
Based on these assumptions and ignoring the possible issue of new shares when
warrants are exercised, the gearing at the end of 4 years is predicted to be 113%.
This is significantly above the target of 100% needed to meet the condition on
NBB's loan. If warrants are exercised, Rs 120 million of new share capital will
be raised, reducing the Year 4 gearing to 107%, but this is still significantly above
the target.
No dividends
A key assumption behind these predictions is that no dividends are paid over this
period. This may not be acceptable to managers or employees. It is also assumed
that cash generated from operations is sufficient to repay Rs 240 million of
mezzanine debt each year, which is by no means obvious from the figures
provided.
Increase in KIBOR
Results will be worse if KIBOR rises above 6% over the period. However, the
purchase of the interest rate cap will stop interest payments on NBB's loan rising
above 11%. Conversely if KIBOR falls, the increase in profit could be
considerable, but it is still very unlikely that the loan condition will be met by
Year 4.
Problems in meeting loan condition
As such, it seems that NBB Bank’s gearing restriction will be a problem, and PA
will not be able to meet the Bank’s loan conditions in four years’ time. However,
if the company is still showing steady growth by Year 4, and there have been no
problems in meeting interest payments, NBB Bank will probably not exercise its
right to recall the loan. If the loan condition is predicted to be a problem, the
directors of PA could consider:
(i) Aiming for continuous improvement in cost effectiveness (and thereby to
improving margins by ensuring costs increase by less than 5% per year)
(ii) Renegotiating the central services contract with PRT, or providing central
services in-house, in order to save costs
(iii) Renegotiating the allowed gearing ratio to a more realistic figure
(iv) Going for further expansion after, say, one or two years (e.g. investigating
whether more retail space could be opened, or a second short run way)
and financing this expansion with an issue of equity funds. However, this
may affect control of the company.
(v) Looking for possible alternative sources of debt or equity finance if the
NBB Bank loan is recalled, including the possibility of flotation on the
stock market
204
Answer Bank
Year 0 Year 1Estimates

Yearfrom
2 Year 3 Year 4
Rs'm Rs'm Rs'm Rs'm Rs'm
Landing fees 1,680
Other revenues 1,032
2,712
Labour 624
Consumables 456
Other expenses 420
1,500
Direct operating profit growing at 5%
p.a. 1,212 1,273 1,336 1,403 1,473
Central services from PRT (360) (378) (397) (417)
NBB loan interest at 9% on Rs 2,400 (216) (216) (216) (216)
Mezzanine debt interest at 14%
on Rs 1,200m (168)
on Rs 960m (134)
on Rs 720m (101)
on Rs 480m (67)
Profit before tax 529 608 689 773
Tax at 33% (175) (201) (227) (255)
Profit after tax 354 407 462 518
Reserves b/f 0 354 761 1,223
Reserves c/f 354 761 1,223 1,741
Share capital + reserves 954 1,361 1,823 2,341
Total debt at end of year 3,360 3,120 2,880 2,640
Gearing: debt/equity 352% 229% 158% 113%
If warrants are exercised, Rs 120 million of new share capital is issued,

reducing the gearing at Year 4 to 2,640/2,461 = 107%.
Assumptions
(i) The central services will be provided by PRT for the full four-year period.
(ii) No dividend will be paid during the first four years.
(iii) Sufficient cash will be generated to repay Rs 240 million of mezzanine
finance on the last day of each year (whilst interest will be paid on the
opening balance) and to fund increased working capital requirements.
(iv) KIBOR is assumed to remain at 6% for the four years.
(v) Tax is payable one year in arrears.
205
(c)
TUTORIAL NOTE
This is an extremely practical requirement. Quite simply, imagine you have
been approached by a company who wishes to borrow a large sum of money.
What questions would you ask, and, what information would you want before
lending them the money?
In order to decide whether the management buyout can be considered for a Rs
1,200 million loan, the venture capital company would need the following
information:
(i) The purpose of the buyout.
(ii) Full details of the management team, in order to evaluate expertise and
experience and to check that there are no 'gaps' in the team.
(iii) The company's business plan, based on a realistic set of strategies.
(Whether or not the strategies are realistic and feasible will be a key issue
here, and a large number of approaches to venture capital companies fail
on this criterion).
(iv) Detailed cash flow forecasts under different scenarios for economic
factors such as growth, and interest rates. Forecasts of profit and
statements of financial position.
(v) Details of the management team's investment in the buy-out. Venture
capital companies like to ensure that the buy-out team is prepared to back
their idea with their own money.
(vi) Availability of security for the loan, including personal guarantees from
the management team. Any other 'sweeteners' that could be offered to the
lender, such as warrants.
(vii) The possibility of appointing a representative of the venture capital
company as a director of PA.
Question 9 - PCT
Marking scheme
(a) Post tax earnings – ½ mark each 1
P/E valuations – ½ mark each 1
Number of shares – ½ mark each 1
Share values before announcement – ½ mark each 1
Share values after announcement – ½ mark each 1
Calculate and discuss relative value of offer to each 3
Co’s shareholders
Combined entity value before announcement – 1 1
mark
Combined entity value after announcement – 1 mark 1
Dividend valuation of each company – 1 mark each 2
Discussion of dividend valuation versus market price 1
206
Answer Bank

(b) Identifying a factor that TST’s shareholders will 4
consider – up to 1 mark each
Discussing each factor that TST’s shareholders will 4
consider – up to 1 mark each
(c) Discussion of how TST’s shareholders might react to 2
share exchange – up to 2 marks
Discussion of how TST’s shareholders might react to 2
cash offer – up to 2 marks
Total 25 marks
(a)
TUTORIAL NOTE
The start to this question is very technical. The process to get to the answer is
however very logical. To begin with the value of each company should be
calculated, which can be done using the P/E approach. This allows you to
work out the value of the combined entity (ignoring synergies etc). From here
the combined value can be split across the shares in line with the equity split
being taken by each merger partner to assess the value being taken from the
merger by the shareholders of PCT and TST. Comparing this to the recent
move in share prices of both companies will allow you to assess the financial
attractiveness of the merger to both sets of shareholders on the terms
proposed.
Evaluation of the share-for-share offer from PCT
Value of the companies' shares before the announcement
PCT TST Combination
Rs'm Rs'm
Earnings before tax 14,628 12,365
Tax (30%) (4,388) (3,710)
Earnings after tax 10,240 8,655
P/E immediately before 11 7
announcement
Total value of equity shares before
announcement:
(= earnings after tax xP/E): Rs 112,640 60,585 173,225
million
No. of shares (= share capital/par 230 210
value): million
Value per share before announcement 490 289
(Rupees)
207
These share prices are within the range of the 20X2 maximum and minimum
share prices given. The value of the two companies together, before the
announcement of the share offer, is Rs 173,225 million.
Value of shares if merger takes place
Assuming the companies are fairly valued and that there is no hidden synergy in
the combination (which is unlikely), the value of the combination will remain
unchanged by the merger, at Rs 173,225 million.
If the merger terms are accepted, at 5 shares in PCT for every 6 shares in TST,
the number of shares in PCT (post-merger) will increase by 5/6 x210 million
= 175 million. This will give a total of 230 + 175 = 405 million shares in PCT,
giving a share price for PCT after the merger of Rs 173,225 million/405 = 428
rupees.
This values TST shares at 5/6 × 428 = 357 rupees which is above the one year
high price, and is 68 rupees, or 23.5% above the most recent share price,
before the announcement.
However, these computations are made redundant by the extreme reaction of the
stock market against PCT's offer:
PCT TST Combination
Change in share price on announcement of
offer: –10% +14%
Value per share after announcement: Rs
PCT: 490 x 0.9 441
TST: 289 x 1.14 329
No of shares: m 230 210
Total value of equity shares after
announcement:
Rs m 101,430 69,090 170,520
Total value of shares before announcement:
Rs m 112,640 60,685 173,325
Total gain/(loss) by shareholders: Rs m (11,210) 8,405 (2,805)
Gain/(loss) per share: rupees (49) 40
The shareholders of PCT have lost more than the shareholders of TST have
gained, creating a net loss in the total value of the two companies. Thus the offer
appears to be beneficial to shareholders in TST, but not to shareholders in PCT.
Valuation using the dividend valuation model
As a benchmark, we can value both companies using the dividend valuation
model
PCT TST
Dividend yield just before announcement 2.40% 3.10%
Share price before announcement Rs 490 Rs 289
Therefore, latest dividend, d Rs 11.76 Rs 8.96
Growth forecast, g 4% 4%
Cost of equity capital, k e 13% 11%
Thus, value per share by DVM: d(1+g)/(k e – g) Rs 136 Rs 133
208
Answer Bank
The share values obtained by the dividend valuation model (DVM) are
significantly lower than the current market prices. The directors of each company
would therefore need to consider carefully what the future dividend policy would
be if the merger goes ahead.
(b)
TUTORIAL NOTE
When considering whether to accept a bid there will always be a dilemma in
taking what is on offer, or, holding firm in the hope that a better offer will
follow if the initial offer is rejected. Aside from this the question requires you
to consider the attractiveness of cash (certain, immediate) versus shares
(potential growth, influence).
Factors to consider when deciding whether to accept or reject the bid Raising the
offer
The shareholders of TST will assess the chances that PCT will make a better
offer if the current offer is rejected. When making this calculation they might
assess whether there are other potential targets for which PCT might bid for.
The value of the offer
An alternative to accepting the offer is to sell their shares on the market. Although
they will probably not want/be able to sell large shareholdings at the current
market price, the comparison of the two values is of prime importance.
Loss of influence
Institutional shareholders will typically own large volumes of shares, but
relatively small stakes in the company overall. Their primary concerns are
typically a constant flow of dividends and long-term capital growth. They tend
to pay relatively little interest in the daily affairs of the companies they invest
in, so individually do not hold much sway. However, if investors meet and
work together they may be able to control a large enough bloc of shares to
hold sway over the proposed tie-up. For instance if shareholders collectively
holding >50% of the votes work together they can effectively go over the
heads of the TST board. If the share-for-share exchange is accepted then TSTs
shareholders will see their stake in the combined entity heavily diluted, and
this loss of control/influence may affect their decision.
PCT's motive for the merger
PCT has developed a reputation for rapid growth, but appears to have limited
growth prospects in the near future, as evidenced by the 4% dividend growth
rate. TST itself has experienced erratic earnings recently making its shares a
volatile investment. If TST’s shareholders accept the offer, it should be because
they believe that combining with PCT can achieve better, and perhaps more
certain, returns than TST can achieve as a stand-alone entity. There is a danger,
however, that PCT is merely seeking to increase its earnings per share by
acquiring TST – this can be easily done because TST’s P/E is lower than PCT's.
PCT may also be hoping to take advantage of TST’s share price being near its
low-point for the year, perhaps looking to make an opportunist gain whilst the
share price is depressed.
209
PCT's plans for the merged companies
The TST investors may want to examine the detailed plans for the management
of the combination, and strategic plans which justify the combination, so as to
determine whether long-term gains are likely for shareholders in the merged
company.
Market viewpoint
The market gives TST a low price-earnings ratio compared with their
competitors, particularly WX. TST’s investors will consider whether the market
has underestimated the value in their company, particularly the intellectual
expertise or whether the market does not believe in TST's management’s ability
to turn the company around.
Shares or cash?
Cash is more certain in value than shares because, as we have seen, shares in
listed companies can fall very quickly. PCT's shares dropped by 10% following
announcement of the merger, illustrating the potential risk involved. To
compensate TST’s investors for accepting the risk, PCT should offer a higher
value in shares than the cash alternative. However, their share offer is worth
(at current prices) 5/6 × Rs 441 = Rs 368 for each TST share, which is less
than the cash offer of Rs 385 per share.
Other key considerations in weighing a share versus cash offers are (i) capital
gains tax implications and (ii) the proposed dividend policy of the combined
entity.
(c)
TUTORIAL NOTE
This is a very subjective question. In reality we don’t know if the offer will be
accepted or rejected, so, you should discuss if and why the offer would be
accepted or rejected.
Consideration of TST’s shareholder response
On the basis of my calculations, I would expect the institutional shareholders of
TST to:
(i) Consider accepting the current share-for share offer made by PCT. The
share prices are now PCT 441 versus TST 329, meaning 5 PCT shares
would be worth Rs 2,205, versus Rs 1,974 for 6 TST shares. This is a gain
of 231 rupees for every 6 shares currently held. The recent fall in PCT’s
share price indicates that this may be the best offer available given the
negative reaction of the market (to PCT’s share price) to the news of the
bid.
(ii) They may be attracted by the cash offer of 385 rupees per share. This is
above the value of equity offered (357 rupees) and the most recent high
share price of 355 rupees. The advantage of cash is that it is certain and
liquid. However, if TST’s shareholders believe a higher offer can be
elicited they may choose to risk waiting for this to happen.
Ultimately the response of TST’s shareholders will hinge on whether they
believe this is a full and final bid, or, an opening offer that may be improved.
210
Answer Bank
Question 10 - Solar Research Pakistan

Marking scheme

(a) Explain Translation risk 1
Explain Transaction risk 1
Explain Economic risk 1
Explain how economic risk can be estimated – using 1
information in the question

(b) Correct use of PPP theory 1
Year 1 forecast 1
Year 2 forecast 1
Year 3 forecast 1

(c) Initial investment and residual values in T0 and T5 – 1
½ mark each
T$ cash inflows T1 – T4 1
Tax at 20% 1
Tax depreciation allowances 1
5% tax deduction 1
Apply exchange rate 1
Less additional logistics planning 1
Net cash flow in Rs m 1

(d) Explain how the controls will impact the project in 1
general terms
Show how controls will impact the project in specific 1
numerical terms
Calculate NPV with exchange controls applied 2
Recommend whether to invest based upon NPV 1
outcome

(e) Strategies must be lawful to try to counter negative 1
impact of controls
Determine if non-dividend payments can be made 1
211
Business structuring as controls not applied to 1
payment for goods imported into the country
TSD could buy quantities of materials and resell 1
elsewhere
Total 25 marks
(a)
TUTORIAL NOTE
Part (a) is a knowledge based introduction to this question. It should present
no obvious difficulty to students.
Types of FX risks
There are three types of foreign exchange (FX) risks generally: translation risk,
transaction risk and economic risk. Two of these will apply to this contract –
transaction risk and economic risk.
Translation risk – this relates to the financial reporting and consolidated accounts
of foreign subsidiaries. If the proposed investment is approved and goes ahead,
then at the time of consolidation, accounts of foreign subsidieary will have to be
initially translated in the presentation currency. The risk is that at the time of
translation, exchange rates may move adversely resulting in adverse impact on
the group result.
Transaction risk – this is a short term risk and is the FX risk in the individual
business transaction. For example, SRP may incur transaction risk if the
exchange rate changes between the sale agreement on the solar panels and the
payment date. The individual transaction risk is any exchange rate loss between
these two time periods, and will also impact on cash flow management within
both companies (because the final amount paid or received may be different to
what they expected to pay/receive when the sale was originally agreed).
Economic risk – this is the risk of changes in the exchange rate over the long
term, due to different economic circumstances in both Pakistan and Australia.
Both the Pakistani and Australian economies are relatively strong, but the
political landscape in Australia is arguably more stable than in Pakistan.
Economic risk is classified as a long-term risk and so is always important in the
appraisal in foreign investments.
Estimating economic risk
The economic risk posed by this investment seems relatively low based on the
growing economies of both countries over the long term.
However, all FX investments carry some economic risk and it needs to be
considered when evaluating any proposed investment. To do this it is essential
to estimate the exchange rate of the two currencies for each year of the
investment.
212
Answer Bank
There is no absolutely reliable method of exchange rate forecasting, although

two possible methods to generate an unbiased estimate could be: the purchasing
power parity method and the interest rate parity method.
(b)
TUTORIAL NOTE
PPP is a well-known piece of theory. Students sometimes get confused when
thinking about whether a spot rate is moving in the right direction. A simple
check is to think ‘are my import going to become more/less expensive’.
Students should know that the country with higher rates of interest and
inflation will see its currency weaken over time, therefore its imports will
become more expensive as its currency devalues.
In this case, the purchasing power parity method must be used because only the
inflation rates have been provided.
The forecast of exchange rates using the purchasing power parity method is as
follows:
January Year 2: 85 x1.055/1.019 = 88.0 (i.e. Rs 88 = A$1)
January Year 3: 85 x(1.055/1.019)2 = 91.1
January Year 4: 85 x (1.055/1.019)3 = 94.3
(c)
TUTORIAL NOTE
This is a basic NPV, with the only twist being the tax depreciation calculation.
Exam technique is key here – with NPV remember to fill in the ‘simple’
sections first e.g. initial investment, cash inflows, tax bill, discount factors etc.
These element should yield close to half marks, meaning that, if the tax
depreciation element is problematic you can afford to leave this out and move
onto the narrative requirement that follows.
Cashflow using the exchange rate (1 rupee = T$2.1145) and data supplied in
Appendices 2 and 3
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
T$ m T$ m T$ m T$ m T$ m T$ m
Initial investment (8,000)
Residual value 1,600
Cash inflows 1,800 2,160 2,592 2,748 2,913
Tax at 20% (360) (432) (518) (550) (583)
Tax dep allowance
(W1) 320 256 205 164 335
Net cash available to
remit (8,000) 1,760 1,984 2,278 2,362 4,266
Pakistan tax @ 5% (88) (99) (114) (118) (133)
Net cash flows (8,000) 1,672 1,885 2,164 2,244 4,133
Net cash flow T$ 4,098
Exchange rate 2.1145
Cash flow in Rs'm 1,938
Additional logistics
planning (15)
Net result cash Rs'm 1,923
213
Note. Residual value in Year 5 is not subject to tax. Therefore additional tax paid
in Year 5 is calculated on the cash flows net of residual value; that is Rs 4,266m
– Rs 1,600m = Rs 2,666m (tax = 5% of Rs 2,502 = Rs 133m).
Working 1 – Tax depreciation allowance
Rs'm Rs'm
0 – Cost 8,000
1 – 20% reducing balance (1,600) 320
6,400
5,120
4,096
4 – 20% reducing balance (819) 164
3,277
5 – 20% reducing balance (655) 131
2,621
Residual value (1,600)
Balancing allowance 1,021 204
(d)
TUTORIAL NOTE
Exchange control will restrict the ability to extract cash from overseas
investments. In the context of NPV calculations this will mean that cash is
locked away overseas, and, the delay in receiving this cash from overseas will
depress the value of cash flows, thus reducing the NPV.
An exchange control is a restriction on payments being remitted internationally
from a country. They can apply to payments denominated in either their domestic
currency, or a foreign currency. They are put in place to generally target
companies owned by foreign investors.
In this instance, the government of Country T has introduced restrictions on
payments being made to a foreign company (SRP).
The impact on SRP is that, as the parent company, the amount of cash it can remit
from Country T as dividends every year over four years is restricted. This
restriction will remain until the exchange control regulations are lifted in Year 5.
Therefore, the NPV for Years 1, 2, 3 and 4 of the subsidiary production facility
need to be adjusted accordingly. Profits retained in the production facility
because of these controls can then be paid out in full as dividends to SRP in Year
5.
214
Answer Bank
With exchange controls

Net
Remitted to Net cash Discount
cash Exchange NPV
Year the parent flows
flows rate rate 12% Rs'm
T$ Rs'm
T$
0 (8,000) 2.1145 (3,783) 1.000 (3,783)
1 1,672 0 2.1145 0 0.893 0
2 1,885 0 2.1145 0 0.797 0
3 2,164 1,732 2.1145 819 0.712 583
4 2,244 1,795 2.1145 849 0.636 540
5 4,133 8,571 2.1145 4,053 0.567 2,298
12,098 4,098 1,938 (362)
* = net cash flows less amounts already remitted
The net NPV is Rs (377 million), the amount remitted, less the Rs 15 million
invested in logistics planning.
The calculations show that, because of the application of exchange controls by
Country T, the project should not be undertaken on a financial basis.
(e)
TUTORIAL NOTE
There are ways of working around exchange controls, as demonstrated in the
answer below. When designing such schemes a company must always be wary
of the legality and side-effects of any arrangements it puts in place. For
instance using artificial values for goods/services transfers may create tax
liabilities in one country, or, be deemed an unlawful tax avoidance strategy.
SRP needs to consider if there are lawful ways to reduce the scale of the problem
as revealed by the updated cash flows.
It is important to highlight that all strategies must be within the law. Strategies
that may be utilised are discussed below.
SRP should determine exactly what payments are restricted under the exchange
controls. The scenario suggests that only dividend payments are restricted. This
means that other payments, such as royalties and management charges, may not
be restricted. SRP should examine if payments can be made from the subsidiary
by other (lawful) means.
It is not stated whether the project in Country T buys goods from SRP. However,
if the venture is structured so that the operation in T buys the goods, then the
restrictions do not appear to apply to payment for goods imported into the
country. SRP could look at its structuring here. If available, they could possibly
increase their transfer prices and therefore increase payments from Country T.
215
Answers to exam style questions
Question 11 - PDT
Marking scheme

(a) Determine method of valuation 1
NPV calculation – correct use of mid-year cash flows, 3
growth rates and presenting PVs
Calculating terminal value 1
Comparison with market price of shares 1
Explain how to allow for risk in the price 1
recommended
Price shareholders might accept in takeover bid 1
Y-Tech cash and cash equivalents 1

(b) Demonstrate how an all share merger will work in 1
this instance
Decide on the suitable arrangement based on market 1
value of PDT and valuation of Y-Tech
Explain the procedure for issuing the shares 1
Determine how the terms of the offer will change 1
Modigliani and Miller's argument 1
CAPM 1
Hamada equation 1
Calculation using Hamada equation 1

(c) Indicate which of these methods of financing you 1
would recommend
State need for additional financing 1
Assess debt versus equity with calculations 1
Explore issue of shares 0.5
Explore alternatives for borrowing 0.5
Determine currency of borrowing 1
216
Answer Bank

(d) Explain and evaluate how synergies may be achieved:
Procurement 1
Operations 1
Sales and marketing 1
General administration 1
(e) For each of the 8 risks identified, use the number of
the risk listed in the table in the scenario and then
next to the relevant number:
Recommend one risk control measure – ½ mark each 4
Justify your recommendation of the risk control 4
measure – ½ mark each
(f) Putting risks into order of severity
Determining the seriousness of each risk – ½ mark 4
each
Providing your reasons for the order selected – ½ 4
mark each
(g) 1 mark for each tax implication 5
Total 25 marks
(a)
TUTORIAL NOTE
To arrive at an offer price you need to perform an NPV using mid-year cash
flows. This can be accurately enough by taking the 12% discount factors and
splitting the difference e.g. T0 = 1.000 T1 = 0.893 so the mid-year discount
factor is the mean of these = 1.893/2 = 0.9465. In accounting for risk the
easiest way to do this in an NPV is to adjust the discount factor being used e.g.
if there is more risk then adjust the discount factor upwards to reduce the value
of future cash flows.
Determine method of valuation
A valuation should be produced based on the present value of the cash flows
given in the case study.
The valuation should be based on the current price of Y-Tech shares plus a
percentage amount to persuade the Y-Tech shareholders to accept the takeover
offer. The valuation produced as a present value (PV) should certainly be
compared with the current market value of Y-Tech shares, but given the cash
flow estimates, a PV-based valuation is preferable.
217
Free cash flow valuation: Calculation
Year 1 Year 2 Year 3 Year 4 Year 5 onwards
Cash flow (Rs'm) 1,623.5 1,972.0 2,295.0 2,635.0 + 7% p.a.
Year 4 PV 56,389.0
DCF factor at 12% 0.9449 0.8437 0.7533 0.6726 0.6726
(mid-year)
PV 1,534.1 1,663.7 1,728.8 1,772.2 37,925.5
Valuation of Y-Tech shares = Rs 44,624 m
Or Rs 44,624 m/50 million shares = 892.5 rupees per share, which equates to
(/85) Y$10.50 per share.
Year 4 PV of cash flows from Year 5 onwards = (2,635.0(1.07)/(0.12 – 0.07) =
56,389.0
Note. This excludes synergies, which when estimated would need to also be
included.
Comparison with anearnings based valuation
Taking the average price to earnings ratio for the industry of 34.1 ((32.0 + 28.6
+ 38.3 + 37.4)/4) and applying this Y-Tech's net profit after tax of Rs 1,309m
suggests a valuation of around Rs 44,637. This is almost identical to the valuation
using the DCF, suggesting the DCF valuation is within a reasonable range.
Comparison with the market price of shares
The valuation produced should be compared with the current market price of Y-
Tech shares (Y$9.41). One can also consider comparable take-over premiums
for recently transacted take-overs for companies listed on the stock exchange for
Country Y (YSX) and in Pakistan as a check to address the risk of paying too
high a price.
The valuation here is above the current market value of Y-Tech shares by 12%
(10.50/9.41= 1.12). This may be a sufficient amount to persuade Y-Tech
shareholders to accept a takeover bid.
Allowing for risk
There is some question about the reliability of the cash flow estimates and risk.
Adjustments to the cash flows should be made to allow for risk, and to establish
a lower starting offer for the shares. Synergies arising from the acquisition will
assist in mitigating risk. Foreign exchange risk should be allowed for, and there
is a possibility of a fall over time in the value of the Y dollar against the Pakistan
rupee.
Another suggestion would be to reduce the expected rate of growth in cash flows
after Year 4. There is also an opportunity to re-estimate a share price assuming
an annual growth rate in cash flows after Year 1 of, say, 5% rather than 7%.
However, another consideration is the price that Y-Tech shareholders might
accept in a takeover bid. Lowering the price, to allow for greater risk, might also
reduce the likelihood that the Y-Tech shareholders will accept an offer for their
shares.
218
Answer Bank
This means that PDT would need to consider whether the risk in offering a price
of, say, 892 rupees or Y$10.50 per share would represent too much of a risk, or
whether the fact it is 12% premium over current prices means that this offer price
is not a risk.
Y-Tech's cash and cash equivalents.
Y-Tech's statement of financial position shows that its cash and cash equivalents
are Rs 2,167.5 million (= Rs 43.35 per share).
If this is surplus cash that PDT would obtain by acquiring Y-Tech, this amount
should be added to the offer price for the shares.
However, it may be agreed that Y-Tech can use the cash to pay a special dividend
before the takeover, or it may be agreed that the cash should be used to pay back
some of Y-Tech's debts.
(b)
TUTORIAL NOTE
There are two ways to deal with a merger of this type (i) the acquiring
Company issues new shares to the acquired company’s shareholders, or (ii) a
new Company is formed and the equity is shared by the shareholders of both
companies. The sticking point will always be the equity split – as clearly both
sets of shareholder will want to feel a financial benefit from the new
arrangements. This can be tricky unless there is compromise on both sides.
Depending on how a merger/takeover is financed there can a dramatic
effect on the cost of capital (CoC) of both companies. For instance in
theory a debt-financed takeover will reduce the CoC as the extra interest
payments will help form a tax shield, plus, debt is generally cheaper than
equity to arrange and service. However, of course there is only so much tax
that can be shielded, and, if debt piles become too high lenders will start to
price-in the risks of bankruptcy.
How will the all-share merger work?
One possibility is that PDT would issue new shares and give them to Y-Tech
shareholders in exchange for their Y-Tech shares.
A second possibility is that a new parent company for the PDT/ Y-Tech will be
created, and shareholders in both companies would exchange their shares for
shares in the new holding company.
The basis for deciding on the arrangement should be the current market value of
PDT shares and the valuation of Y-Tech shares for the purpose of a takeover.
Logistics of how power will shift also needs to be considered. The case will result
in approximately 30% new shares being issued. This may require shareholder
approval and consideration of whether the major shareholder's interest in PDT
will be diluted.
Impact on financial gearing and cost of capital
If we accept Modigliani and Miller's (with tax) argument, the cost of capital will
be reduced by higher gearing (financing the acquisition by borrowing) and
increased by issuing new equity.
219
Current cost of equity of PDT
Using the capital asset pricing model, the current cost of equity of PDT = 7%
+ 1.25(6%) = 14.5%.
If the company decides to finance the acquisition by borrowing, the cost of equity
will rise, even though the weighted average cost of capital may fall.
Alternative view
Lacking further information about the acquisition price for Y-Tech, it is not
possible to calculate an estimated change in the cost of equity or the weighted
average cost of capital. That is assuming Y-Tech's equity beta is the same as
PDT.
On the other hand, it's also possible to speculate about what the cost of equity
and cost of capital may become, for example by using the Hamada equation: ßg
= ßu [1 + (1 – t)VD/VE].
For example:
Given that the current equity beta of PDT is 1.25, we can estimate the asset beta
(ungeared beta):
Using the Hamada equation: ßg = ßu [1 + (1 – t)VD/VE]. 1.25 = ßu [1 + (1 –
0.30) 24,973/102,000]
ßu = 1.07
Presuming PDT would borrow a further Rs 44,624 m, representing the valuation
of Y-Tech from part (a), then gearing and financial risk will rise, increasing the
cost of equity as shareholders would require a higher return for the additional
financial risk.
Suppose that the gearing of the company after a takeover, when the finance is
obtained by borrowing, rises to (24,973 + 44,624)/102,000 = 0.682. Then, the
equity beta of PDT will rise from its asset beta of 1.04 to 1.58 as shown by the
Hamada equation in the following working.
ßg = ßu [1 + (1 – t)VD/VE] ßg = 1.07 [1 + (1 – 0.3) 0.682]
ßg = 1.58
This would mean a cost of equity of 7% + 1.58(6%) = 16.48%.
(c)
TUTORIAL NOTE
This is a very tricky requirement. You will need to start by working out the
amount required to finance the deal, using the valuation of Rs 44.6Bn in
requirement (a). From here you can work out the finance gap by comparing
this to the available cash balances.
In terms of finding this cash there is the traditional option of new debt (more
loans) v new equity (rights issue). A good answer will discuss the viability of
these options e.g. costs and availability of these sources of new finance.
220
Answer Bank
How much financing is needed and from what source?

The purchase price of Y-Tech is Rs 44,624 m is assumed from part (a). Need for
additional financing
Since PDT's statement of financial position shows cash and cash equivalents of
only Rs 688.5 million, it is clear that to make the acquisition, the company will
have to raise a substantial amount of new capital.
Debt versus equity
The market value of PDT shares is 120 million × Rs 850 = Rs 102,000 million.
The balance sheet value of its debt is Rs 24,973 million. Let's assume that this is
the market value of the debt.
The gearing of PDT, measured as debt: equity, is therefore about 24.4%
(24,973/102,000).
PDT could probably raise the finance by borrowing if it wanted to do so. If it
borrowed Rs 44,624 million, the gearing ratio would rise (assuming no change
in the share price) to (24,973 + 44,624)/102,000 = 68.2%. This appears to be
quite high, so may not be acceptable to PDT's shareholders, based upon what we
see in the industry competitors’ data. An analysis of Exhibit 4 provides a D/E
range of between 20.1% and 45.6%, which suggests a debt: equity gearing ratio
of 68.2% is high for this industry and it is may therefore be unacceptable to stock
market investors.
If it issued new shares at the same price as the current market valuation, the
gearing ratio would fall to (24,973/(102,000 + 44,624) = 17.0%.
If recommendation is to issue shares
If the recommendation is to issue shares, the size of the issue would be quite
large relative to the current value of PDT's equity, based on value of shares of Rs
102,000 million. The shares could be issued on the PGX, possibly as a rights
issue.
Alternatives for borrowing
If the recommendation is to borrow the money, there are several borrowing
options:
(i) From one or more banks in Pakistan
(ii) From one or more banks in Country Y
(iii) By issuing bonds
The company will need to consider the term of the borrowing. In view of the
estimated cash flows arising as a result of a takeover (for example, in the form
of dividend remittances or payments of internal management charges), a long
term of borrowing would be a good option.
The company could borrow for as long a term as possible and then at maturity of
this loan seek to refinance by obtaining a new loan.
221
Currency of borrowing
Loans could be denominated in either Pakistan rupees or the currency of Country
Y (Y$).
The advantage of borrowing in Pakistan rupees is that the lending banks would
be Pakistan banks, with which PDT may have a good commercial relationship.
The advantage of borrowing in Y$ is that this will reduce the foreign currency
risk (= the risk of a fall in the value of the Y$ against the Pakistan rupees over
time), by matching revenues in Y$ (from Y-Tech's operations, presumably
largely in Y$) and expenditures (loan costs in Y$).
(d)
TUTORIAL NOTE
The financial success of a takeover/merger often depends on achieving
synergies – as a company will typically be acquired at a price in excess of its
pre-acquisition valuation. Stating synergies is very different to achieving
them, so, to gain support of shareholders/lenders you would need to be able to
critically assess any planned synergies to demonstrate whether they can
actually be achieved. This is the process you are undertaking here.
Possible synergies
(i) Synergies in procurement
A larger company will buy in larger quantities from its suppliers, provided
that procurement operations are centralised.
A larger customer (buyer) should be able to negotiate better purchasing
deals, such as lower prices for data centre equipment.
It seems quite possible that PDT should be able to negotiate new
purchasing arrangements with its selected suppliers. However, this will
not happen if Y-Tech retains its own purchasing department for its data
centres in Country Y, because PDT and Y-Tech would not be using the
same suppliers and the same purchasing agreements.
(ii) Synergies in operations
Some takeovers provide opportunities for synergy by combining the
operations of the two companies into a single set of operations – for
example operating from a single site.
It is not clear that a takeover of Y-Tech, whose operations are in a different
country, will create opportunities for operating synergies.
(iii) Sales and marketing synergies
Sales and marketing synergies are likely to be revenue synergies, by
providing the sales and marketing teams of the two companies with access
to different markets.
For example, the sales team of PDT may have an opportunity to sell data
centre services in Pakistan and other countries to Y-Tech's corporate
customers in Country Y. Similarly, the sales team of Y-Tech may get an
opportunity to sell data centre services in Country Y to PDT's customers.
222
Answer Bank
With the enlarged company it may also be possible to devise new services
or new pricing packages for 'bundled' services, which it can offer to all
customers.
(iv) General administration synergies
General administration synergies are likely to be cost synergies. These are
achieved by removing duplicated administrative services and operations
('cutting head office staff').
A takeover of Y-Tech may not achieve any administration synergies
because the two companies are geographically distant, and especially so
if their customers speak different languages (the language of Country Y is
not known). It is not clear where administrative savings could be made.
If anything, administration costs may rise, due to costs of travelling /
communication between Pakistan and Country Y.
(e)
TUTORIAL NOTE
Risk management is another key process in managing an acquired entity.
When taking over, or, merging with another business you will be exposed to
new and/or enhanced risks. This is true even if taking over an industry rival as
even though you may be providing the same products/services these may be
being built/supplied using different processes, or, in an organisation with a
different culture. You will therefore need to be able to accurately map these
risks then come up with appropriate risk management techniques.
Risk control
Risk Risk control activities
1 An over-supply of data centre Monitor demand and supply (and

capacity in Country Y could prices) in the market, to establish
lead to downward pressure trends and changes
on prices.
Monitoring market trends will allow
PDT to plan ahead, rather than reacting
to events.
2 The complex nature of data Regular monitoring of the nature of

centres mean that demand – customer orders – and
maintaining an efficient compare with current facilities and
centre requires an capacity.
understanding of the nature
It is vital to ensure PDT’s operational
of future changes in customer
scope meets demand, as efficient
requirements.
operations will ensure the maximum
level of profitability is achieved at any
given level of sales turnover.
223
3 The company's data centres Maintain a health and safety
contain complex electrical procedures manual and appoint a
and mechanical equipment manger with responsibility for health
which must be operated and and safety
maintained. Staff safety is a vital area of operations
as accidents will cause personal harm,
reduce morale and create legal
compliance problems for PDT.
4 New data centres planned for Employ skilled and experienced staff.
Country Y, or upgrades to As a service provider PDT is reliance
existing data centres in on its staff to help them deliver
Country Y, could suffer from services and add value. Investment is
completion delays or cost therefore required to acquire and
overruns. develop talented staff.
5 The market in which the Close monitoring of developments in
company operates could be the industry
subject to material Work closely with customers to
technological or operational understand their strategies and
change. changing needs
In a competitive market PDT must
strive to stay at the forefront of
technological changes, else its offering
will quickly become obsolete in the
fast-moving industry it works in.
6 Acquisition may not deliver Prepare detailed plans for the
the expected synergies. achievement of synergies
Allocate individual management
responsibilities for the
implementation of those plans
As a listed company shareholders of
PDT will be anxious to see value
delivered by the combination. The
company must demonstrate how they
are adding value by the company tie-
up.
7 Acquisition may not deliver Detailed post-acquisition financial
the expected financial results. planning and vigorous application of
budgets and budgetary control
measures
As above shareholders of PDT will be
keen to see how quickly the financial
targets that were set are being reached.
Management must demonstrate that
they are actively manging the
combined operations to deliver value.
224
Answer Bank

8 Foreign currency risk: There Over time, it is impossible to avoid
may be significant changes in currency risk. However, the risk can
the exchange rate between be reduced by matching revenues and
the Country Y currency and costs in Country Y currency as far as
the Pakistan dollar. possible.
Forex movements have the potential to
cause profit volatility that PDT’s
existing shareholders did not subscribe
to when they invested in the company,
thus altering its risk profile. Managers
will have to demonstrate that these
additional risks are being adequately
managed.
(f)
TUTORIAL NOTE
Once risks have been mapped it makes sense to prioritise them, as quite simply
it is not practical to do everything at once. In this exercise the precise order is
relatively unimportant, as this will always be a subjective exercise. The real
focus, and skill here, is being able to provide a compelling justification behind
your ranking, so that you can persuade your managers to take the actions that
you feel are required. Not all managers will be risk experts, so, you’ll need to
provide practical arguments e.g. if we don’t do this, then, this consequence will
occur.
Risk prioritisation – credit to be given for any rational ranking
Ranking Risk Rationale for severity ranking

1 – most Acquisition may not The most severe risk is the failure of a
severe deliver the expected successful integration of Y-Tech into
synergies. the PDT group due to planned
synergies and financial returns not
being achieved. This will have
implications for the share price and
business value.
This is shared with number 2 below,
which could also be ranked as 1.
The acquisition failing has the
potential for the biggest loss in
relation to the acquisition project
itself.
225
2 Acquisition may not The most severe risks are the failure
deliver the expected of a successful integration of Y-Tech
financial results. into the PDT group due to planned
synergies and financial returns not
being achieved. This will have
implications for the share price and
business value.
This is shared with number 1 below,
which could also be ranked as 2.
The acquisition failing has the
potential for the biggest loss in
relation to the acquisition project
itself.
3 New data centres This is an operational risk. It has a
planned for Country high impact if it occurs, but the
Y, or upgrades to probability is low if adequate
existing data centres planning is undertaken and control
in Country Y, could measures are successfully
suffer from implemented.
completion delays or Overall ranking should be in the
cost overruns. middle of the severity list.
4 An over-supply of This is a version of competitor risk. It
data centre capacity can be ranked as a medium risk
in Country Y could (medium impact/medium probability)
lead to downward to the ongoing success of Y-Tech and
pressure on prices. future operations in Country Y.
Overall ranking should be in the
middle of the severity list.
5 The company's data Employee injury is a medium risk

centres contain but with a high probability,
complex electrical especially if risk control measures
and mechanical (health and safety measures, audits)
equipment which fail.
must be operated and The impact of an employee injury
maintained. is low but the probability is
medium-high.
6 Foreign currency risk: Over time, it is impossible to avoid
There may be currency risk. However, it can usually
significant changes in be adequately and successfully control
the exchange rate through FX risk measures being
between the currency implemented.
of Country Y and the Impact is medium, and probability is
Pakistan dollar. low.
226
Answer Bank

7 The market in which Changes in the market have the
the company operates potential to make infrastructure and
could be subject to technology obsolete, which would
material have a very severe impact. However,
technological or innovations can generally be
operational change. monitored and planned for, so they can
usually be successfully mitigated.
The probability of Y-Tech not
adapting to overall changes in the
industry is low.
8 – least The complex nature Changes in customer requirements (if

severe of data centres mean sudden) have the potential to make
that maintaining an infrastructure and technology obsolete
efficient centre – and suddenly not meet customer
requires an needs – which would have a very
understanding of the severe impact. However, trends in
nature of future customer requirements can generally
changes in customer be monitored and planned for, so they
requirements. can usually be successfully mitigated.
(g) Merging of Y- Tech and PDT will be classified as amalgamation under ITO 2001
as entire business of Y – Tech and PDT is now referred to as PDT and hence all
the assets and liabilities of both companies will now be considered as the assets
and liabilities of the amalgamated companies.
Expenditure incurred by PDT on legal and financial advisory services and other
administrative cost relating to planning and implementation of amalgamation, a
deduction shall be allowed as deduction.
The assessed loss (excluding capital loss) for the tax year, other than brought
forward and capital loss, of Y – Tech and PDT shall be set off against business
profits and gains of the PDT (Post merger) in the year of amalgamation.
Incase if the loss is not adjusted against the profits and gains for the tax year the
unadjusted loss shall be carried forward for adjustment up to a period of six tax
years succeeding the year of amalgamation.
Since PDT will own/acquire 100% of the business of Y – Tech, therefore no
gain/loss shall be determined on the transfer of assets between both companies.
227
Question 12 - KMC
Marking scheme
(a) Identify and explain a strategic reasons in favour 4
of the proposed acquisition – 1 mark each
(b) Calculate a terminal value for Years 5 and onwards 1
Apply 11% discount factor 1
Explain to use the required return of the investor as 1
from KMC’s perspective
Calculate present values (PV) for each year 1
Calculate final PV 1
Deduct outstanding borrowings to determine value of 1
equity
Add on estimated cash at hand and explain 1
adjustment
Present the final PV and comment on current value of 1
PAMC's equity shares
Explain uncertainty in the predicted cash flows 1
potentially overstating valuation
Explain discount factor could be understated if 1
PAMC’s business risk is > 11%
Explain cash flows have not been verified so subject to 1
due diligence
The valuation ignores potential synergies 1
Any other valid reservations raised 1
(c) Adbul – issue of retained profits 1
Benazir – equity finance, discussion of dividend yield 1
Waquar – and debt finance, looking at use of WACC 1
and gearing considerations
Calculate impact on gearing if purchase of KMC goes 1
ahead via debt finance
Explain impact of repaying KMC’s existing debt of Rs 1
643m
Explain possibility of a rights share issue or public 1
issue by PAMC
228
Answer Bank

Explain possibility of a merger by purchasing PAMC 1
with the issue of new KMC shares
Explain a hybrid financing arrangement of new debt 1
and equity
(d) Comment on strategic rationale for the acquisition 1
Comment on price to be paid based on valuation 1
Comment on the need for due diligence 1
Comment on preferred method of financing 1
Provide clear conditions on which to proceed with 1
acquisition
Key people and/or knowledge leave 1
Cultural difficulties 1
Systems integration cause problems 1
Organisational structure issues 1
Fail to manage synergies needed to justify the price 1
paid
(e) Strategy and policy for health and safety 1
People and structures 1
Processes, systems and controls 1
Assurance 1
Conclusions 1
(f) Responsibilities of the Audit Committee 1
Responsibilities of the Risk Committee 1
Cross representation of membership 1
Company Secretary same on both committees 1
Board retain overall control of certain elements of risk 1
(g) Informed of reasons for the breaches 1
Seriousness of consequences 1
Remedial action 1
Correct setting of limits 1
229
Report at next board meeting 1
(other valid points can be made, e.g. assessing
adequacy of the internal control systems)
Total 50 marks
TUTORIAL NOTE
Acquisitions can be undertaken in a ‘friendly’ or ‘hostile’ manner, e.g. with or without
the support of the board of the target company. Even before you get to this stage you
would need to obtain a consensus in your own company between the board and the
shareholders, especially as takeovers require a premium to be paid. As such you need
to be able to advise a company on the merits of a takeover. Many of the advantages are
generic, however, you will need to be able to tailor your advice to the specifics of t he
situation in order to provide value-adding advice to clients.
(a) Strategic reasons for acquisition
To achieve synergies. This is sometimes known as the 2 + 2 = 5 effect. Two
businesses combined into one can achieve more than the two businesses
separately. Synergy can result in higher revenues, lower costs and lower risk when
aorganisations combine.
Sales synergies
The acquisition of a tractor manufacturer provides expansion and diversification.
The acquisition creates an opportunity to introduce the established PAMC brand
into existing or new KMC products that we develop in the future. Whilst KMC
has not been involved in the agricultural sector for a long time there may be some
residual brand awareness that can be leveraged. Furthermore, this tie-up
combines two domestic brands with strong reputations for traditional low-cost
products, this may allow both businesses to trade on their traditional roots more
powerfully.
Cost synergies
Examples of cost synergies are savings in purchasing costs due to buying in larger
quantities. As both companies are involved in vehicle manufacturing, there are
bound to be some common component purchases, such as metals and lubricants.
Where purchases from the same supplier are combined it would be expected that
better prices could be negotiated. Alongside this there should be possibilities to
combine and reduce some administrative costs by combining administration and
management systems.
Reduction in risk synergy
The diversification of the revenue streams means that the overall company results
may be less affected by an economic downturn, as the combined company will be
serving two separate markets. Motorbikes are a consumer product, whereas
tractors are a commercial product. During economic cycles, such as growth and
recession, these markets are likely to grow and contract at different rates,
smoothing the overall impact of the cycles.
230
Answer Bank
Acquisition of skills, expertise and talent

The acquisition of PAMC will provide additional knowledge, skills and
experience in the design, manufacture and distribution of mechanical machinery.
Whilst there are obvious differences in the product ranges there are enough
similarities to mean that the companies and their employees can benefit from
sharing knowledge.
(b) Valuation of PAMC
TUTORIAL NOTE
Company valuations are a common exam requirement. You need to be able to
deploy a number of techniques, such as P/E, dividend valuation and discounted
cashflow methods. You look at the later technique here. You should remember
that the present value technique tends to give a very high valuation, mainly as it
uses a perpetuity to arrive at a terminal value. As such you need to be able
critique this form of valuation so that you can barter down the price that you are
prepared to pay to acquire a target company e.g. if a target has values themselves
using this technique, you should be prepared to critically evaluate the
assumptions being used in order to arrive at a ‘more reasonable’ valuation.
Year 1 2 3 4 5 and onwards
Real cash flows(Rs'm) 92.90 98.90 104.50 114.40 114.40
Inflation adjustment x x
 x x x x x x

x
Nominal cash flows Rs'm 97.5 109.0 120.4 137.7 143.2
Terminal value for Year 5

and onwards 143.2/(0.11 – 0.04)
[Amount/(WACC –
expected inflation)]
Terminal value at Year 4
2,045.7
value
11% discount factor
(KMC's current weighted 0.901 0.812 0.731 0.659 0.659
cost of capital)t
Present value (Rs'm)
Total present value =
Rs 1,703.2 87.8 88.5 88.0 90.7 1,348.1
231
The outstanding borrowings for PAMC according to its statement of financial
position at 31 March are Rs 643 million. Therefore, the estimated value of
PAMC's equity is Rs 1,703.2m – 643.0m = Rs 1,060.2 million.
The estimated cash in hand (based on the figures at 31 March 20X7) is Rs 68
million, which is fairly insubstantial. This increases the valuation of the
company's equity, from Rs 1,703.2 million to Rs 1,771.2 million. However, it is
likely some cash is required to maintain operational liquidity and therefore the
Directors of KMC are likely to negotiate a price lower as some cash may not be
considered as surplus.
Uncertainties and reservations in the valuation of PAMC
The predicted cash flows are uncertain for the following reasons:
(i) Although the directors of KMC have been involved preparing the cash
flow forecast, and are anticipating sales growth in PAMC, there is no
guarantee this level of sales will be achieved following acquisition.
Moreover, the growth figures are based on the directors’ discussions with
PAMC, so they may be optimistic if PAMC has presented an unduly
confident economic outlook.
(ii) Inflation is predicted to be 5% in Year 1, falling to 4.5% in Year 3 and
then to 4% from Year 5 onwards with no apparent rationale for this. It is
possible inflation may rise. Therefore it would be more prudent to assume
inflation is maintained at 5% in the valuation, at least.
(iii) There is insufficient information to determine if sufficient costs have been
incorporated. The growth in cash flows are based on increases in sales
volumes, but there is no guarantee that these increased sales will be
matched by increased profitability.
(iv) The valuation assumes PAMC continues into perpetuity with growth of
4%. Terminal values tend to over-value companies for this reason. This is
why the values above are in excess of its current market value of Rs 1,560
(Rs 52 × 30 million shares), which appears to already include an
acquisition premium.
(v) The valuation appears to ignore post-acquisition integration costs which,
if significant, would lower the value of PAMC to KMC.
They factors could significantly reduce the valuation thereby increasing
the risk that KMC overpays for PAMC. It is recommended that the
purchase of PAMC is subject to due diligence procedures to gain some
assurance about the reliability of the forecast cash flows, and possible
variability in them.
The valuation currently uses KMC's existing discount factor of 11% which
assumes there will be no change in business risk or financial risk as a result
of the acquisition. This is unrealistic as PAMC operates in a different
industry and it is likely additional debt finance will be required to finance,
or partly finance, the acquisition, which will raise financial risk.
232
Answer Bank
(c)
TUTORIAL NOTE
Once a takeover offer has been agreed the acquiring company then needs to
consider how to finance a deal. The analysis in these requirements will focus
on the merits of equity (retained earnings, rights issues, fresh equity) versus
debt (loans, debentures, convertible debt), and of course a mix of these. There
will never be a generic solution here as each situation must be assessed on its
merits e.g. current gearing, attitude of shareholders, availability of debt
finance, and preference of the target company’s shareholders.
Abdul Khan's comment – use retained earnings
Retained profits do not have issue costs and hence appear attractive.
Retained profits are also relatively cheap as there are no issue costs and they are
convenient, for example there will be some risk and cost in raising external
finance. This is a form of equity finance as the use of available cash will reduce
dividend pay outs in the short term so this investment will require a relatively
high rate of return to compensate shareholders for the acquisition risk and loss of
short term dividends that they are taking on.
However, KMC is an established listed company. The share price is currently
high and it should be possible to raise the external finance required on reasonable
terms.
More importantly, it appears Abdul has misunderstood the nature of retained
profits. Retained profits do not reflect cash balances that can be drawn on for
capital expenditure; they reflect the amount of equity capital tied up in the whole
business, not just cash. KMC only has Rs 739 million of cash, which is
insufficient to fund the acquisition of PAMC.
The sale of the traditional motorcycle business may indeed raise some cash.
However arranging a trade sale could be a lengthy and uncertain process –
assuming that a cash buyer can be found, and, at a price that is acceptable to
KMC.
Benazir Zardari's comment – raise new equity finance
Benazir Zardari is advocating an issue of new shares as he believes these are
cheap, given dividend yield is 3%. Dividend yield is measured using current
dividends, not the future dividends that will be important for this project. The
dividend yield does not reflect the total reward that may be demanded by
shareholders, since they may also require a capital gain, so understates the
required return of new equity investors and therefore also understates the cost of
a new issue.
New investors would expect at least the current cost of equity as their required
return, and they may possibly require a higher return if the business risk of
PAMC is perceived to be higher than KMC.
233
Whilst it is true that the financial risk to KMC's shareholders would fall (as its
gearing will reduce with the issue of new share capital), the overall weighted
average cost of capital is likely to rise as, fundamentally, equity finance is more
expensive than debt finance due to the higher risk that equity investors take on.
A new share issue is time consuming, as a prospectus is required to market the
share issue to new investors. This time delay may be too long for PAMC
shareholders to wait or another predator company making a bid for PAMC. A
rights issue can be completed in a shorter timeframe, so may be preferable if
there is appetite for further investment by the existing shareholders.
Waqar-ul-Haq's comment – raise new debt finance
KMC will face increased financial risk as gearing increases, along with the
possible increase in business risk. The security that the company provides,
compared with the debt it has, will also not improve as gearing levels increase.
To establish whether it is worthwhile acquiring PAMC via debt finance, KMC
should appraise the future returns using a project-specific weighted average cost
of capital (WACC) based on the different costs of all the sources of finance the
company uses. WACC should be calculated using a revised cost of equity that
takes account of the increases in business and financial risk. The cost of other
forms of debt may also rise because of the increased risks.
The cost of debt capital should be compared with the costs of other sources of
finance (equity shares). In addition, there is no single cost that applies to all types
of debt. Different forms of debt themselves have different costs. Waqar’s
estimate of the post-tax cost of debt of 6.12% for corporate bonds and 5.12% for
bank loans suggests that additional debt finance is cheap relative to equity
finance. However, these costs are not verified and may not apply to the
significant amount of debt which is likely to be required to finance this
acquisition.
(d)
TUTORIAL NOTE
When you are asked to make a recommendation there may not a ‘correct
option’. What you must do is weigh the merits of you earlier analysis e.g.
strategic and financial evaluations, then, come to a recommendation
supported by the logic of your earlier analysis. When making a
recommendation in an exam question the strength on your argument is often
more important than the recommendation itself. This is because the
recommendation itself is a simple yes/no, and often there is no clear-cut
outcome. You must therefore succinctly summarise the main arguments in
favour of/against that support your view.
The post-integration risks are a key aspect of building you argument. Here you
need to establish what could go wrong – and you will find that many of these
are fairly generic e.g. lack of synergies achieved. What cannot be generic is
your analysis of these issues e.g. you must explain why in these circumstances
the risks are relevant and what steps can be taken to mitigate these risks.
234
Answer Bank
Recommendation
The acquisition is a good fit for the following strategic reasons.
(i) PAMC is a domestic mechanical engineering firm, as is KMC.
(ii) It represents some diversity into a commercial market which may generate
some synergy with KMC's operations, as well as diversifying some market
risks.
(iii) PAMC is locally owned and also listed on the PSX so the acquisition
process should be relatively smooth and it will be apparent quickly if the
market approves by the reaction of the share price.
The current market value of PAMC is Rs 1,560 m (30m shares x Rs 52)
which suggests the cash flow valuation of Rs 1,771.2 million from part
(b) is not excessive. It is recommended that the directors of KMC appoint
independent advisors to perform due diligence procedures on PAMC and
revise the valuation based on their findings which includes an assessment
for potential sales and costs synergies.
On the basis of the analysis above I would recommend that the acquisition
should then proceed if suitable finance can be put in place, the price
negotiated below the revised valuation to limit the risk of over-paying.
Key risk: Expected revenue synergies may not be realised
KMC would expect the combined revenues of both companies to increase post-
acquisition. PAMC would expect to be lever some additional sales through
increased publicity and brand awareness. However, there is always the risk that
potential synergies in this area are over-stated, so any portion of the takeover
price attributed to this is never repaid. Equally, there is a risk that management
fails to combine these cross-promotional and cross-selling opportunities.
This risk should be mitigated by taking a realistic approach to valuing these
potential gains to avoid over-paying.
Key risk: Key people and key specialist knowledge (e.g. original owners of
PAMC may leave).
This is particularly an issue for PAMC, as although PAMC’s technical designs
and workshops will be acquired these may not be particularly valuable without
the people who design and build the tractors. For instance the sales contracts of
a business’s owner is typically one of the most valuable parts of an acquired
company. A large amount of the value of the acquisition relates to the skills,
knowledge and networks of those individuals.
The consideration could be at least in part contingent upon post-acquisition
performance, for example, a profit share over the following five years.
The acquisition process could include bonding new staff with new contracts or
employment offers.
A loyalty bonus of, say, a year's salary could be payable to key people in three
years' time and contingent upon performance.
235
Key risk: Cultural difficulties on integration
There is always a chance of culture clash in any acquisition, and this may well
be the case where a smaller company like PAMC is taken-over by a larger
operation. This risk could be exacerbated if Abdul pushed ahead with his plan to
produce foreign-made tractor designs, as this may cause offence to PAMC’s staff
given their background in producing their own designs.
Cultural clashes or difficulties could be mitigated by the fact both companies are
in the same sector, and both are locally owned, so they could have similar
underlying cultures. Moreover, in the short term, KMC will have little
involvement in PAMC’s current operations, so if PAMC can continue to operate
largely autonomously there will be less risk of any clashes.
Key risk: Systems integration will cost money and/or may be problematic
This will reduce business performance. This issue should be thoroughly
investigated pre-acquisition and integration costs factored in to negotiations. A
tentative project plan should be outlined to ensure the post-acquisition process is
as clear and timely as possible.
Key risk: Organisational structure issues
Although the acquisition is an opportunity to refresh the human resources
structure of the new business (for example some shared services with KMC, in
terms of human resource, administration and finance) there is the risk that
personnel are not clear who their line manager is and what their role is. This may
increase staff turnover, and reduce motivation and organisational effectiveness.
This should be planned pre-acquisition as much as possible in consultation with
PAMC owners and communicated swiftly.
(e)
TUTORIAL NOTE
The AI department can be a valuable resource for any business. However,
given the wide scope of their roles and responsibilities it is essential that they
are deployed in a manner that will deliver best value-for-money. This task
allows you to practise thinking about (i) how to prioritise tasks and (ii) how to
justify your preferred order of activities.
In requirements of this type it is the justification of the order of activities that
carries more weight than the order itself. You must provide objectively sounds
reasoning as to why something is of relatively high, or low priority.
The table below outlines a plan for the IA exercise and highlights the matters that
the internal auditors will need to review and investigate.
Area of investigation/ Main points for review

report format
Health and safety Establish clear policy
objectives in place
Review applicable regulatory and industry-specific

standards
236
Answer Bank
Area of investigation/ Main points for review

report format
People and structures Clear responsibilities for
health and safety
Organisational charts
Control measures for allocated responsibilities
Processes, controls, Controls are properly applied in practice and cover

systems all manufacturing operations involving toxic
materials
Processes are properly followed and cover all
relevant manufacturing operations
Adequate systems in place and cover all

relevant manufacturing operations
Assurance Established standards and rules are actually applied

in practice
Collect relevant data
Collect evidence
Conclusions Conclude if procedures, processes and systems

comply with legal requirements and industry
standards
Conclude if procedures, processes and systems
comply with KMC health and safety policy
objectives
Assess overall risks to employees
Assess overall risks to public health
Make estimate of potential risk to the company in

terms of costs of non-compliance
(f)
TUTORIAL NOTE
Corporate Governance is an important part of the syllabus, and, questions in
this area should be relatively straightforward. This is because you have a clear
point of reference in the Code of Corporate Governance 2012 and Public
Sector Companies Rules 2013. If you have good knowledge of these rules then
you should find it relatively easy to discuss areas like these below – the roles
and responsibilities of the Audit and Risk committees.
237
The Audit Committee (AC)
The primary responsibility of the AC should be to monitor the independence of
the external auditors, review the quality of the audit, and make recommendations
about the re-appointment of the current auditors or appointment of new auditors.
The AC should also make a recommendation to the Board about approving the
financial statements of the company prior to publication.
The AC therefore has an interest in any risks that could result in misleading
financial statements or in an unreliable audit opinion about the financial
statements.
The AC is also responsible for reviewing the effectiveness of the internal audit
function.
Prior to the creation of the risk committee, the AC should be responsible for
reviewing the effectiveness of the company’s internal controls. If a risk
committee is created, the AC should retain responsibility for monitoring financial
controls, but responsibility for monitoring other internal controls (e.g.
operational; compliance controls) should pass to the risk committee.
The AC should retain responsibility for monitoring the independence of the
external auditors and risks to that independence. The AC should therefore be
given responsibility for establishing guidelines about the nature, scope and
amount of non-audit work given to the external audit firm by the company.
The Risk Committee (RC)
The RC of the Board should be the main communications link between the Board
and the management risk committees and specialist risk officers. The Committee
should report to the Board of KMC regularly on risk management issues.
The RC should be responsible for reviewing the effectiveness of the systems of
risk management and internal control within the company, except to the extent
that internal control for financial risks is reviewed by the AC.
The RC should therefore monitor the effectiveness of strategic risk management,
and whether the management of strategic risks is consistent with the Board's
policies (risk appetite).
Similarly, the RC should similarly monitor the effectiveness of internal control
systems for operational risks and compliance risks (except to the extent that the
AC monitors risks and risk management issues relating to accounting and
financial reporting).
The RC should, therefore, monitor the company’s overall ability to identify and
manage risks. It is not the role of the AC, despite what the Chairman of the AC
at KMC may think.
Reducing the likelihood of disagreements between the two committees at KMC
Have some cross-representation of members on the committees (ensuring that at
least some members of each committee are standalone). The AC Chairman may
be appointed as a member of the RC, and the RC Chairman may be
appointed as a member of the AC. This should serve to make the AC chairman
happier about the change of structure being proposed.
238
Answer Bank
The Company Secretary should be secretary to both committees and should

notify the committees of any possible disagreement or misunderstanding with the
other committee, so that the problem can be discussed and (hopefully) resolved.
The Board of KMC as a whole should retain overall responsibility for certain
aspects of risk, such as risk appetite and risk tolerance levels.
(g)
TUTORIAL NOTE
This is a tricky requirement as it requires total application to the scenario –
there are no ‘knowledge’ marks here. You will need to analyse Exhibit 3 and,
with regard to what you know about role and responsibility of an audit
committee, advise them on a sequence of ‘common sense’ steps they should
take in regard to this ethical problem.
The Committee should have been informed of the reasons for each of the
breaches, their consequences, and the measures so far taken by management in
response.
The Committee should assess the seriousness of the consequences of the
breaches of the tolerance level limits – for example might financial penalties be
imposed by the regulatory authorities?
The Committee should ask management about the effects of any remedial action
taken so far. The Committee should also ask to be kept informed promptly of any
further breaches of the tolerance level limits.
As the number of breaches is so much higher than the target level in the company
policy, the Committee should look at two issues. Are the limits set correctly, and
are the breaches material in nature?
The Committee may decide to report on the matter to the Board at the next Board
meeting.
Key points to report on here (and points which should be addressed in the internal
audit exercise) are: have appropriate internal controls been established at KMC,
and if they’ve been established, are they being properly followed? The
Committee may also consider the breaches when making an assessment of the
adequacy of the internal control systems for operations and regulatory
compliance.
Question 13 - Graffoff
Marking scheme
(a) Identify the advantages of franchising – up to 1 mark 3
each
Explain the advantages of franchising – up to 1 mark 3
each
Identify the disadvantages of franchising – up to 1 3
mark each
Explain the disadvantages of franchising – up to 1 3
mark each
239
(b) Identify other forms of strategic alliance – up to 1 2
mark each
Evaluating other forms of strategic alliance – up to 3 6
marks each
(c) Calculate impact of reducing receivables days 2
Calculate impact of decreasing payables days 2
Calculate impact of debt factoring 2
Conclusions 2
(d) Subject to deduction at source 0.5
No tax credit allowed against tax liability re: 0.5
dividends
Dividends not an allowable expense for the company 0.5
Tax deducted against salary by the company is not 0.5
final discharge of tax liability
Salary is a tax-deductible expense for the company 0.5
hence taxable income of the company reduces.
Rate of tax on taxable income of company is higher 0.5
Maximum for this section 2.5 marks
(e) Identification and definition of royalty 0.5
Royalties paid by franchises who are residents – 1
Pakistan source income and normal tax regime
Royalty received from foreign enterprise for use of 1
patents outside Pakistan shall be exempt
Maximum for this section 2.5 marks
Total 25 marks
(a)
TUTORIAL NOTE
The business in this scenario has obvious growth potential, and, in this case
seems to have settled on franchising as the preferred option. In this instance
you therefore need to focus on the specific advantages and disadvantages
of this approach. In other questions you could easily be asked to assess a
range of growth techniques. In this instance you could refer to Ansoff’s
matrix (market/product axes) and/or Lynch’s expansion matrix (internal v
external and organic v inorganic axes) to identify options that could be
critically assessed.
In requirements such as the one below it is critical that you are scenario-
specific e.g. why is franchising a good/bad idea for Kamran and his business?
240
Answer Bank
Franchising would involve independently run businesses entering into a franchise

agreement with Graffoff to purchase training, equipment and materials, in
exchange for an exclusive geographical franchise area.
Advantages
Kamran's original expansion plan involved Graffoff leasing appropriate
premises. If the franchising option is taken then this would instead be done by
the franchisees, therefore, this option would allow Graffoff to avoid the cost
associated with leasing and fitting out the depots.
The substantial upfront payment that would be received from the franchisees
would provide funds which Kamran could then use for either investment or
dividend payments.
The franchisees would also be responsible for the operational costs of their
franchise, again allowing Graffoff to avoid such costs.
Franchisees are often motivated by the fact that they run their own business, and
the responsibility for motivating their staff also lies with them. This would make
the franchising option attractive to Kamran as it would allow him to avoid
employee motivational issues, which he has acknowledged is not his strength.
A further advantage of the franchising option is that Kamran would not have to
raise finance or manage the period of expansion. He could continue to run
Graffoff in much the same way as he is currently.
Disadvantages
A key disadvantage is that it is likely that short-term and long-term returns to
Graffoff will be lower than if the business expanding organically and opened the
new depots itself. This is because the majority of the profits from the franchise
business will be taken by the franchisees. Graffoff will also be dependent on
income from materials supply and a relatively small percentage of the annual
sales of the contract.
The upfront fee paid by the franchisee will be the same whether or not the
franchise turns out to be successful, but any continuing income is completely
dependent on its success. Similarly, the reputation of the product is likely to
depend on the way it is sold by the franchisees, and the service customers receive
from the franchisees. Therefore it is important that franchisees are selected
appropriately and carefully controlled. It would seem that Graffoff has no
experience of this, or any systems in place to control and audit the performance
of the franchisees. Investment and development of such systems is therefore
necessary prior to the launch of the franchise scheme.
Graffoff currently has a very low profile, and Kamran has so far failed to build a
highly visible brand. A franchise scheme, which relies heavily on branding, will
not succeed unless this is rectified. Kamran could attempt to do this by employing
marketing expertise and launching vigorous campaigns.
Attracting franchisees in the first place may be difficult if potential franchisees
recognise that sales volumes will be difficult to maintain once the patent has
expired. However, Kamran has strong product development capabilities so he
could aim to improve the product to extend the patent, rather than focusing on
business expansion.
241
(b)
TUTORIAL NOTE
There are a number of other strategic alliances (see Lynch’s expansion matrix
for ideas). In this question you would be looking to identify 2, possibly 3
options, and then assessing each in turn, in much the same way as you did in
part (a).
A strategic alliance involves the sharing of resources and activities by two or
more organisations in order to pursue a strategy. Materials, skills, innovation,
finance and access to markets can often be accessed more readily via
collaboration than by a single organisation alone.
Franchising is one form of strategic alliance, however, there are other forms of
alliance that Kamran could consider. He will most likely be interested in co-
specialising, given that Graffoff has strengths in product design and development
but weaknesses in marketing, retail and finance. This co-specialisation could be
achieved with the following.
Joint venture
This is where the two companies jointly set up and control a new organisation
and is often a way of entering a new geographical area. In this case, however,
expansion will be within the same country. At present, no organisations have
been identified as potential joint venture partners, and setting up a contractual
relationship once a suitable organisation is found could be a lengthy process.
Kamran may also find it difficult to give up the amount of control necessary for
the joint venture to succeed given his entrepreneurial spirit.
Network arrangement
This is where two or more organisations work in collaboration without a formal
relationship. Kamran has already rejected the offer made by The Equipment
Emporium to sell his product in their 57 stores on the basis that his product
requires proper training.
Kamran might consider going back to them and offering to set up small outlets
in their stores where the product could be demonstrated and sold, in exchange
for payment of a fee to The Equipment Emporium. This would have a similar
effect to organic growth but without the high investment. The Equipment
Emporium's stores are already set up and already benefit from a well- recognised
brand with a strong marketing presence.
This arrangement would seem ideal as it draws on both partners' expertise, and
would allow Graffoff's expansion to occur rapidly.
A common problem relating to informal arrangements such as this involves
concerns that one party would steal the other's ideas. However, this does not seem
likely in this case as The Equipment Emporium is focused mainly on products
rather than services, and Graffoff has no interest in becoming a general machine
superstore.
242
Answer Bank
(c)
TUTORIAL NOTE
Financial feasibility is a core component of strategic analysis, quite simply a
great idea is of no use unless it is affordable. In this instance there are a number
of options, and, the financial contribution of each should be calculated in turn
e.g. reducing receivables days, stretching payables days, using a debt factoring
agency. Each of these should release more working capital, however each of
these will have associated costs, so, once you have finished your calculations
you will need to assess (i) whether the necessary funds could be raised and (ii)
whether these calculations are realistic e.g. if receivables days are squeezed
will sales be lost?
Kamran is committed to paying high dividends, therefore the possible sources of
internal finance open to him are tighter credit control and delayed payment to
suppliers. Reduced inventory may also be an option, but no information relating
to this is given in the scenario, and the financial data in Exhibit 1 suggests
Graffoff holds relatively little inventory.
Tighter credit control
Customers are given a 30 day payment term, however, the average time taken
for them to pay their debts is 59 days [(48/298) x 365 = 58.8].
If credit control is tightened up and the average is brought down to 30 days
approximately Rs 23.5 million could be released for funding.
Reducing the average to 40 days – the industry standard – would release
approximately Rs 15.3 million.
To achieve this, significant improvements would have to be made to the accounts
receivable procedures; but the receivables department is currently under-staffed
which is making the employees demotivated. Some of these gains therefore
would most likely be offset by the cost of increased staffing.
Kamran also dislikes conflict with customers. This is why he has allowed the
extended payment terms to occur. A change to enforcing the 30 day payment
terms could create difficulties and put a strain on relationships with customers.
However, in to improve the company’s credit control, Kamran will have to stop
undermining the efforts of the accounts receivable department by offering such
generous terms to customers.
Delayed payment to suppliers
On average, Graffoff takes only 20 days to pay its suppliers [(14/256) x 365 =
19.96]. This is far quicker than the industry standard of 40 days. If the company
were to delay its payments so that they were only made after 40 days
approximately Rs 14 million could be released for investment.
There is no reason why this change could not be put in place, as the fast payment
appears to be simply due to the 'zealous administrator in accounts payable who
likes to reduce creditors'. It is also noted that Graffoff is 'unique in its punctuality
of payments'.
243
Even if payments are only delayed to 30 days (the normal credit terms in
Karachi), Rs 7 million would still be realised.
If these changes were made to both tighten credit control and delay payments
then a maximum of Rs 37.5 million could be raised (by reducing credit terms to
30 days and increasing payables days to 40) resulting in a short-term, one-off
acceleration of cash inflow.
Debt Factoring
This would involve a third party taking over Graffoff's debt collection. Assuming
that a factoring company will pay 80% of approved trade receivables in advance,
this would translate to an immediate cash inflow of Rs
38.4 million. Given the existing problems with credit control, this could be an
attractive alternative. You should however bear in mind the cost of factoring,
which can appear to be very reasonable, though in fact can be prohibitively
expensive. For instance if fees of 2% were levied, and cash was received 1 month
earlier then the annualised cost would be 24% on a straight-line basis, and of
course even higher on a compound basis.
Conclusion
If all of the measures above were taken a total of Rs 75.9 million could be raised,
just short of the target of Rs 80 million, it is therefore not possible to internally
generate all of the funds required for the organic growth plan. However, it would
seem that internally raised finance could be sufficient to finance either
franchising, or an opportunistic alliance with The Equipment Emporium.
Alternatively the expansion plans could be scaled back slightly.
(d) Salary versus dividend
(1) Dividend received by Mr. Kamran is subject to deduction of tax at source
by the company is deemed final discharge of tax liability. Accordingly,
neither any deduction is allowed (like zakat, profit on debt for construction
of house, children education expenses) nor is any tax credit allowed
against tax liability in respect of dividends.
(2) Dividend is not allowed as an expense to the company hence no impact
on calculation of taxable income of the company.
(3) On the other hand, the tax deducted against salary by the company is not
final discharge of tax liability and deductions from income and credits
against tax liability are available for adjustment.
(4) Salary is a tax-deductible expense for the company hence taxable income
of the company reduces.
Since rate of tax on taxable income of company is higher as compare to
rate of tax on salary income therefore claim of salary expense is beneficial
for the company and Mr. Kamran from tax planning perspective.
(e) If Graffoff enters into a Franchising Agreement, the amount received from the
franchisees will fall under the definition of Royalty income as it will be considered
as Consideration Received from the use of, or right to use any patent, invention,
design or model, secret formula or process, trademark or other like property or
right;
244
Answer Bank
For royalties paid by Franchisees who are Residents, it shall be considered as

Pakistan-source income and shall be subject to tax under normal tax regime.
Furthermore any royalty received from a foreign enterprise in consideration for
the use of patents outside Pakistan, such Income shall be exempt from tax under
Clause 131 of Part 2 of Second Schedule.
Question 14 - PCL
Marking scheme
(a) Identify a benefit of reward schemes – up to 1 mark 2
each
Explaining a benefit of reward schemes – up to 1 mark 2
each
Identify drawback of reward schemes – up to 1 mark 2
each
Explaining a drawback of reward schemes – up to 1 2
mark each
(b) Calculate Yr 1 profit of each scheme – ½ mark each 1.5
Calculate Yr 1 capital employed of each scheme – ½ 1.5
mark each
Calculate Yr 1 ROI of each scheme – 1 mark 1
Calculate Yr 2 profit of each scheme – ½ mark each 1.5
Calculate Yr 2 capital employed of each scheme – ½ 1.5
mark each
Calculate Yr 2 ROI of each scheme – 1 mark 1
Discuss perspective of managers v executive board – 2
up to 2 marks
(c) Explain concept of RI 1
Explain positive aspects of RI as a performance 2
measure – up to 1 mark each
Explain positive aspects of RI as a performance 2
measure – up to 1 mark each
(d) Using correct cash flows in NPV 0.5
Using 12% cumulative discount factor 0.5
Calculating value of follow-on costs – ½ mark each 1
Calculating NPV outcomes – original ½ – follow-ons ½ 1
Arguments in favour of positive CSR – 1 mark per
point 3
245
(e) Discussion leading to conclusion that it's an industrial 0.5
activity
% for first year allowance 0.5
Calculation of capital allowance 2
Total 25 marks
(a)
TUTORIAL NOTE
Attracting and retaining talented staff is a challenge for all ambitious
organisations. A balance must be struck between several factors including (i)
market competitiveness (ii) employee expectations (iii) employer affordability
(iv) shareholder returns. Some of these issues are touched upon in the first part
of this question.
Benefits for the organisation
Align goals – The aim of a well-designed reward scheme should be to encourage
behaviour which supports the organisation's strategy and helps it to achieve its
goals. A reward scheme can help to do this by aligning employees' goals with
those of the organisation. For instance as PCL is made up of a number of
operating divisions each could set-up a bonus scheme relevant to its own goals
e.g. mining efficiency or
civil engineering innovations.
Provide incentives – A reward scheme should also provide an incentive to
achieve a good level of performance, and the existence of a reward scheme can
help to both attract and retain employees who are making favourable
contributions to the running of the organisation. To this end employees in each
PCL division should be able to see a transparent link between the performance
of their division and the rewards that they can receive. If possible a further link
to the individual’s contribution to divisional performance should be added.
Potential drawbacks for the organisation
Poorly designed measures – Whilst a well-designed reward scheme can benefit
an organisation, reward schemes can also be detrimental if the performance
measures used are poorly designed, or if unrealistic performance targets are set.
For instance if a bonus scheme results in short cuts being taken in regards to
health and safety in a mine they dangerous and dysfunctional behaviour may
result.
Two particular issues which could arise in this context are: short-term decision
making, and increased risk taking. For example, if directors/managers know
that their bonuses depend on annual profit targets being reached, they may be
encouraged to undertake risky projects which might be profitable in the short
term (and therefore increase their bonus), but may not be beneficial to PCL as
a whole over the longer term.
246
Answer Bank
Lack of goal congruence – The situation at PCL highlights the potential dangers
of poorly designed performance measures. The nature of the management
scheme means that divisional directors will only support new investments which
generate a favourable ROI during their first two years. However, this means they
are likely to reject schemes which could generate overall value for PCL, but don't
have a favourable ROI in their first two years. In this way, the reward scheme
could lead to a lack of goal congruence between the IOA Division and PCL as a
whole.
(b)
TUTORIAL NOTE
Goal congruence is an aim of all organisations. Quite simply if everyone’s
efforts are focused in the same direction then better outcomes are achieve for
all through economies of effort. When a business is divisionalised for control
purposes then finding a ‘fair’ way of assessing performance is important for a
number of reason, not least of which remuneration. This requirement allows
you to practise calculating ROI, then, to explore how it can on occasions lead
to dysfunctional behaviour e.g. incentivising divisional managers to act in a
manner that does not benefit the company as a whole.
Divisional management's decision making will be influenced by the fact that their
annual bonus payments are calculated with reference to ROI earned during the
first two years of an investment. We therefore need to look at the ROI of the three
projects in Years 1 and 2.
Nokundi Chinot Kalabagh
Rs'm Rs'm Rs'm
Year 1 Cash flow
Depreciation: 1,020 1,955 2,040
4,080/4 years (1,020) (1,020)
4,080/3 years (1,360)
Profit 0 595 1,020
Average capital:
(4,080 + 3,060)/2 3,570 3,570
(4,080 + 2,720)/2 3,400
ROI (profit/average capital) x 100%) 0% 17.5% 28.6%
Year 2 Cash flow
Depreciation: 1,360 1,955 1,700
4,080/4 years (1,020) (1,020)
4,080/3 years (1,360)
Profit 340 595 680
Average capital:
(3,060 + 2,040)/2 2,550 2,550
(2,720 + 1,360)/2 2,040
ROI (profit/average capital) x 100%) 13.3% 29.2% 26.7%
247
The management of the IOA Division will prefer to invest in the Kalabagh
project as it has by far the highest ROI in Year 1, and an ROI only marginally
lower than that of the Chinot project in Year 2 and so will result in higher bonus
payments for them in Years 1 and 2. They will not look further than this to
consider the whole life of each project. This reflects a short-term focus that is at
odds with the view of the board of directors of PCL. As the latter's objective will
likely include the maximisation of shareholder wealth over the longer term, the
board is likely to choose the Nokundi project as this has the highest expected
NPV.
The incentive plan motivates management to adopt a short-term focus which is
detrimental to the organisation as a whole and leads to a lack of goal congruence
and dysfunctional decision-making.
The attitude to risk of the directors of PCL will have an impact, however. The
Chinot project has a life of three years (compared with four for Nokundi and
Kalabagh projects) which means that the cash flow estimates associated with it
are less subject to uncertainty.
(c)
TUTORIAL NOTE
RI is an alternative measure of performance. In this requirement you need to
discuss if it would be a better measure for PCL than ROI. There is not enough
data to produce calculations so focus on the relative merits +/– of RI versus
ROI.
RI is an alternative way of measuring the performance of an investment centre,
instead of using ROI, and using RI a basis for a performance measurement
system has a number of advantages.
RI is a measure of the centre's profits after deducting a notional or imputed
interest cost. The imputed cost of capital might be the organisation's cost of
borrowing or its weighted average cost of capital.
RI is positive for investments which generates earnings above the cost of capital,
so if it is used as a basis for performance measurement it will result in projects
being undertaken that will increase shareholder value. It also allows different
costs of capital to be applied to investments with different risk characteristics, so
it is a more flexible measure than ROI.
However, using net book value at the start of each year, and depreciating on a
straight-line basis to a nil residual value, tends to distort project returns in the
early years of a project's life. RI also cannot be used to make comparisons
between investment centres as it is an absolute measure of performance (whereas
ROI is a relative measure, showing % returns). Finally, RI does not relate the
size of a centre's income to the size of the investment, other than indirectly
through the interest charge.
248
Answer Bank
(d)
TUTORIAL NOTE
The NPV calculation here is relatively straightforward (i) calculate the returns
on the project including the Rs 340 million needed to clear 90% of the
pollution (ii) then the impact of the follow-on investment of Rs 340 million
needed to clear the remaining 10%. You can then discuss the contrasting
pressures of (i) the need to maximise shareholder returns (ii) legal compliance
(iii) going ‘above and beyond’ legal minimum standards e.g. following a CSR
agenda.
Haripur project
Cash flow Discount factor Discounted cash flow
Rs'm 12% Rs'm
Year 0 (2,040) 1.000 (2,040)
Years 1–4 850 3.037 2,581
NPV 541
Excluding the costs of redressing the environmental damage at the end of its life,
the Haripur project is expected to generate a positive NPV of Rs 541 million,
which might suggest the IOA Division should undertake the project.
However, PCL also needs to consider whether it is strategically appropriate to
then spend a further two sums of Rs 340 million in Year 4 on redressing the
environmental damage caused by the project.
Environmental repair
Rs'm
NPV as calculated 541
Year 4 expenditure (Rs 340 million x 0.636) (216)
NPV 325
Further expenditure (Rs 340 million x 0.636) (216)
NPV 109
The decision over whether to spend the extra Rs 340m presents a dilemma
between maximising shareholder wealth, and acting responsibly, and, what does
‘responsible’ really mean.
Depending upon how socially responsible the board of PCL is, and whether they
think they have a moral obligation to clear up their own pollution, it could find
the NPV of the Haripur project reduced from Rs 325 million (after the minimum
required clean up expenditure) to Rs 109 million.
Whilst it appears that the pollution discharged into the river will fall within legal
limits, the sight of polluted water could create substantial negative public opinion
and publicity for the company. As such, PCL may find its future activities
limited, or at least subjected to intense scrutiny, if pressure groups target the
company. This, coupled with any negative publicity about the company, may
make it more difficult for PCL to undertake similar projects in the future.
Therefore, absorbing these costs, and being seen as a socially responsible
company, should help to promote local goodwill and could bring greater longer-
term benefits for PCL.
249
(e) There is an insufficient information to decide if Haripur Project uses
mechanically transmitted energy rather than energy generated by Humans or
Animals. But based on the fact the mining activities are performed by 125 people
at the Haripur Site, Haripur will be considered as an Industrial Undertaking under
the provisions of Income Tax Ordinance 2001 as it involves the working of a
mine.
Since Haripur is designated as an under developed area, the Plant & Machinery
installed is subject to first year allowance at a rate of 90% under section 23A of
the ITO 2001.
Detailed calculation of the Capital allowances pertaining to the above is as
under:
Initial Expenditure 2040
Plant Machinery/Equipment @ 80% 1632
First Year Allowance @ 90% 1468.8

Remaining WDV 163.2
Tax Depreciation @ 15% 24.48 1493.28

WDV @ Year 1 End 138.72
Tax Depreciation @ 15% 20.808
Tax Depreciation @ 15% 17.6868
Disposal Proceeds 150.3378
Tax Gain on Disposal 50.1126
Question 15 - Khan and Co.
Marking scheme
Allowance for Year 1
(a) Estimate of depreciation 1
Estimate of tax 1
Estimate of changes in working capital 2
Projection of statement of profits 3
Projection of statement of cash flows 3
(b) Calculation/identification of free cash flow 1
Calculation of terminal value 2
Calculation of present values and business value 3
(c) Commentary on required rate of return – up to 2 2
marks
Assumptions about the growth rates – up to 2 marks 2
Other relevant points 1
250
Answer Bank

(d) Legal provisions – up to 0.5 mark for each point 2
Calculations up to 0.5 mark for each point 1.5
Options available up to 0.5 mark for each point 1.5
Total 25 marks
(a)
TUTORIAL NOTE
Cash flow forecasts are always time consuming. The trick here is to spend a
few moments planning your workings here e.g. you need 3 columns (one for
each year), and space for the key (cash flows in and out).
There are a couple of ‘tricky’ workings here, specifically the operating costs,
depreciation to add back, and taxation. Leave spaces for these in your
workings, and, if you are short of time you should leave any incomplete
workings. If you are under time-pressure your remaining minutes will be better
spent on the remaining parts of the question, even if you have to substitute in
any figures that you didn’t have time to calculate.
Using the information in the question it is clear that in order to produce a
projected cash flow statement we must first produce a projected statement of
profit or loss for each of the next three years.
Year 1 Year 2 Year 3
Rs'm Rs'm Rs'm
Projected statement of profit or loss
Revenue (9% growth) 6,306 6,873 7,492
Cost of Sales (9% growth) 3,656 3,985 4,344
Gross profit 2,650 2,888 3,148
Other operating costs (W1) 2,293 2,451 2,624
Operating profit 357 437 524
Projected cash flows
Operating profit 357 437 524
Add back depreciation (W2) 113 113 114
Less incremental working capital (W3) (23) (25) (27)
Less interest (94) (94) (94)
Less taxation (W4) (50) (79) (103)
303 351 414
Less additions to non-current assets (91) (109) (131)
Free cash flows to equity 212 242 283
251
Rs'm Rs'm Rs'm
Workings
1 - Operating costs
Variable costs (9% growth) or 15% of sales 946 1,031 1,124
Fixed costs (6% growth) 1,234 1,308 1,386
Depreciation at 10% (see below) 113 113 114
Total operating costs 2,293 2,451 2,624
2 - Depreciation and NCA

Opening NBV 1,038 1,016 1,012
Additions (20% growth) 91 109 131
NCA at end of the year 1,129 1,125 1,143
Depreciation at 10% 113 113 114
3 - Working capital
WCP requirements (9% growth) 280 305 332

Incremental increases 23 25 27
Note. That the working capital figure excludes cash, therefore the current (year
0) working capital figure is Rs 315 m – Rs 58 m = Rs 257 m
4 - Taxation
Per last year SOPL 50
Previous years’ operating profit 357 437
Less interest (94) (94)
Profit before tax 263 343
Tax at 30% 79 103
(b)
TUTORIAL NOTE
In line with part (a) you should ensure that you begin this requirement once
half of the total time allocated to this question has elapsed. If necessary you
should just substitute in a couple of the figure you will have needed to bring
forward from part (a) e.g. free cash flow to equity and terminal value. You will
not lose marks in part (b) for doing this.
Again, if you are short of time here be prepared to insert any missing figures
so you can complete the narrative section in part (c) which you may find
relatively easy compared to the more complex aspects of the calculations in
the first two parts of this question.
252
Answer Bank
Value of business using free cash flow to equity and terminal value
Rs'm Rs'm Rs'm
Free cash flow to equity (from (a)) 212 242 283

Terminal value (W1) 4,168
Total 4,451
Discount factor (10%) 0.909 0.826 0.751
Present value 193 200 3,343
Value of the business 3,736
Working
Terminal value
Terminal value = FCFN (1+ g)/k – g where g = growth rate
k = required rate of return
Terminal value = 283 (1 + 0.03)/0.10 – 0.03
(c)
TUTORIAL NOTE
Valuations and critically evaluating the figures you have calculated has been
a feature of many questions in this question bank. Many of the headings in the
solution below are fairly generic, so, you must remember to tailor your
analysis to the specifics of the scenario where possible e.g. how realistic do
the growth rates look compared to GDP in Pakistan as a whole?
Assumptions and uncertainties within the valuation

Whilst the valuation of the business is a useful estimate, it should be treated with
caution as it is subject to certain assumptions.
Rate of return
The rate of return of 10% is assumed to fairly reflect the required market rate of
return for a business of this type, which compensates you for the business risk to
which you are exposed. Whilst the required return for an investment held in a
widely diversified portfolio should only compensate you for market risk, if you
hold the same investment individually you may expect a higher return due to
your increased exposure to risk.
Growth rates
The growth rate applied to terminal value is assumed to be certain into the
indefinite future. In the case of a three year projection this is unlikely to be the
case, due to unexpected economic conditions and the type of business. In order
to reduce the effects of such uncertainties, different growth rates could be applied
to the calculations to determine business valuation in a variety of scenarios.
Although there has been tremendous growth in Pakistan in recent years a 9%
recurring rate of growth seems quite optimistic.
253
Interest rates and tax rates
Similar to the growth rate, it has been assumed that interest rates and tax rates
will remain unchanged during the three year period. If economic conditions
suggest that changes may take place revised calculations could reflect different
possible rates to update the estimate of business valuation.
Costs, revenues and non-current assets
It has been assumed that the figures used for these factors are certain and that the
business is a going concern. It may be worth investigating the potential
variability of these factors and the range of values that may result for such
variability. Changes in estimates will obviously affect operating profit and
projected cash flows, which in turn will affect the estimated value of the business.
(d) Legal Provisions
The tax deducted at source in respect of revenue received from rendering of
engineering services is subject to deduction of tax at source @ 8% of the value
of services inclusive of sales tax.
The tax so deducted is minimum tax in respect of income arising from rendering
of such services however clause 94, part IV, second schedule to Income Tax
Ordinance, 2001 provides exemption to certain sectors (including engineering
services) from minimum tax subject to the following conditions;
The company is a filer
Tax payable shall not be less than 2% of annual turnover from aforesaid services
An irrevocable undertaking is to be submitted by the company that the company
will present its accounts for tax audit within 30 days of filing of tax return.
Exemption certificate from tax deduction at source may be issued to such
taxpayer upon payment of quarterly advance tax equal to 2% of turnover for the
corresponding period of immediately preceding tax year.
Instead of obtaining exemption certificate the taxpayer referred in clause 94 may
opt for carry forward of minimum tax which is in excess of normal tax liability
and adjust the excess amount of minimum tax against normal tax liability of
subsequent tax year and if such excess amount still remains unadjusted, it can be
carried forward up to five subsequent tax years.
Calculations
The gross revenue for Wahid & Co. inclusive of sales tax = 3,652/100 x 116 =
Rs 4,236 million.
The income tax deducted @ 8% as minimum tax = 4,236 x 8% = Rs 339
million.
The normal tax liability @ 30 % is Rs 301 million.
Option Available
The above calculations suggest that minimum tax liability is more than normal
tax liability therefore there is a case for taking benefit of provisions of clause 94,
part IV, Second Schedule.
254
Answer Bank
The company has the option to pay quarterly advance tax as explained above and
obtain exemption certificate for tax year 2019 however the company will have to
submit its accounts for tax audit within 30 days of filing of tax return.
Alternative the company needs to forecast its profit and loss account for
subsequent years and see if there is potential normal tax liability in future years
to absorb excess amount of minimum tax. In such a case the company may not
opt for exemption certificate and hence would not have to present itself
voluntarily for the tax audit.
Question No 16 - Lahore World Travel Ltd
Part (a)
Tutorial notes
This requirement is not very complex, however, identification of correct performance
analysis ratios is very important to ensure that maximum marks would be awarded.
Here, students should clearly identify Profit Margins and Return on Capital Employed
(ROCE) as performance measure KPIs based on the information provided in the
question. Based on the calculations, discussions are also required to critically evaluate
the potential acquisition. Students are expected to use numerical figures to support their
arguments. There is another requirement of this part is to comment on advantages/
disadvantages of potential acquisition. Students are expected to consider the
information provided in the question while describing advantages/ disadvantages. The
answer should be balanced among advantages and disadvantages. At the end, brief
conclusion is also expected to finalize this requirement.
2018 Performance LWT LWT Safari Safari

analysis 2018 2017 Adventure Adventure
plc 2018 plc 2017
Rs Rs £ millions £ millions
millions millions
Revenue 11,892 11,458 21.5 20.0
Profit after tax for the 2,200 2,160 4.4 4.1
year to 30 June 2018
Revenue Growth (%) 3.8% 7.5%
Profit Margin (%) 18.5% 18.9% 20.5% 20.5%
Total Market
Capitalisation 30,000 30,000 50.0 50.0
(Value of equity and (W1) (W2)
debt)
Return on Capital 7.3% 7.2% 8.8% 8.2%
Employed (%)
Workings
1 LWT – 40 million shares  500 Rs + Rs 10,000 million (debt)
2 Safari Adventure plc – 20 million shares  £2.50
255
Revenue
LWT revenue growth in 2018 of 3.8% is significantly below Safari revenue growth of 7.5%,
suggesting that the board of directors are correct that growth is slower than Safari in their
core travel areas of luxury and corporate travel. However, LWT does not advertise and has
no clear marketing strategy, so they could be losing ground to new competitors, which they
are unaware of. Therefore LWT may consider investing in marketing to boost existing
growth instead of an acquisition strategy at this point. LWT's performance reporting is
limited and there is no evidence of competitor benchmarking. Recent growth in Safari is
consistent with the 8% increase in customers indicated by the Safari director. However,
sustainability of future growth is unclear as growth will be limited to three sites and hotel
room capacity at these sites, and LWT currently knows little about the safari market.
Profit Margin
LWTs profit margin has fallen slightly by 0.4% to 18.5% which suggests either further
discounting to achieve revenue targets or rising costs have not been passed on to customers
in pricing. LWT lacks the detailed management reporting to understand the reasons for the
fall in margin and an improvement in management reporting is advised to better understand
the business and control cost. An acquisition at this time may be a distraction for senior
management when there are reporting issues to address. The profit margin at Safari is 2%
higher at 20.5%. However, it is unknown if this additional margin is sufficient to compensate
for the additional risk of operating safari parks situated outside Pakistan.
Return on capital employed (ROCE)
Based on current equity and debt values, Safari Adventure plc offers a similar ROCE at 8.8%
vs 7.3% generated by LWT in 2018. However, if LWT agree pay Safari a premium above
the current share price then Safari's 8.8% ROCE will reduce as the capital employed rises
and it could fall below LWT's current ROCE of 7.3% which may not be acceptable.
Advantages of acquiring Safari Adventure plc
 If the current Pakistan travel market is stagnating then acquiring a well-established,
successful travel company with a proven track record in overseas markets and growth
potential will aid LWT's strategic objective of achieving growth.
 The acquisition of a safari business is strategically aligned with LWT's core markets
as the luxury travel and corporate travel market could be cross-sold luxury safari
holidays.
 Diversification benefits may add value as LWT learns from Safari adding value to
existing LWT operations, and LWT's customer service excellence could add value at
Safari.
Disadvantages of acquiring Safari Adventure plc
 The acquisition risks are significant as LWT has no experience running hotels or safari
parks so LWT would need to ensure sufficient existing knowledge and experience
remains in Safari post acquisition. LWT may have to incentivise some key employees
to remain.
 Political conditions of location of Safari parks need to be evaluated carefully as LWT
risks significant losses if political change prevents visitors from obtaining travel visas
or it becomes unsafe for customers to visit. Furthermore, changes in regulation,
conservation or use of land could make the operation of safari parks more challenging
or costly to operate. These factors could reduce bookings or impact on reputation.
256
Answer Bank
 LWT already highly geared and servicing interest on further debt could be difficult.
Less risky opportunities should also be considered such as for developing existing
markets further by funding a new marketing strategy.
 Land and development restrictions may prevent expansion of visitor accommodation
which will restrict future growth.
Conclusion
The advantages of acquiring Safari mean the acquisition warrants further investigation.
However, a major concern is that the risks identified are too high for the potential margin of
20.5% and ROCE of 8.8% as these are only marginally higher than LWT is currently
generating on its existing travel agency business. This suggests further market development
of the luxury and corporate travel markets could be a preferred strategic alternative that is
worth further investigation.
Part (b)
Tutorial notes
The numerical calculation is not very tricky but time management is a key to secure
maximum marks in this requirement as very solid commentary regarding advice to the
board (based on numerical calculations) is expected from students followed by the
conclusion. Hence, it is very important to complete the calculation in time so that
adequate time would be available for second part of this requirement i.e. advice to the
board. Numerical calculations are not very complex, however, there are few
complicated areas to handle i.e. the loan value should be deducted to determine the
value of combined shares only. Students should clearly mention all the assumptions
and critically comments on its sensitivity as well.
Part (b)
Free cash flow valuation of a combined group
Year 6
Year Year Year Year Year
and
1 2 3 4 5
onwards
Lahore World Travel Ltd
(Rs millions) 2,500 2,700 2,900 3,000 3,100
Safari Adventure plc
(£ millions) 5.0 5.2 5.4 5.5 5.5
Safari Adventure plc
(Rs millions) at Rs 150 : 750 780 810 825 825
£1
Revenue synergy
(Rs millions) 150 150 150 150 150
Sale of surplus land
(Rs millions) 500
Total 3,900 3,630 3,860 3,975 4,075
Perpetuity year 6 onwards 45,278
(4,075/0.09)
Total free cash flows for the
combined group 3,900 3,630 3,860 3,975 4,075 45,278
Discount Factor 9% 0.917 0.842 0.772 0.708 0.650 0.650
Present Value (PV) 3,576 3,056 2,980 2,814 2,649 29,431
257
Total Market Capitalisation for 44,506 The total PV represents the value of
the combined group of LWT & Equity and the value of debt in the
Safari new combined group
Less: existing LWT loans (10,000) The loan be deducted to determine
the value of shares only
Value of Equity in new 34,506
combined group
Current equity value of LWT (20,000) 40 million shares at Rs 500 each
only
Maximum price for Safari 14,506 This represents the shareholder value
Adventure plc if Safari was added to LWT, so it's
the maximum LWT should pay.
Advice to the Board
A maximum value of Rs 14,506 million suggests the offer price of Rs 9,000 million would
generate Rs 5,506 million in value on acquisition. However, this significantly relies on the
following:
(1) All forecast assumptions are valid. This may not be case as:
 The assumed growth in the cash flows may be unachievable if there is a reduction
in consumer interest in safari holidays, barriers preventing the acquisition of
additional safari sites or issues increasing existing hotel capacity.
 Despite Adeena's optimism, revenue synergy of Rs 150 million from existing LWT
customers may not be realised.
 It may not be possible to sell land in Malawi for Rs 500 million for development
as this may be restricted under a government preservation order. Also, this land
may be essential to safari operations by providing a habitat for existing wildlife.
 The assumption that the exchange remains constant at Rs 150 : £1 may not hold.
(2) The required return of 9% is acceptable to shareholders based on the risk of the new
venture.
 Running an overseas safari parks in Africa is riskier than LWT's current operations,
particularly as LWT rely on the retaining local management experience and
stabilise political conditions of Africa region. It is likely the required return will
need to be higher. It is suggested LWT must re-evaluate the required return for this
acquisition.
Conclusion
The acquisition does have its merits, and therefore we advise the acquisition is considered
further subject to the satisfactory completion of due diligence. As Safari Adventures plc
clearly intends to sell then this provides an opportunity for LWT to negotiate a lower price.
A price closer to the current share price of Rs 7,500 million (20 million  £2.5  Rs 150 :
£1) may be acceptable and will provide a greater return to LWT for the risks identified.
258
Answer Bank
Part (c)
Tutorial notes
This requirement is highly time pressured as many calculations are required to
determine required ratios under both financing options. After calculations, students are
also expected to use this information and provide recommendation to the Board of
Directors regarding financing option. Efficient planning is key to secure maximum
marks in this requirement as calculations are not very complex. Students should be able
to save time for discussions and recommendations. Students are expected to mention
notes to the assumptions while performing calculations. Recommendations should be
balanced covering maximum ratios calculated in the requirement. Since, calculations
are based on many assumptions, it is expected that due diligence should activity should
be recommended in the end.
Part (c)
Current position LWT Safari Adventure Comments
Profit after tax in 2,200 660 £4.4m 
2018 Rs 150 : £1 = Rs 660
(Rs millions)
Current value of 20,000 7,500
equity (40m  Rs 500) (20m  £2.5
(Rs millions)  Rs 150 : £1)
Current value of 10,000 – Using book value
debt
EPS 55 33
(Rs per share)
Gearing 33.3% 0.0% Measured as debt/(debt +
equity)
After acquisition Financed by Financed by a

position New Debt share for share
exchange
Combined group 3,400 From part (b) – Rs 3,900
profit after tax in 3,400 million –
2019 (Rs millions) Rs 500 million for sale of
surplus land. Reasonable to
assume
free cash flow is equivalent to
profit after tax.
Additional post tax (540) N/a New loan of Rs 9,000 million
loan interest at 6%  0.06
(Rs millions)
259
After acquisition Financed by Financed by a
position New Debt share for share
exchange
Revised group
profit after tax (Rs 2,860 3,400
millions)
One-for-one share exchange
20 million new LWT shares
issued to Safari Adventure plc
shareholders replacing
Number of LWT
40 60 (40 + 20) 20 million Safari shares.
shares (millions)
This will result in the existing
shareholder's ownership in
LWT reducing from 100% to
66.6% (40m/60m).
Earnings per 71.5 56.7
share (Rs)
Combined Value
of Equity (Rs 34,506 34,506 From Part (b)
Millions)
Value of Debt 10,000 +
(Rs millions) 9,000 = 10,000
19,000
Gearing 35.5% 22.5% Measured debt/debt + equity
Impact of funding decision

This analysis assumes LWT pay the price of Rs 9 million for Safari Adventure plc.
Control and gearing
An acquisition with cash is preferred as existing LWT shareholder retain 100% control.
However, credit availability to arrange a further loan may not be available to LWT from its
existing or other banks. Furthermore, existing shareholders may consider the financial risk
of increased gearing to 35.5% be unacceptably high. However, this may not be a problem as
this is largely unchanged.
The impact on working capital cash flow may be a greater problem as borrowing Rs 9,000
million at 6% will mean an additional Rs 540 million of interest must be paid annually and
this may be difficult to service in the early years of acquisition where capital investment in
the new venture is likely to be required. Also, it is possible that existing Rs. 10,000 million
loan will have used available security, making an additional Rs. 9,000 million loan
unsecured. Therefore a higher rate of interest on the loan may ultimately be charged.
A share-for-share exchange will reduce gearing from 33% to 22.5%. However, the terms of
one LWT share for one Safari share is generous as it values the Safari at Rs 11,500 million
(Rs 34,506 million x 33% ownership) which is Rs 2,500 million above the offer price of Rs
9,000 million.
260
Answer Bank
Earnings per Share (EPS)

Both financing methods predict an increased in EPS from Rs 55 in 2018 to Rs 71.5 if financed
by debt and Rs 56.7 if financed by equity. The debt option is more attractive as the profit is
retained by LWT's existing shareholders.
Conclusion
Debt finance is cheaper than the equity finance option and it maximises post acquisition EPS
at Rs 71.5.
However, LWTs current gearing of 33.3% may be considered high and therefore
shareholders may not be comfortable with additional borrowing, particularly as LWT had
problems integrating the Lux Travel subsidiary four years ago. New acquisitions tend to
demand cash investment in the early years, so it may be difficult for LWT to meet the annual
interest and capital repayments on Rs 19,000 million of loans in the early years post-
acquisition.
It is recommended that LWT discuss additional borrowing with the banks, to confirm credit
availability, and with shareholders to confirm they will support higher borrowing at Rs
19,000 million. Detailed forecasts are recommended to confirm that LWT can service the
annual interest at this level of debt and only proceed with further borrowing subject to
securing confirmation of loan affordability.
If debt finance is not affordable or acceptable to LWT shareholders then an acquisition
financed with a share-for share exchange is recommended. However, it is recommended that
revised share for share terms are negotiated so LWT minimises the dilution of ownership to
its existing shareholders.
Proceeding with an offer under either finance arrangement is subject to satisfactory
completion of due diligence procedures.
Part (d)
Tutorial notes
Here, students are advised to consider key strategic areas of Safari Adventure plc.
Careful reading of questions is key to secure maximum marks in this requirement as
students are expected to use maximum information given in the questions to answer
this requirement, for example, safari sites ownership, operations and forecast
assumptions.
The following are key areas that should be examined during a due diligence process which
must be completed prior to finalising the decision to purchase Safari Adventure plc. The due
diligence exercise could affect the purchase decision, valuation or offer price.
Site Ownership, and restrictions on land use or land sale
 Confirm that Safari owns all three safari sites by reviewing ownership deeds and
confirm any restrictions on the use of land, such as sale rights or development rights
as this may prohibit the sale of land in Malawi which is assumed in the valuation.
 A buyer for the 2019 sale of the Malawi land of Rs 500 million should ideally be found
and confirmation should be obtained that this sale will not impede operations in any
way at the Malawi site.
261
Operations, key management and employees
 An LWT representative should visit each site to confirm it exists as described, it is
currently operational with guests and safaris taking place, and detailed operational
checks should be completed to ensure each safari site operates as described by Safari
Adventure plc.
 LWT have no experience in running hotels or safari parks so key talent in both
management and operations should be identified by obtaining a list of staff, roles and
responsibilities, experience and performance reports. This will allow LWT to plan for
the retention of key staff post acquisition.
Industry and political outlook in Malawi and Botswana
 Political analysis and expert advice should be sought to understand the risk to
foreign-owned commercial operations from political change or unrest.
 A review of the safari park industry should be conducted for legal and regulatory
compliance, and ethical requirements to identify areas of non-compliance. The
directors will need to evaluate the significance of these on the acquisition.
Financial history, position and forecast assumptions
 Evidence of the pipeline of future safari bookings for the next year to confirm the
feasibility of forecast growth assumption.
 Compare hotel capacity and past occupancy data with growth assumptions to confirm
that growth forecasts are reasonable.
 A detailed forecast profit and loss should be compared with actual revenue for the five
months and the costs to identify potentially understated or missing costs in the
forecasts.
 LWT should review the board minutes of Safari Adventure plc and interview key
directors to understand the reasons why the company is being sold.
Commitments, contingencies and legal claims
 Information about past and ongoing legal claims should be discussed with Safari's legal
advisors to identify potential additional costs or actions which may result in park
closures or operational issues.
Part (e)
Tutorial notes
Here, students are advised to invest some time in efficient planning to avoid writing
too much and writing such information which is not required. Only relevant
information from Section 109A, 59AA, 59B, 28 of the Income Tax Ordinance, 2001
is required to address the requirements of this section. As the answer is required in a
note form so it should be structured accordingly.
262
Answer Bank
Note to the board of directors

I have evaluated all the three matters and my advice on each matter is as follows:
Viewpoint of Mr. Shahbaz Karim
Controlled Foreign Company (CFC)
Mr. Shahbaz Karim correctly identifies that the concept of CFC has been introduced through
Section 109A of the Income Tax Ordinance, 2001. Under this section, a company is
considered as CFC only when it meets all the four requirements mentioned in this section.
One of the requirements is that the shares of the company are not traded on any stock
exchange which is recognized by the law of the country in which the company is resident for
the tax purposes. Since SA is listed on London Stock Exchange, it would not be considered
as CFC.
Group taxation
Under section 59AA of the Income Tax Ordinance 2001, group taxation is restricted to
companies locally incorporated under the Companies Ordinance 1984. Therefore, the option
mentioned by the director would not be available to LWT.
Treatment of dividends to be received from SA
Under Section 5 read with the First Schedule, 15% tax shall be imposed on LWT when it
would receive dividend from SA. The tax imposed shall be considered as final tax on the
amount of dividend and:
(i) no deduction shall be allowable for any expenditure incurred in deriving the
amount of dividend;
(ii) the amount of dividend shall not be reduced by any deductible amount or set off of
any loss;
(iii) tax payable by LWT on dividend shall not be reduced by any tax credits.
Financing option considering by LWT
Option 1: Borrow and acquire with Cash
Under section 28 of ITO 2001, LWT would be allowed to claim a deduction for any interest
on loan incurred.
Option 2: Acquire with a share for share exchange
No tax implications as acquisition of a foreign subsidiary would not attract any group
taxation (Section 59AA) or group relief (Section 59B).
Question no 17 - The Fresh Fish Company
(a) The Fishing Division
Tutorial notes
The requirement asks for the performance assessment of three divisions. Here, students
need to plan to identify and discuss the most important areas which reflect the
performance of the division. Given there are 15 marks available, a split of 5 marks for
each division would be reasonable assumption. Time management is absolutely
essential to ensure coverage of all available marks. It is vital that students use the
numerical evidence in their strategic recommendations which gives their answers
professional credibility and help them to ensure maximum marks.
263
2018 2017 Change %
Turnover of market sector (Rs 24,950 23,750 1,200 5.1%
million)
Turnover of the Fishing Division 2,940 2,688 252 9.4%
(Rs million)
Market share 11.8% 11.3% 0.5%
Gross profit (Rs million) 138 131 7 5.3%
Volume of fish caught and 53,400 52,125 1,275 2.4%
farmed (tonnes)
No of fishing vessels 202 200 2 1.0%
The Fishing Division accounts for 11.8% of the Pakistan fishing market, which is consistent
with its fleet size of 10% of fishing vessels operating in the Karachi Harbour. Despite
evidence of falling fish stocks, the value of the market is growing due to the increasing price
of fish. A 1% increase in the number of fishing vessels in 2018 to 202 and a secure supply
of fish from fish farms account for the Fishing Division's increasing market share from 11.3%
to 11.8%.
Turnover has increased by 9.4%, which is higher than the 2.4% increase in fish caught and
farmed. This suggest the wholesale price of fish is increasing. This may well be because
supplies are constrained by government fishing quotas.
Gross profit has increased 5.3% to Rs 138 million which is not in line with growth in
turnover, suggesting ineffective divisional cost control.
The Fishing Division is strategically important as a supplier to both the Fish Processing
Division and the Fish Restaurant Division. With only 11.8% market share, further expansion
of the fishing fleet is feasible by purchasing further boats or removing competition by
competitor acquisition which will provide further growth as the popularity of fish with
consumers is unlikely to decrease. Currently, 50% of fish is sold to Fish processing division
so there is potential for growth by increasing the proportion of fish sold to the Fish Processing
Division and Restaurant Divsion, whilst maintaining its current external customers. Fishing
capacity may be further increased by expanding its fish farms.
2018 2017 Change %
Turnover of market sector 5,580 5,100 480 9.4%
(Rs million)
Turnover of The Fish
Processing
Division (Rs million) 2,212 2,065 147 7.1%
Market Share 39.6% 40.5% 0.9%
Gross profit (Rs million) 194 218 (24) (11.0)%
Volume of fish processed 32,040 31,850 190 0.6%
(tonnes)
264
Answer Bank
The Fish Processing Division

The Fish Processing Division holds 39.6% of market share and is likely to be the market
leader although its share has decreased slightly by 0.9% which suggests increasing
competition. A significant percentage of its fish is provided by The Fishing Division although
the majority of fish processing is under contract with other companies.
It is a profitable division with an increase in turnover of 7.1%. The volume of fish processed
in 2018 has only increased by 0.6% as the market price for processed fish products is
increasing as processing volumes are static. This may also suggest that the division is near
capacity as its machinery and manually intensive processing methods are unchanged since
acquisition 20 years ago.
Gross profit is disappointingly flat at Rs 194 million despite a 7.1% increase in turnover
which suggests the division is dealing with possible cost control challenges.
The Fish Processing Division could potentially be a more profitable division of the Karachi
Fishing Company as the price and popularity of processed fish products increases. One
possible growth area is negotiating with the Fishing Division to process more of its fish,
subject to capacity. This arrangement should benefit the profit of both divisions as processing
business is diverted from competitors.
The Fish Processing Division could also look at increasing processing capacity by
introducing modern machinery, expansion at its processing site or through acquisition of
other small fish processing companies.
The Fish Restaurant Division
The Fish Restaurant Division is the most recent addition to the Karachi Fishing Company
group and is now a significant contributor to group revenue with Rs 7.4 million in 2018.
However, the average number of meals served per day has fallen by 6.9% in 2018 suggesting
operational problems or falling consumer interest. Revenue has fallen by 3.8% suggesting
the division has been protected to a degree by price increases in its restaurants. One factor
could be the menu has not changed since the diners launched eight years ago and an increase
in menu prices could be causing some customers to eat elsewhere. Other contributing factors
could be a decline in meal quality or service, new competition or changing consumer food
tastes and further market research is advised.
The division's gross loss has increased by 11.5% to Rs 700 million, which is significant.
However, it is not unusual for restaurant chains to turnaround to profit as they find their
optimum operating model.
The Fish Restaurant Division has the potential to be a more significant division if it can
turnaround, return to profit and expand the Karachi Fish Diner brand both in Pakistan and
overseas by marketing the appeal of a fresh, high quality and delicious fish-based menu.
Therefore, the Karachi Food Company must consider whether to avoid the risk of further
losses by divesting the Fish Restaurant Division now and focus on growth in the other
divisions, or to implement a turnaround strategy and provide further investment to allow the
Restaurant Division to expand. The demand for dining out is likely to rise as the population
in Pakistan becomes more affluent as the economy grows.
265
Conclusion
The Fishing Division and Processing Division both have growth potential and should be
retained. The Restaurant Division will need to demonstrate a credible turnaround plan and
business case to ensure the retention of this division is worthwhile.
2018 2017 Change %
Turnover (Rs million) 7,388 7,677 (289) (3.8%)
Gross profit (loss) (Rs million) (700) (628) (72) (11.5)%
No of restaurants 20 20 – 0%
Average number of meals served
by the
Restaurant Division per day 7,768 8,340 (572) (6.9%)
Part (b)
Tutorial notes
To answer the requirement of this section, students are expected to use practical
knowledge while discussing turnaround action plans i.e. enhancing quality / customers’
experience, reducing costs, performance monitoring and customer feedback. Each logical
action plan would secure 1 mark. It is very important that focus should remain on
turnaround and performance of this particular division.
The Karachi Fish Diner chain of restaurants are loss making and customer volume is
reducing. A strategic turnaround is required to be implemented quickly and should focus on
getting the existing business right before any new restaurant sites are considered. The
following points would be vital to a successful turnaround strategy.
 Leadership – The eventual success of a turnaround strategy will depend on the
divisions ability to prioritise necessary activities and to deliver fast, significant
improvements. Therefore, a change leader should be appointed who is empowered to
deliver the turnaround programme and report regularly on progress. This could include
a series of workshops to consult with management and employees to create a
compelling strategic vision.
 Brand and customer feedback – The Karachi Fish Diners have a strong brand and
reputation for being fashionable and serving fresh quality meals. However, it is vital
that management understand precisely why customers are choosing to eat elsewhere
through gathering customer feedback and using the results to identify changes. Such
changes may include, for example, staff training to improve service or updating the
menu to reflect more contemporary tastes. The division may need to refresh and
relaunch the 'Karachi Fish Diner' brand as a result.
 Menus and options – The restaurants offer too many meal options, which is expensive
to operate and can increase food waste. The range of menu options should be reduced
to include only its most popular items and trial new meals based on customer feedback.
 Pricing and promotion – Management should complete a benchmarking review of
competitor restaurants to understand areas of competitive weakness. For example,
management should consider reducing its meal prices if evidence suggests its
restaurant pricing is too high. An increase in customer bookings may offset this price
decrease. Short-term offers such as 'meal of the day' or promotional discounts could
attract new customers, but care must be taken not to devalue the brand.
266
Answer Bank
 Cost control – Improving employee productivity and reducing non-essential costs is

necessary to limit current losses. In reducing costs, it is vital that the brand is not
compromised. Interdivisional pricing and decision making could be updated to avoid
competitors being chosen over the Fish Processing Division.
 Key performance reporting – it is unclear whether the performance of each restaurant
is analysed separately against targets or against each other. The worse 25% performing
restaurants should be identified for a turnaround focus, with the possibility of changing
restaurant management on evidence this is major contributing factor as indicated by
recent employee comments regarding poor management. Poorly performing
restaurants could be closed where it is clear a turnaround strategy will not work.
Part (c)
Tutorial notes
This requirement is highly time pressured. Efficient planning and use of practical
knowledge is essential to secure maximum marks. A complete value chain of the
business should be analyzed to identify those areas where new technology could be
leveraged to make processes more efficient. The benefit of CRM would be two fold i.e.
enhance customer experience and maintain optimal inventory levels. For KPIs, students
are expected to identify at least one KPI from each division and briefly discuss how it
would help to improve the business. While discussing shared service centre, cost
reduction is critical to mention. Further, processes would be leaner under shared service
centre.
New Technology
With a fresh product such as fish, it is essential that the product is transported to processing
sites, wholesalers and restaurants as quickly as possible. An integrated customer order and
logistics system can optimise delivery routes to customers which reduces the risk of fish
becoming spoiled. Additionally, planned fishing activity can be linked to seasonal demand
which avoids unnecessary fishing and wastage in low demand periods. A logistics system
can aid the planning of third-party fishing vessels at peak times which will reduce the size
and cost of a permanent fleet.
Updating the fish processing plants (including for example increased automation) will
improve plant efficiency, improve processing capacity at existing sites and reduce the
number of plant operatives if the process is less manually intensive.
In the restaurant division, an online booking system will make it easier for customers to book
and will also provide customer data which can be used for marketing communications, such
as the launch of new seasonal menus and other promotional offers.
Customer relationship management (CRM)
A CRM system can keep a record of all customer interactions and analyse previous orders
which will highlight trends in demand and types of fish requested. The fishing of particular
varieties, such as shrimp or tuna, can be flexed to customer needs. This will avoid the over-
fishing of stocks which cannot be sold and will allow better planning of fish varieties and
volumes in fish farms.
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Key performance indicators
Key performance indicators can improve margins by facilitating faster decision making or
providing early indicators of operational problems. Examples may include:
 Fishing division – % waste compared to target can be monitored so the fishing fleet
can target on catching fish which are only in demand by customers.
 Processing division – Time to process per tonne, or unused capacity can be monitored
to improve efficiency which will reduce costs. Performance monitoring will identify
regular times of low utilisation. In such times, lower processing charges can be offered
to external customers to utilise spare capacity and free up busier times.
 Restaurant division – The use of customer surveys will allow the division to react to
adverse feedback. Customer complaints and time to serve a meal can also be monitored
to understand and improve the dining experience which will encourage new and
returning customers through better customer reviews.
Shared service centre
Services such as invoicing, procurement, management reporting and logistics can be
provided by a single centralised service centre which can free up management time to focus
on specific divisional issues, customer relationships, revenue growth strategies and
operational efficiency.
The shared use of resources and competencies can reduce costs and create value by removing
duplicate processes in each division and improve the efficiency and quality of the shared
service.
Question No 18 - Techcon Ltd
Part (a)
Tutorial notes
There are two parts of this requirement i.e. ethical and commercial implications. For
ethical implications, students should have good knowledge of Code of Corporate
Governance Regulations, 2017 to augment their comments regarding ethical concerns
raised due to CEO’s behavior. For commercial implications, students should use
practical knowledge to answer the requirement i.e. bad reputation, decline in share
price, possible difficulties in raising finances and litigations issues.
Ethics
The behaviour of the CEO raises several significant ethical concerns. It should be considered
against the requirement of the 2017 Code of Corporate Governance Regulations, which states
that:
'…the board of directors of a company shall carry out its fiduciary duties with a sense of
objective judgement and in good faith in the best interests of the company and its
stakeholders.'
The fact that the CEO has lost his temper with shareholders and walked out of a meeting
suggests that he is not showing appropriate courtesy and professional behaviour to that key
stakeholder group. One of the critical roles of the CEO is to maintain a positive relationship
with major shareholders.
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Answer Bank
In addition, the CEO's remark on social media about his satnav, even if it was intended as a
joke, shows a disregard for the interests of the company and cast doubt on the reliability of
the company's products. It will be demoralising for employees, shareholders and anyone else
with an interest in it. The fact that he thought it was an appropriate to make this comment to
over 500,000 social media followers and the lack of a subsequent apology, shows a
concerning lack of professional judgement expected from a CEO.
A further reason for concern is that a flippant comment was made about the reliability of his
products when, as the accident illustrates, an unreliable satnav can be very unsafe for
customers. This suggests that he may not take customer safety seriously and casts doubt on
his integrity.
Commercial
In addition, there are several commercial concerns about the CEO's behaviour. His treatment
of shareholders, and attitude towards safety, as shown in his walking out of a meeting and
comments about the accident, are likely to make the shares less attractive and so the share
price will fall. This fall may mean that Techcon has difficulty raising capital in future, or be
vulnerable to a takeover bid.
These events are also likely to lead to a fall in sales of satnavs, and possibly other products
if the brand is seen as unreliable. Even if the satnav was not to blame for the accident, it is
likely that the social media remark and the accident will be linked by the media, the public
and even the competitors.
If Mr Iqbal believes that the satnav was to blame for his accident, it is quite possible that he
will launch a legal case against Techcon. This will require management time and money to
defend, and may result in Techcon paying compensation or a fine.
Part (b)
Tutorial notes
This section requires very strong command on Code of Corporate Governance
Regulations, 2019 to identify deficiencies in current practices. It is essential that students
effectively plan for the requirements to complete the breadth of deficiencies in the time
available i.e. Chairman and CEO roles are not separate, inadequate independent
directors, no quarterly board meetings, lack of sound internal control system and
independence of internal audit function.
A comparison of Techcon's current practice with best practice, as set out in the Listed
Companies (Code of Corporate Governance) Regulations, 2017, shows several significant
deficiencies.
Firstly, the Code requires that the roles of Chairman and Chief Executive Officer should be
separated. This is to avoid any one person acquiring too much dominance over the company
and exercising decision-making without proper discussion and scrutiny. The board minutes
show Salmaan Umaar very much dominating the discussions, suggesting that by combining
these roles, he is indeed exercising too much dominance and a separate, independent
Chairman of the Board would help to address this.
The Code also requires that there should be at least two independent directors, or one-third
of the total directors, whichever is higher. While there are three non-executive directors
currently on the board, one represents a shareholder and the other is the CEO's brother and a
shareholder himself. This leaves only NED2 as apparently independent, which reduces his
ability to challenge decisions. There are eight directors in total, so three should be
independent. Suitable new independent directors should be recruited.
269
It appears from the minutes that the previous board meeting was held on 4 April, meaning a
gap of nearly six months before the next meeting was held on 29 October. This is too long a
gap to allow for proper discussion of issues affecting the company. Ideally, the board should
meet at least quarterly.
It is also concerning that the Operations Director and Company Secretary did not attend the
board meeting, despite being critical members of the board. In particular, the Code states that
the Company Secretary should attend all meetings, or a nominee appointed by the board if a
Company Secretary is not able to attend.
The duties of the board include ensuring that 'a system of sound internal control is established'
but the discussions documented in the minutes seem to suggest a lack of internal controls, with
decisions being made at the personal direction of the CEO. For example, a branding consultant
was appointed without any involvement even from the Marketing Director. There is scope to
improve the quality of discussion and challenge by having key decisions brought to the board
for scrutiny before being finalised, rather than simply made by the CEO.
It is important that the internal audit function operates independently of senior management,
reporting functionally to the audit committee to ensure their independence. From the board
minutes, it seems that the CEO is personally directing the focus of the internal audit function,
which is not appropriate. As chair of the audit committee, NED2 needs to assert the
independence of the function to focus on areas they see as highest risk.
Part (c)
Tutorial notes
There are two parts of this requirement. For first part, students are expected to read the
scenario carefully and identify key skills required at Chief Executive Office to
turnaround the image of the company i.e. experience of similar quoted company,
excellent relationship building skills and strong focus on quality products. Using the
information given in the question to identify additional skills required is the key to
ensure maximum marks. For second part, students are expected to compare
professional qualification, experience and skills of both candidates and recommend one
candidate for the role of CEO. It is essential to identify and assign weightages to
different attributes i.e. qualification, experience, skills and competencies according to
the given scenario and recommend the candidate accordingly.
Person specification
The items included in the draft person specification are important but there are some
additional points that could usefully be included.
Firstly, it would be helpful for the candidates to have CEO or senior management experience
at a quoted company. Managing a quoted company and dealing with the shareholder
relationships and compliance issues that result in very different from a privately-owned
company. The new CEO will have to rebuild relationships with shareholders and quite
probably regulators, so previous experience of doing this would be helpful.
A good candidate would also be skilled at building relationships with board members. It
seems that the relationship between the CEO and board has been quite poor, which makes it
very difficult to run the company effectively. Rebuilding this relationship will be a key task
of the new CEO and it would be helpful for them to have experience of this.
270
Answer Bank
In its rapid growth, Techcon may have failed to develop appropriate controls, as seen by the
centralised decision-making by the previous CEO and concerns over the safety and reliability
of products. It would be useful for a new CEO to have experience of putting more formal
controls in place and strengthening an organisation's overall control environment.
One other point that could usefully be added is a preference for the candidate to have a strong
focus on quality of products. While Techcon's products have been innovative and successful,
the CEO's tweet and apparent lack of concern for quality and safety suggest that some of the
focus on customer satisfaction may have been lost. A CEO with a strong track record in this
area could help re-establish this focus.
Candidates
Candidate A:
Both candidates do appear strong and worth considering. Candidate A has experience of
running a major technology company, which is highly relevant, as well as an emphasis on
talent management, which will be important for an innovative, fast-growing company like
Techcon. They also have experience of managing relationships including with the board, and
in being proactive in communicating with them.
Candidate A is a qualified accountant and former Finance Director, which should ensure a
good commercial understanding and focus on effective internal control. On the other hand,
Candidate A does not seem to have direct experience of running a fast-growing business, as
DYJ is already a large company. It is also owned by a private equity firm, which means that
A will not have experience of dealing with the compliance aspects of being a quoted company
or dealing with institutional shareholders, at least not recently.
Candidate B:
Candidate B has direct experience of leading a company through a floatation and adjusting
to the new environment that this required, including the focus on controls, managing
relationships and hiring a suitable management team. This seems like very relevant
experience to improve Techcon in its current situation, as it adjusts to being a quoted
company.
Candidate B also has a very successful record, with growth of 300% in turnover under his/her
leadership, although further investigation would be needed to identify the causes of this, and
how effectively that revenue was translated into profit.
Candidate B also focuses on the customer, an emphasis that will be important to Techcon in
recovering their situation.
Candidate B's education is not specified, and this would also need to be the subject of
enquiry.
Conclusion and recommendation
Candidate A and B are both strong candidates and further investigation is needed, but based
on the information supplied Candidate B has more relevant skills and experience to lead the
improvements required at Techcon, particularly having led a fast-growing company and
managing the transition to being quoted.
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Question No 19 - Ashir and Arham
Part a
Tutorial Notes
It is a straightforward requirement without having any challenge for students. As
financial risks have already been outlined in question, students are expected to use their
business acumen and academic knowledge of subject matter to evaluate impact of each
financial risk on the organization. In addition, risk mitigation strategy is also required
to manage the identified financial risks.
The purchase of the ammonia exposes AA to two key and interrelated financial risks: (i)
commodity price risk; and (ii) foreign exchange risk of the US$ moving against the Rs. In
the context of the specific transaction to purchase 2,000 tonnes of ammonia, if the price of
ammonia rises, and/or the US$ strengthens against the Rs, before 15 Jan 2022, then the cost,
in rupees terms, will increase.
Unless any cost increase can be passed on to the customer, in the form of a higher selling
price, then the sales contract on which the ammonia is to be used will be less profitable, or
indeed, it may make a loss.
Risk Management
Commodity price risk
The commodity price risk for an individual purchase transaction could be mitigated most
easily by a futures contract for delivery of ammonia in Jan 2022. This would lock-in the
current price in US$ terms and prevent further commodity price movements. However, it
would lock the price at the forward rate of $520 per tonne giving an overall price of
$1,040,000. This would remove any upside benefit if the price of ammonia fell by 15 Jan
2022. In addition, although this hedge arrangement may be successful against any US$
denominated commodity price movement, there is still a risk of exchange rate movement
affecting the rupees cost of the ammonia.
The futures contract could be margin traded so physical delivery on the contract is not
required. Thus, the profit on the margin trade from an increase in the price of ammonia would
offset the increase in costs on the underlying contract.
Currency risk
Any potential currency movement could be separately hedged (from the commodity price
movement) by a number of methods:
 Money market cover. AA could exchange an amount of Rs. immediately into US$ such
that, with interest, it will accumulate to $1,040,000 by 15 Jan.
 Currency forward contract. This would operate similarly to above, but AA would wish
to acquire US$1,040,000 at a predetermined exchange rate in Jan 2022.
 Currency option. Similarly, AA could acquire an option to purchase US$ at a fixed rate
in Jan 2022. This is thus a call option. This would be more expensive upfront than a
forward contract because it is a one-way bet.
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Answer Bank
However, AA’s approach to risk management for individual transactions should take a
broader ‘strategic’ view of risk. Futures and forward contracts, when used for hedging, are
intended to fix a price for transactions that will be settled at a future date, but in doing so,
they prevent the company from taking advantage of any favorable movement in the spot
price.
In this example the spot price is $500 per tonne. The futures price is $520 but has fallen from
$530 in just a few days. The company may not wish to commit itself to a fixed price of $520
if the spot price seems more likely than not to stay below this level.
For large transactions, when the future movement in the spot price is difficult to predict, it
may be worth considering the use of call options, although these obviously have a cost (the
premium). Alternatively, the choice may be ‘not to hedge’, taking the view that the spot price
will be lower than the forward price or futures price at settlement date.
AA’s finance department should hedge transaction exposures within the framework of an
overall policy towards the management of price risk for different commodities and exchange
rates. Other points should also be considered.
 Hedging needs to be considered collectively for all transactions (macro hedging) rather
than for each contract. For instance, 15% of AA’s revenues are generated in the US, but
there is no factory in the US. As a result, US$ denominated costs may be a natural hedge
against US$ denominated revenues. It would only be the net US$ exposure that would
require hedging.
 Hedging policy may be to partially hedge transaction exposures and leave them partly
unhedged. It might not be necessary to hedge the whole amount of future
income/expenditure. If LL is willing to take some risk, only a proportion of the exposure
would need to be hedged (e.g., in the example of the ammonia transaction, 50% or 1,000
tonnes). This would leave some upside potential.
 If the highly probable need for ammonia does not materialize (e.g., a cancelled sales
contract) then, perversely, hedging could increase risk as there is now an exposed one-
sided commitment from the hedge instrument (i.e., an unmatched hedge position). This
might be mitigated if we need ammonia for other contracts, but timing is crucial given
the costs and dangers of storage of ammonia.
Part b
Tutorial Notes
The requirement is related to the assessment of newly proposed integrated information
system. Students are expected to outline possible benefits and problems of integrated
information system in relation with facts mentioned in Exhibit - 4. Time management
is also very important to cover all related points within time to secure maximum marks.
273
Benefits
 Facilitates improved decision making – At the strategic level, AA’s management should
be looking at how well the company is performing in relation to its key performance
indicators. By summarizing key information, and providing managers with easy access
to it, the EIS should help senior managers to be better informed when making strategic
decisions.
 However, the EIS should also allow management to drill-down to the more detailed
operational records to help understand the reasons for any variances in performance, and
to identify ways of improving performance.
 Amount of information available – The new system should increase the amount of
information that will be available to managers, and the speed with which it becomes
available to them. In particular, the system will allow the managers to use more up to
date (real-time) information than they are currently able to use. In turn, having more
information available to them should increase the amount of analysis managers can
perform in relation to any strategic decisions.
 Consistency – Whereas summary data used to come from a range of different systems, it
will now come from a single database, which should again improve the quality of data
available to management. For example, there should no longer be any inconsistencies in
the data being submitted by different factories. This means that AA’s head office staff
and management will now be able to focus more on analyzing the data rather than having
to spend time reconciling different figures or reports prepared by different factories.
 Tactical information – The EIS will also give access to tactical information such as
budgets, which will help managers control the business more effectively; most obviously
by comparing actual financial performance against budget.
 External information – Executive information systems typically include data and
information from external sources as well as internal information. Given the impact that
external factors (for example, exchange rate movements or commodity price movements)
can have on AA’s performance this information could be very useful to managers – both
in terms of analyzing current results or in planning for the future.
 Management should also be able to make use of the external information in the EIS more
generally when identifying risks and opportunities for the business. This could also be
useful if AA does introduce integrated reporting, because one of the questions which its
integrated report needs to cover is the risks and opportunities which could affect its
ability to create value in the future.
Potential problems and issues
 Information overload – Although allowing managers access to more information could
be a benefit of the EIS, if the amount of information available is not controlled then
information overload could become a problem. For example, managers could become
obsessed with looking at detailed information rather than focusing on strategic issues and
overall performance against key performance indicators.
 Training – Because the EIS is a new system, in order to maximise the benefit which
managers can get from using it, they will need to be trained in how to use it.
274
Answer Bank
 Extent of data captured – Although the new system will improve the speed with which
information is available, and the consistency of that information across different
factories, it is still not clear how much non-financial information it will collect or provide
to management. For example, will the system collect data about the level of emissions or
leaks from the factories’ production processes?
If this data is not recorded anywhere in the factories, then despite having the new integrated
system, management will still not be able to monitor performance in some of the key areas
of LL’s business.
Part c
Tutorial Notes
The requirement is not very complex, however, a good understanding about integrated
reporting is critical to draft logical answer. Having a good understanding about the topic,
students are expected to highlight a high-level overview of integrated reporting & its
components and opportunity for AA to adopt integrated reporting along with potential
benefits to organization of adopting integrated reporting, particular in respect of social and
manufactured capital. However, students are advised to plan the answer in effective
manner and be relevant to avoid unnecessary details.
Integrated reporting (IR) aims to combine the different strands of reporting (financial,
management commentary, governance and remuneration, and sustainability reporting) into
a coherent whole that explains an organization's ability to create and sustain value in the
short, medium and long term. As such, integrated reporting also highlights the importance of
long-term business sustainability for an organization.
By encouraging entities to focus on their ability to create and sustain value over the longer
term, IR should help them take decisions which are more sustainable, and which ensure a
more effective allocation of scarce resources.
Context of performance reporting – In an integrated report, AA will still report on its
financial and operational performance, as it currently does, but it will also report on social
and environmental aspects of its performance.
Given the potentially dangerous nature of the chemicals AA uses in its production processes,
and the damaging consequences of a chemical spill, it is important that AA maintains an
appropriate system of controls over its physical processes, and regularly reviews those
controls, to minimize the risk damaging impacts on the environment.
Impacts on different categories of capital – More generally, IR requires an organization to
explain the outcomes of its performance in terms of six categories of capital: financial;
manufactured; intellectual; human; social and relationship; and natural.
Using these six categories could provide AA with a more comprehensive framework for
analyzing its performance than its current approach, which appears to focus predominantly
on financial performance.
However, the ‘integrated’ nature of the reporting also means that in its report AA should
highlight the interrelatedness and dependencies between different factors which affect its
ability to create value over time. For example, investing in new machinery or factory
upgrades should help to improve the efficiency and safety of AA’s production processes, and
possibly to reduce pollution, but these benefits will come at the financial cost of acquiring
the new machinery.
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Future strategy and outlook – Another important contrast between IR and traditional
performance reporting, is that IR has a greater focus on future strategy and outlook. The main
focus of AA’s current report is likely to be the performance in the past year; so, the report is
backward-looking.
However, in an integrated report, AA’s management would provide not only a summary of
past performance but also a summary of how the company’s strategy, governance and
performance can lead to the creation of value in the future. As such, IR underlines the
importance of planning and looking forward.
Integrated reporting and performance measures
Two of the key questions which an integrated report should address are: to what extent has a
company achieved its strategic objectives; and what are the outcomes of its performance in
terms of the six capitals? Integrated reporting is based on the belief that in order to achieve
sustainable long-term growth in a business and in business value, there must be accumulation
of all six types of capital – although the significance of each type of capital may vary between
different types of business.
In order to do this, it will need to establish key performance measures for each of these six
capitals, and to set targets for each. These measures should relate to aspects of performance
that are expected to have a significant impact over the long term in helping the company to
achieve its strategic objectives.
Assuming that AA’s current performance measures focus primarily on financial capital, then
introducing IR will require AA to develop a range of new (non-financial) performance
measures looking at its manufactured capital, human capital, intellectual capital, social
capital, and its impact on natural capital.
Several directors have reservations of the value of reporting on some of these aspects of
capital. They are correct to take the view that integrated reporting should focus on
performance that affects long-term value, so the benefits of reporting on social capital and
manufactured capital, for example, would need to be considered in the context of how these
add to the long-term value of the business.
Although definitions vary, social capital refers to matters such as company reputation, brand
reputation and relationships with stakeholders. Given the nature of AA’s business, social
capital may be of less concern than it is for manufacturers of consumer products. Even so, a
reputation for fair dealing with suppliers and customers, and compliance with regulations,
can affect the long-term status of the company in its industry. A problem however is to
establish suitable key performance indicators (KPIs) that measure the company’s
relationships with stakeholders.
Manufactured capital refers to ‘performance’ in terms of machinery and equipment, and
other manufactured items. For a manufacturing company, this can be a critical measure of
performance. Successful manufacturers are those that not only increase the amount of their
capital assets: they also have assets that are efficient and use up-to-date technology. So, in
addition to reporting on the growth in the amount or value of property, plant and equipment,
AA should also consider measures such as output per machine hour (or a similar measure of
productivity) and average age of key equipment.
These measures should help AA and its shareholders to focus their attention on the long term
as well as on the shorter-term financial aspects of performance, because performance that
affects the long term will contribute to growth in business value.
276
Answer Bank
Question No 20 - Rabia Limited

Part a (I)
Tutorial Notes
The requirement asks for the industry and market assessment in which company is
operating. Here, students are advised to use Poter's Five Forces model for industry
analysis. Students are expected to mention their industry analysis using the given facts
in the question under each force of Poter's Five Forces industry analysis framework
including bargaining power of buyers, bargaining power of suppliers, threats from new
entrant, threats from substitutes and rivalry amongst competitors.
An analysis of IT industry and market in which RL is operating

The first part of this report analyses RL Company’s market and the industry using the Porter’s
Five Forces model.
(i) Bargaining power of buyers
RL is competing in two markets. In the IT manufactured components, which is more mature
and where it has less than 1.2% of the market share, it is a supplier of marginal significance,
despite 70% of its gross profit or cash contribution being generated in this segment. Its
customers in the neighboring single market (30%) with its own currency are likely to demand
low prices, high quality and reliability. They may not accept late delivery of orders. It appears
that alternative sources of supply are readily available and that switching costs are relatively
low. Multinational OEMs have significant bargaining power in this market, particularly the
OEM which accounts for 50% of FCS’s current data communications component sales.
In the second market, where services are provided to mainly domestic, SMEs and a few larger
companies, the buyers appear to have less bargaining power. RL is catering for each
customer’s specific needs and so each solution is, to some degree, a bespoke solution. This
makes it much harder for buyers to compare products and prices of potential suppliers.
Alternative sources of supply are much more difficult to find as there only three companies
(including RL) in this specialist marketplace.
The bargaining power of suppliers
Although RL manufactures 50% of all components used in its IT manufactured components,
reducing its overall reliance on suppliers in this sector, it seems unlikely that RL will be able
to exert much influence on its suppliers, which provide the other 50%. As a relatively small
player in the said market, the company does not have the power to exert buyer pressure on
its two large suppliers, either in terms of price or delivery. Current problems associated with
the delivery of components are having a significant impact on the company’s ability to meet
customer deadlines and expectations.
Suppliers of financial capital, namely lenders, have gained more bargaining power as RL has
had to borrow more to sustain their recent growth.
If labor is seen as a supplier, then evidence again suggests that RL is in a relatively weak
position particularly since there has been a limited trade union membership. However, the
union members are mainly in the IT manufactured components division where employee
remuneration and employment rights are already compliant with national employment laws.
The scenario also indicates the difficulty of finding high caliber network staff with RL’s
small size and location making it difficult to attract the key personnel necessary for future
growth in this sector.
277
Threats from new entrants
RL is operating in an industry where the costs of entry are significant because it is capital
and knowledge intensive. Economies of scale compel new entrants to enter at significant
output levels or suffer a cost disadvantage. Furthermore, the need to offer comprehensive
aftersales support, although a problem for RL, does also create a significant barrier to new
entrants. Finally, the exit costs and barriers such as industry-specific knowledge, skills and
assets, reduce the attractiveness of the marketplace to new entrants.
Threats from substitutes
There is evidence that large, successful, high technology companies are particularly
vulnerable to ignoring the challenge from disruptive new technologies which can replace the
need for certain high technology products and services overnight. However, the relatively
small size of RL may give it a competitive advantage in its ability to respond quickly and
flexibly to change, as long as it can attract the right caliber of expertise to achieve this.
Rivalry amongst competitors
Very different levels of competition are being experienced in the two marketplaces RL is
operating in. It is clear that the high volume, low-margin component business offers intense
competition with buyers who are able to use their size to extract favorable prices. RL only
has 1.2% of this market. The ability of RL to generate better market share and volumes
through product innovation in this market seems highly unlikely.
The intensity of rivalry in the network management systems sector is significantly less in this
specialist market. RL is dealing with a smaller number of large and medium-sized users,
designing products specific to their needs. In Porter’s terms, RL is adopting a focused
differentiation strategy. In these low-volume high-margin markets, the emphasis has to be
on increasing the volume side of the business, but at the same time making sure that they
have the resources to attract and support new customers.
Part a (II)
Tutorial Notes
The requirement is related to the evaluation of historical financial performance of
organization. Students need to evaluate performance of RL in each given year along
with logical commentary. Students are also expected to identify the relevant
performance analysis ratios and calculate the same to support their commentary with
numeric numbers. At the end, it is suggested to mention a conclusive statement on the
financial performance of RL in last three years along with a best possible way forward
for RL.
The following is an evaluation of the financial performance of RL between 2018 and 2021.
The financial data shows revenue reaching a peak in 2020, before falling away (by just over
9%) in 2021.
Although 2020 was a record year for revenues, increased cost of sales meant that gross profit
declined significantly. The gross profit margin has declined every year in the period under
consideration, and the reasons for this need to be investigated. The rapid fall in 2021 suggests
that operating costs have not been brought under control to reflect the sudden sales decline.
278
Answer Bank
2021 2020 2019 2018

Gross profit margin (gross
28·49% 34·46% 37·50% 44·84%
profit/revenue)
In 2021, although RL seems to have made reductions in overhead costs, finance costs have
increased despite the fall in revenue, leading to a progressive decline in net profit margin in
the period under consideration.
2021 2020 2019 2018
Net profit margin (net profit
2·16% 8·11% 10·15% 11·37%
after interest and tax/revenue)
The overall financial picture is of a company which has failed to control its core operating
and finance costs as it generated increases in revenue until 2020 and as revenues fell in 2021.
Finance costs are increasing as a proportion of net profit before interest and tax (NPBIT) as
shown below:
2021 2020 2019 2018
Interest cover ratio
1·25 2·74 3·08 5·93
(NPBIT/finance costs)
Further, It is also clear that capital budgeting and investment is slowing from 10% to 7% of
turnover over the period. The R&D budget is also falling and is at 3% of turnover in 2021
compared with 6% in 2018, which is a 50% decline. These statistics indicate a clear depletion
of the manufacturing capital of RL in future.
However, human capital has performed reasonably well from a productivity perspective.
Analyzing the data, productivity reached a peak in 2020 and has only fallen slightly in the
last financial year:
2021 2020 2019 2018
Sales revenue per employee
54·72 54·81 47·55 31·66
(Rs.’000)
The number of late contracts has doubled since 2018 and the number of complaints from
customers has increased from 1·5% of orders to 3·4%.
Conclusions
RL needs to be aware of the dynamics relating to its market and industry, particularly the
power of key customers and over reliance on two main suppliers. It must also be aware of
and manage the threats from substitutes and new entrants in its two main business segments.
RL’s financial performance in several areas is weak and indicates a strategic drift which will
need to be addressed.
Part b
Tutorial Notes
The requirement is straightforward, however, a good practical understanding about the
data analytics is required to reproduce the benefits and opportunities through
introduction of big data analytics to RL and their customers. Students may mention
benefits/opportunities in bullet points and a short paragraph focusing on practical points
as presentation notes to save time.
279
Slide 1: Benefits of big data analytics
Bullet points:
 Sentiment analysis
 Soft surveillance and consumer behavior tracking
 Open communication channels with clients
 Predictive analytics (which can monitor inventory levels and ensure product availability)
 Analysis of customers’ purchasing behaviors
Notes: As RL operates in a country, where a huge population connected to the internet and
presumably purchasing a significant proportion of their products and services online, RL can
sell data analytics capability to its clients. It can do this by showing them how to use this
capability to capture, store and process data from their customers. By developing
sophisticated marketing analytics with big data, RL’s clients can properly evaluate their own
marketing performance, gain insight into their customers’ purchasing patterns, discern key
market trends and permit them to make evidence-based marketing decisions.
Slide 2: Further opportunities to RL customers of big data analytics
Further opportunities offered by big data analytics for RL’s customers, include the following:
Bullet points:
 Potential to unlock significant value
 Ability to collect more accurate and detailed performance information
 Big data allows ever-narrower segmentation
 Sophisticated analytics can substantially improve decision-making
 Big data can be used to develop the next generation of products and services
Notes: Big data analytics makes information about RL customers’ clients more transparent
and allows RL’s customers to collect more accurate and timely information at a fraction of
the costs of hosting expensive architectures such as data warehouses and allows RL’s clients
considerable cost savings using cloud computing capability or open-source software such as
‘Hadoop clusters’ for storing and processing large amounts of data. Using this, and through
‘data mining’ using social and business networking data, RL’s clients can undertake a much
more sophisticated analysis of their customers and therefore much more precisely tailor their
products or services allowing valuable insights which would otherwise remain hidden and
unlock more customer value. The other key opportunity is to allow RL’s clients to develop
bespoke products for their customers based on their precise needs and consumer behaviors.
Part b (I)
Tutorial Notes
This part requires good knowledge of risk analysis and risk management framework.
Students are expected to identify key risks for the company including strategic, busines,
environmental and financial risks using heat maps. Students are also expected to evaluate
impact of each risk on the organization and mention suitable risk management strategy for
each identified risk.
280
Answer Bank
The potential risks which the company could face whether or not it re-aligns its business are
as follows:
Strategic risk, business risk, financial risk and environmental risk.
Heat map for key risks faced by RL Company
Strategic risk
The key strategic risk which RL faces is the increased competition in the IT manufactured
products, the reduced margins and potential decline in the future. At the same time RL faces
the risk of missing an opportunity to use its competencies to develop the potentially more
profitable area of its business. RL currently faces lower market share and declining
shareholder value, and this is projected to be a 10% decline year on year for the next three
years. To reduce or avoid these risks, RL could re-align its business towards the more
profitable domestic market by investing in the network support business in terms of increased
R&D, fixed asset investment and improvements in policies relating to staff retention and
recruitment to support this potential growth area. This would also reduce its general cost
base.
Business risk
As already explained in the five forces analysis, apart from heavy dependence on its main
business sector of IT components, RL is facing economic risk from overdependence on key
customers (one of the OEM customers accounts for 45% of its sales). RL is also over reliant
for its supplies of IT components on two large multinational suppliers from which it
currently faces serious supply shortages. It also risks further losses of staff and greater
recruitment difficulties caused by poor staff morale and due to the unattractive location of
RL’s headquarters. Under the TARA framework, it is advisable to reduce these risks by
widening the supplier and customer base. From a supply perspective, the benefits of this
strategy would be to spread the risk of a disruption to the supplies from one or both of the
two current suppliers. The strategy would also help RL in terms of bargaining power,
particularly if it is not getting favorable terms from them. Similarly, widening the customer
base, or concentrating on a higher value strategy will reduce its dependence on the data
communications business and also the bargaining power of their main OEM customer and
help their profitability. RL can reduce the staff retention and recruitment risk by adopting
281
tactics and implementing policies to improve the culture of the organization and the morale
of their key staff. This could be achieved through offering greater empowerment and
devolving more authority to middle managers. An improvement in intrinsic rewards and in
pay and conditions, or allowing staff to relocate, or work from other geographical locations
which are more attractive to them, may also help to mitigate this risk.
Financial risk
The main risk is the devaluing currency in the main market into which RL sells a significant
proportion of its IT components. A weakening currency in the economic community from
which customers settle their payments means that RL is facing a currency translation
exposure as monies received in the devaluing currency will effectively reduce the turnover
collected from customers in these markets. Under the TARA framework, the risk could be
reduced or transferred by using foreign currency hedging instruments or by taking out loans
in the denomination of the weaker foreign currency, using the payments from the continental
customers to offset the liability. The other main financial risk is the high level of gearing and
the risk of breaking bank covenants and of default. This risk could be mitigated by either
converting some of the debt into equity or by repaying or redeeming loans from RL’s
considerable cash reserves, or by issuing more shares.
Environmental Risk
RL is not itself at risk of potential environmental impact but is facing a risk of creating an
increased carbon footprint or environmental impact which it is not effectively managing, and
which may itself create environmental costs and incur a carbon tax liability.
Part b (II)
Tutorial Notes
Efficient planning and use of business acumen are required to secure maximum marks in
this part. Students need to consider commercial factors to evaluate all three mentioned
strategies. Students are also expected to comment on the calculations/assumptions used
in the given scenario.
The ‘do nothing’ strategy is not considered an option by the board. A reasonably quick
financial analysis would confirm that this is not a viable option, but that confirmation has not
been included in the board report (Exhibit -5) or in report prepared by consultants (Exhibit -
3)
Therefore, a financial evaluation of the ‘do nothing’ option against the other two options
would give a more complete picture. In fact, are there any other strategic options available
to RL? These do not seem to have been considered by the board.
Is it reasonable to extrapolate that a recent decline of 10% in total RL revenues is indicative
of future trends in cash contribution by segment? There seems to be no explanation of how
the relative cash contribution of each segment in 2021 was arrived at, other than being
calculated after interest and tax. The definition of cash contribution also needs to be
investigated further to verify whether it is calculated before capital expenditure or is a free
cash flow, because the forecasts might differ, depending on how this cash flow is defined.
Is it possible to assume that annual additional fixed costs will be constant in each year of the
forecast planning period as stated? In reality, there might be greater fixed cost expenditure
in the first year of the new strategy and less in the subsequent years.
282
Answer Bank
Is it reasonable to assume that fixed cost savings in the data communications plant would be
the same regardless of which growth forecast emerges? This seems unreasonable as potential
savings in that division would probably depend to some extent on the level of growth which
materializes from Strategy 2, if implemented.
The calculations within the spreadsheet all seem accurate, but time value for money has not
been taken into account. If the cash flows after interest and tax were discounted, they would
need to be discounted by the geared cost of capital, which is estimated at 12%. Making this
adjustment to the cash flow will yield a net present value for the project and will change the
payback estimate. This is shown below:
2022 (m) 2023 (m) 2024 (m)
Net incremental cash flow from re-alignment: -0.09 -0.02 +0.12
Net present value = (–0·09 x 1/1·12) – (0·02 x 1/1·122) + (0·12 x 1/1·123) = (–0·08 – 0·016
+ 0·107) = –0·011
This means that Strategy 2 (the re-alignment strategy) has a negative NPV of Rs.11,000
which means it does not pay back in the three-year planning horizon.
Part b (III)
Tutorial Notes
The requirement is not very complex; however, students are advised to read facts very
carefully and plan the answer effectively. Students are expected to commercially analyze
all three options using their business acumen and recommend any two profitable options
with a comprehensive and logical commentary to justify the recommended options.
Most of the information is available in the related exhibits for commentary, however,
attention of student is required to reproduce facts in structural way.
The purely financial evaluation in (b) above shows that RL should not re-align towards the
higher-value more differentiated network support segment, although undiscounted payback
would indicate that it just repays for itself within three years.
However, the strategic and broader business benefits to be gained from re-aligning in this
way are that it will help RL become a differentiator, concentrating on higher value, lower
volume business, rather than continuing to maintain an increasingly challenging cost focus.
This might be preferable to remaining as active in the high-volume low margin components
manufacturing business, particularly as the company is so reliant on two key suppliers, where
supplies are being disrupted and where 30% of their OEM customers are representing an
increasing risk of higher currency translation costs.
From the financial performance data, it seems that manufacturing cost control is one of the
key problems for RL, so the business benefits will include the ability to transfer resources
from the manufacturing to the support side and the potential to make labor cost savings in
the manufacturing area which is more labor intensive and where labor and employment costs
in Peshawar are high. RL can also reduce its carbon footprint further and reduce its
environmental impact.
The IT benefits for RL will be that it will develop greater capability in the new emerging
technologies of cloud-based services and big data processing services which will give it a
competitive advantage over traditional players in the data electronics market.
283
The strategy to re-align the business will make a small negative net present value of –
Rs.11,000 over the next three years, which on the face of it would not justify the strategy on
financial grounds alone, assuming that the forecasts were valid. However, while RL directors
were unable or unwilling to consider the cash flows beyond a three-year planning period, due
to subjectivity and prudence, it is reasonable to assume that there would be additional positive
net cash flow benefits accruing to RL, well beyond the planning horizon. These seem to be
rising exponentially from the trend observed. It could also be assumed, particularly in such
a competitive and innovative sector as IT components, that the ability of RL to maintain its
current market share and overall turnover over time could be questioned, should no
investment or re-alignment of the business take place.
Therefore, considering both strategic and wider business reasons, RL would be advised to
implement the re-alignment of the business and focus on expanding the network support side
of the business and invest in the necessary fixed costs, staff recruitment and working capital
required, by using internally generated funds or issuing more shares.
Part d (I)
Tutorial Notes
The requirement is quite complex and time pressured. Efficient planning and practical
knowledge is required to secure maximum marks. Students are expected to use Mendelow
matrix to describe interest and powers of shareholders, employees and lenders before and
after flotation. Further, students are also expected to mention impact of flotation on
strategy of RL to engage shareholders, employees and lenders and this part requires more
practical knowledge.
Working notes with relevant visual aids

Using the Mendelow matrix it can be established that before RL was listed or quoted on the
national stock market, it had the following stakeholder groups:
Before flotation: Described follows
Shareholders these were private shareholders comprising the founder’s
majority holding and possibly those of family and close business
associates
Employees mainly non-unionized and loyal to a smaller family-oriented
business
Lenders insignificant borrowings before flotation – presumably overdraft
and other short-term loans
After flotation: Described follows
Shareholders wider group of public individual investors and a 30% holding by
institutional investors
Employees more skilled staff, but operating core staff mostly unionized
Lenders much more powerful and interested – higher gearing and
covenants in place
284
Answer Bank
The following table shows the Mendelow matrix positioning and strategies for these groups
before and after flotation:
Stakeholder Mendelow grid position and Mendelow grid position and
groups strategy before flotation strategy after flotation
Shareholders High power/high interest – actively Lower power/high interest – keep

involve informed (particularly institutional
shareholders)
Employees Low power/high interest – keep Higher power/high interest – keep

informed satisfied or involve more actively
Lenders Low power/low interest – minimal Higher power/high interest – keep

effort well informed and keep satisfied
(Note: Alternatively, a grid could be presented where arrows could be used to indicate
where stakeholders had moved within and between quadrants after being publicly
listed)
The strategies RL Company management would adopt pre- and post-flotation would differ
as determined by the changed positions on the Mendelow matrix. The main change in
strategies would be as follows in relation to the above stakeholders:
Shareholders: Clearly before the flotation, private shareholders, being the owner and his
family or close friends, would have far more interest and power than the majority of
shareholders after the flotation, so the need to actively involve is less necessary, but evidence
from the case suggests that there is a lack of engagement with institutional shareholders
which could be problematic as this group has far more power than other shareholders,
so RL should develop reporting and communications channels with this important group.
Employees: Before flotation most employees were non-unionized and the culture of RL was
not to involve, engage or inform employees and expect them to follow instructions. After
flotation 80% of the manufacturing workforce are now unionized and additional employment
legislation such as minimum wage and mandatory company pensions are being introduced
which will force RL to not only keep employees and their representatives informed and fairly
well satisfied, but also to more actively involve them– in particular regarding the pension
arrangements.
Lenders: Before flotation RL was predominately funded from shareholders’ funds and had
few borrowings, so this stakeholder had little power or influence and possibly little interest
in RL, particularly if the loan capital represented an insignificant proportion of the lender’s
total portfolio. After the flotation, RL has become increasingly more highly geared in order
to expand into new markets and therefore the risk faced by the lender is greater and this
increases the lenders’ level of interest in RL and its ability to sustain this level of borrowing
and to repay the original capital. As lenders have placed legally binding covenants on the
company preventing it from exceeding its current gearing levels, it also has more power over
RL, meaning that RL will have to keep lenders well informed and certainly keep them
satisfied.
285
Part d (II)
Tutorial Notes
This part demands thorough understanding of code of ethics. Students are advised to read
the related exhibit thoroughly with full attention to identify ethical issues and remain
focused by writing to the points to secure maximum marks within time.
Professionally and ethically, there are some issues relating to how the staff satisfaction
survey has been conducted, which we would like to highlight.
Lack of integrity – Unfortunately it appears that staff may have been misled in that there
were assurances given that the survey responses would be anonymous, but the personal
information required gives the impression to staff that management can identify the
respondents of the survey.
Lack of objectivity – From discussions with staff representatives, it is possible that key areas
known to be of concern to staff (obtained from the informal grapevine) may have been
omitted from the survey and the survey could have dissuaded people from giving negative
feedback, particularly about confidence in management. From a statistical perspective, the
results were presented in quite a subjective way by using graph styles which may have
misrepresented the true findings, focusing more on the aspects which staff found most
positive.
Professional competence and due care – The design of the survey and the way in which
results were presented may be viewed as being somewhat unprofessional and may not have
achieved what it was intended to achieve. This could have been avoided if more care had
been taken with its design.
Confidentiality – One matter of serious concern relates to the fact that some employees were
identified and interviewed by senior managers as a result of their apparent negative responses
to the survey. This action appears to have breached the fundamental principle of
confidentiality.
Professional behavior – RL management should not attempt to identify ‘dissident’ staff or
schedule and conduct interviews with these individuals, as it could be described as
demonstrating unprofessional behavior. This is particularly worrying when some
interviewees perceive that they have been intimidated or even threatened by the comments
made at some of these meetings. Another point we would wish to raise is the danger of
operating ‘double standards’ when the survey was supposed to be anonymous, but staff
identified for interview were themselves required to keep confidential the fact that they had
been identified and interviewed.
Question No 21 - Kalam Hotels
Part 1 (a)
Tutorial Notes
This requirement is highly time pressured. Efficient planning and use of practical
knowledge are essential to secure maximum marks. Students are expected to analyze the
business value chain of the organization in a thorough manner to identify success factors
of Kalam Hotels in Funland including factor conditions, demand conditions, related and
supported industries, firm strategy, rivalry, and government support. Students are also
advised to remain focused while reading and understanding of business value chain.
286
Answer Bank
Factors enabling Kalam Hotels’ success in Funland

If we are to consider developing the Kalam Hotels brand within another country, a useful
starting point would be to understand the key factors which have made Kalam hotels so
successful in Funland, and then assess the availability of these same factors and conditions
in other countries. This would allow us to evaluate the viability of such a strategy and assess
our ability to achieve sustainable competitive advantage overseas. Below are key factors
present in Funland which have helped Kalam Hotels to be successful.
Factor conditions
We should start by assessing the factor conditions, which include the physical resources,
human resources, knowledge and infrastructure present within Funland, which Kalam Hotel
chain is able to access. Funland has some advantages in regard of its factor conditions, as it
has a well-developed infrastructure, based on sound local and national investment policies
in air, road and rail travel. A new airport has recently been constructed in Funland’s second
largest city, generating an additional 2·5 million overseas passengers to Funland last year.
This is likely to have a significant impact on tourism and the number of visitors to Funland
and therefore will obviously assist in supporting the hotel industry and, of course, our own
business.
As a business, we have exploited the transport infrastructure which Funland offers, locating
our hotels on major road networks and near to rail stations. National and regional level
investment in such infrastructure has been a great advantage to our business.
Also, Funland’s education system is another endowment to Kalam hotels’ service supply.
The education system supports the travel and tourism industry with universities offering
highly regarded travel and tourism qualifications, which in turn leads to the availability of
highly skilled human resources within the hotel and tourism industries. However, we must
be aware that although the education system supports the provision of labor in the industry,
we appear to have a problem in recruiting and retaining skilled staff and this is something
we must work on in the future.
Therefore, Funland has positive factor conditions in both infrastructure and human resources
which have had a positive effect on the success of our business.
Demand conditions
When an organization is located in a country where the home market demand is strong and
where home-based customers are sophisticated and require high standards of innovation
and/or quality, this can assist it in achieving sustainable competitive advantage.
In the case of Funland, it is evident from the recently published Hotel Industry Report, that
travelers in Funland continue to be highly demanding customers, who expect high standards
but also value for money. It is noted in the report that a recent survey of online hotel
customers clearly indicated that 70% would shop around for the best deal in the best location.
This indicates that our customers are sophisticated, and this must drive us to respond to their
needs.
Therefore, focusing on our customers’ needs and our particular focus on value for money, as
highlighted in the Chairman’s Report on Performance, has helped Kalam hotels to offer
services which are in line with customer demands. This has allowed us to maintain and
strengthen our competitive advantage, whilst other organizations, such as two of Funland’s
most long established hotel chains, have both gone out of business this year. It is evident that
they have not responded effectively to the needs of its home-based customers.
287
Related and supporting industries
The success of an industry can also be influenced by other industries/organizations which
support it and supply it. In the case of Kalam hotels, our location in Funland provides us with
an advantage due to the highly developed hotel and tourism industries within the country.
Travel companies both online and on the high street are thriving in Funland, which clearly
will support and enhance the business opportunities of Kalam hotels.
Online hotel booking websites and price comparison sites are also a key factor in driving the
success of hotel businesses. In particular, the price comparison websites, comparing our
prices with our closest competitors drives our business to be more competitive and to offer
better and more flexible pricing options for customers. Only those hotels which can respond
to this and are adaptable and flexible to customer pricing demands will survive and remain
competitive. This is a potential reason why the two luxury hotel chains mentioned in the
previous section have gone out of business this year.
In addition, growth in the business activity in the overall economy of Funland, will also
support the development of more business travel in the country which is another factor in
supporting the growth and development of our business traveler provision and opportunities
in Funland.
Firm strategy, structure and rivalry
Success can be influenced by the way an organization is created, organized and managed.
Evidence suggests, from the comments made in the recent chairman’s Report on
Performance for FY 2021 that in Funland there is continuing growth of the budget hotel
market, as the luxury and mid-price sectors continue to decline. This is an obvious advantage
for Kalam hotels, as we are the leading budget brand hotel chain in Funland. Therefore, we
are perfectly placed to exploit the overall market conditions in the economy. Our brand is a
key strength, and we must ensure we maintain this strong brand image and customer loyalty
to the brand.
Our brand itself is the focus of our overall strategy, which is one of value for money and
overall operating efficiency in order to ensure the best price for our customers. As stated
above, we have highly demanding business and leisure customers in Funland who are looking
for value for money and best price and are prepared to shop around for this. Therefore, our
strategy of a value for money approach, as highlighted in the chairman’s Report on
Performance FY2021, should assist in building upon this demand from customers and
provide us with sustainable competitive advantage.
Competitive rivalry is also a key consideration, with growth in business activity in the
economy driving more opportunities and creating a highly competitive environment. As can
be seen in the Hotel Industry Report f, two new national branded chains of hotels have opened
during this year in the strategic locations of Funland and national competition remains
intense.
This rivalry is a key factor in encouraging us to innovate and be flexible to our customer
demands, in particular to respond to key trends in the industry, such as technological
developments and in particular, the threat of disruptive technologies. The two luxury chains
of hotels which have recently gone out of business in Funland may indeed point to the fact
that the intensity of rivalry in the industry is affecting the luxury end of the market more
adversely than the more flexible budget hotels. This supports our overall strategic position
as a budget hotel operator.
288
Answer Bank
Government support
It is clear that the Funland government is supportive of the travel and hotel industry in a
number of ways. As already mentioned, investment in infrastructure at both a regional and
national level is a major influence on attracting travelers to Funland, in particular the
investment in the new airport, as previously highlighted. Additionally, support in the
education sector to develop skilled and well-trained staff for the travel and tourism industry
is also a key factor in ensuring a high level of supply of talented and well-educated staff for
our hotels.
A further factor highlighted in the Hotel Industry Report is that the government of Funland
has recently announced investment and incentives for investors in the sector. Again, this
points to a high level of government support to encourage a thriving business economy,
including the tourism and hotel industry. Kalam hotels could take advantage of such tax
breaks.
Part 1 (b)
Tutorial Notes
In order to evaluate a commercial opportunity; business acumen and financial expertise
are required. Good report writing skills are also required to secure maximum marks in this
part. Students are expected to evaluate the acquisition proposal considering the financial
and non-financial aspects of the proposed opportunity. Students are expected to use
following three lenses for assessment but not limited to; Strategic fit of the proposed
acquisition, Acceptability of the acquisition and Assessment of resource requirement of
the proposed acquisition, At the end, students are advised to mention a conclusive
paragraph
To: Finance Director

From: Business analyst
Date: November 2021
Year
0 1 2 3 4 5 6
Revenues 48,180,000 48,180,000 53,961,600 53,961,600 53,961,600 53,961,600
Initial investment 80,000,000
Refurbishment 10,000,000 5,000,000
Environment Investment 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Training Costs 3,000,000 1,500,000 1,500,000 1,500,000 1,500,000 1,500,000
Operating Costs 21,681,000 21,681,000 24,282,720 24,282,720 24,282,720 24,282,720
Total Costs 90,000,000 30,681,000 24,181,000 26,782,720 26,782,720 26,782,720 26,782,720
Cash Flow -90,000,000 17,499,000 23,999,000 27,178,880 27,178,880 27,178,880 27,178,880
Discount factor 12% 1.00 0.89 0.80 0.71 0.64 0.57 0.51
Present Value -90,000,000 15,624,107 19,131,856 19,345,390 17,272,670 15,422,026 13,769,666
Net Present Value 10,565,715
289
An evaluation of the proposed acquisition of the CLIFFTON hotel chain
Introduction
The following report presents an evaluation of the proposal to acquire the CLIFFTON hotel
chain located in Fundunia. The report will consider the financial viability of the proposal and
also consider a range of other criteria upon which to base the final decision and will evaluate
the implications of this proposal for Kalam hotels.
Table 1: financial evaluation of the proposal (Note all figures have been converted to the $)
From the net present value calculation of the proposed acquisition of the CLIFFTON hotel
chain (Table 1), it would appear to be financially viable, returning an NPV of nearly $10·6
million. This equates to a return on the initial investment of 13·2%. Discounted payback
occurs at approximately five years and three months.
However, it would be necessary to assess the viability and reliability of the data contained in
the above NPV to assess how realistic the revenue predictions are, based upon predicted
customer numbers and revenue per room calculations. Economic conditions may be difficult
to predict in a country such as Fundunia and we would need to take a cautious approach in
any forecast revenue results. Likewise, although our initial investment and refurbishment
costs may be relatively straightforward to assess, long-term costs in training and operations
need to be carefully considered, particularly in the light of the lack of investment which has
been carried out in these hotels previously.
We should also consider foreign currency risk exposure, in relation to the stability of the
Fundunia currency. We have never operated any hotels overseas and this brings with it a
number of challenges for our business in terms of translation and transaction risks. We have
carried out our NPV calculation in our own currency ($), but we must consider the potential
impact of the Fundunia currency fluctuations in particular on our forecasted revenues and
operating costs.
Before making any decision based upon these financial results, I would like to see possibly
a range of NPV calculations based upon best and worst-case scenarios. In addition, before
proceeding with the acquisition of the CLIFFTON hotel chain, we should also consider a
range of other issues which are set out below:
Strategic fit of the proposed acquisition
We should assess whether the proposed acquisition of CLIFFTON is in line with our strategic
position; that is, does it have a strategic fit with the rest of our business? We should also
consider the cultural fit with our existing operations, particularly as the CLIFFTON hotel
chain is located in a different country, 150,000 miles away.
As the CLIFFTON hotel chain is within our current sphere of business operations as a hotel,
it would be considered to have a strategic fit. However, the strength of that strategic fit may
be questionable, based on the fact that it is a mid-range hotel chain offering additional
facilities such as gyms and pool facilities. Our current Kalam hotels located in Funland do
not offer such additional facilities and we would need to carefully consider how to integrate
CLIFFTON’s hotels into the Kalam hotels brand, which is based upon a ‘budget’ offering.
Therefore, strategic fit may not be as clear-cut as we may think.
290
Answer Bank
However, it is evident from the recent Hotel Industry Report, that consolidation in the
marketplace is becoming common, and hotels operating within different sectors of the market
are consolidating through acquisition. Therefore, it would seem that this option could be
suitable, based upon recent acquisition activity in the market. Also, our chairman has
suggested in his Report on Performance for FY 2021 that Kalam hotels chain is considering
the strategic direction of developing the Kalam hotels brand overseas and therefore this
would exploit this potential opportunity for us.
Another consideration is the cultural fit of the CLIFFTON hotel chain. As Fundunia is
located over 150,000 miles away from Funland and the fact that the hotels are not budget
hotels, there may be cultural differences to consider. The fact that it is a family-run business
may also mean that it has a family-based culture which may be difficult to change and
integrate into our current operations and style of management.
National culture is also clearly different in Fundunia and may be challenging for Kalam
hotels. Poor employment practices and evidence of use of under-age labour in the hotel
industry in Fundunia must be thoroughly investigated and we must make sure that our own
cultural behaviours are transferred to replace ones which are clearly not suitable for our own
operations. This must be a priority for Kalam hotels, as our own reputation could be damaged
by association with the CLIFFTON hotel chain if we do not address these issues. However,
we will also be sensitive to cultural differences and only make changes where necessary.
Acceptability of the acquisition
When considering the acceptability of the proposed acquisition of the CLIFFTON hotel
chain, we need to evaluate whether it is consistent with our current objectives in terms of risk
and return, and importantly whether it will be acceptable to our stakeholders.
When considering the calculations of net present value, it would be prudent to test the
sensitivity of some of our assumptions to evaluate the overall impact of and potential
sensitivity of these factors on the final outcome. For example, a failure to achieve the
expected occupancy levels from year 3 onwards could reduce the final NPV significantly, as
expected revenues would be significantly reduced. Any combination of variable changes
needs to be tested, to assess our sensitivity to potential changes in the underlying assumptions
made and the risks which these changes may pose. We must also verify the accuracy of our
assumptions.
We also need to consider acceptability of the proposed acquisition to our stakeholders. Our
own staff based in Funland may be largely indifferent to the decision, but those hotel
managers who may be requested to re-locate may potentially be reluctant (or conversely may
indeed be enthusiastic at the proposal). We must ensure that this is communicated effectively
to these hotel managers in good time, should the decision to acquire CLIFFTON be made.
Staff in Fundunia will likely react positively to this investment, if it means that employment
will continue and there is likely to be a high possibility of improved employment rights and
an improvement in working conditions and opportunities for training.
Our shareholders are likely to be favorable towards the strategy if it creates a positive return
on shareholder wealth. The chairman has clearly stated in his Report on Performance that
this is a proposed strategy and therefore shareholders will be accepting of this business
development opportunity, as long as it impacts favorably on the profits of the business.
However, we must be mindful of the impact of this decision on our shareholders if they
believe this decision may impact adversely on our reputation, as this could indeed impact
adversely on shareholder wealth. Effective and regular communication with our shareholders
must be carried out.
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Customers in Fundunia may not favor this direction for CLIFFTON hotels if it means an
increase in prices. However, hotel refurbishments and updates should increase the quality of
the hotel offering, which have clearly become outdated due to lack of investment. This
improvement to the quality of the CLIFFTON hotels should satisfy potential customers.
We also need to consider how the wider community and the media will react to this decision.
There is a risk that it will be seen as unfavorable by the wider public, as Fundunia does not
operate to the standards of Funland and may be seen as being unethical to operate in a low
wage economy. We must make it clear to these stakeholders that it is our intention to operate
at the highest ethical standards within Fundunia, should the acquisition be successful. For
example, we should follow strict guidelines on offering a fair wage to employees and not
allowing under-age workers.
Assessment of resource requirement of the proposed acquisition
We must also consider whether we have the resources we need to carry out the acquisition
of the CLIFFTON hotel chain. It would appear that we have the necessary funds available to
undertake the strategy, through a combination of debt and equity.
We are a highly profitable business and shareholders will be expecting us to continue the
growth in profit which we have achieved in recent years. Therefore, shareholders should be
supportive of such an investment through equity and debt finance.
We also need to consider our core competences and our strategic capabilities required to
undertake this acquisition. We have never undertaken an acquisition strategy before,
therefore we must assess our own management skills and capabilities to undertake this
strategy successfully. Without the necessary expertise, we could make a number of errors in
the process of acquisition, resulting in its failure. We may need to consider hiring external
consultants to assist with the acquisition process.
We must also assess our skills and competences to operate and manage these hotels in
Veeladia. We have highly skilled staff who can be used to train and work with the
CLIFFTON hotel staff to ensure that we manage the transition carefully and successfully.
However, it is likely that local staff will not have the same level of training, commitment and
loyalty which will need to be developed if the venture is to succeed. This may be a large
barrier to overcome. However, the planned investment in training local staff is significant
and therefore this should go a long way to ensuring that the proposed acquisition is
successful.
However, on-going management and monitoring of local staff and management will be
critical.
Concluding comments
There are a number of positive factors to suggest that the acquisition of CLIFFTON hotel
chain is a viable strategy for Kalam hotels. However, the board of directors should prioritize
which aspects of the decision criteria are most important to the success of the venture before
making a final decision.
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Part 2
Tutorial Notes
Good writing skills are mandatory to secure maximum marks in this part. Students need
to plan to identify factors which need to be addressed in press release. Students are
expected to clarify all allegations against proposed acquisition in a logical manner and
explanations should be aligned with the ethical principles of Kalam Hotels. Further,
students are also expected to comment on following minimum matters in press release but
not limited to employee rights, environmental investment, employment opportunities, long
term approach etc.
For immediate release

Kalam hotels’ proposed acquisition of the CLIFFTON hotel chain, Fundunia
Kalam Hotels, Funland’s most popular and largest budget hotel chain, has recently
announced its intention to acquire the family-run ‘CLIFFTON’ chain of hotels, located in
Fundunia. Since the announcement, there have been some concerns raised that the acquisition
of the CLIFFTON hotel chain goes against the high principles and standards which Kalam
hotels strives to attain.
Kalam hotels wishes to make clear the following points in response to these concerns:
1. Employees’ rights
Although the CLIFFTON hotel chain is located in a low wage economy, it would be Kalam
hotels’ intention to ensure that its staff located in Fundunia are not exploited in any way, and
if it is found that child labor is being used or staff are working excessive hours, then this
practice will immediately be ceased on acquisition. Kalam values its hotel staff highly and is
committed to ensuring that it is a great place to work, and this commitment will also be given
to its hotel staff in Fundunia.
It is not unethical for Kalam hotels to pay staff in Fundunia below the rates which its staff
in Funland are paid, particularly if the wage rates are favorable when benchmarked within
the local economy, for similar employees in the hotel sector. This is common business
practice across many industries operating in multiple locations. However, as stated above, it
is not the intention of Kalam hotels to exploit staff located in Fundunia. Kalam hotels invests
around $10 million annually in skills and development programmes for its staff in Funland,
and has implemented the new Funland National Living Wage six months in advance of the
government’s launch date. Therefore, rates of pay will be reviewed for all staff and will be
commensurate with the role undertaken and the expected and fair wage rate in Fundunia. We
will provide training opportunities for all staff and will also offer employment contracts
which will give employees security of employment.
2. Employment opportunities
Kalam hotels’s intention is to provide employment and development opportunities for the
staff employed in all of its hotels. Over the next six years, Kalam hotels intends to invest $10
million in training and staff development in Fundunia to ensure staff there are as highly
skilled as those operating in Funland.
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In line with our diversity and equality policies, Kalam hotels will immediately cease the
policy of only employing male hotel managers and will implement a policy of selection for
senior roles based upon experience and suitability for the role and not based upon gender,
age or ethnicity. Obviously, Kalam hotels will need to ensure cultural sensitivity in all of its
employment activities but will ensure that its own employment policies, in terms of equality
and diversity, are adhered to, wherever it is located throughout the world.
3. Environmental investment
In terms of the environmental impact of the decision to acquire the CLIFFTON hotel chain,
Kalam hotels intends to invest $6 million over the next six years in environmental investment
in the CLIFFTON hotels. This should go some way towards prevention of further incidents
of pollution which have recently occurred in some of its hotels.
In addition, a thorough investigation of environmental practices and policies of the whole
business and at individual hotel sites would need to be carried out to assess any further
investment, training or policies which need to be implemented throughout the CLIFFTON
hotel chain. It will be expected that all of CLIFFTON hotels will operate to the same
environmental and sustainable standards as all Kalam hotels, once the environmental
investments are fully operational.
Targets will be set and monitored by Kalam hotels for all of the CLIFFTON hotels in terms
of recycling, CO2 emissions and levels of wastage, in line with those operated throughout
the rest of the business and training will be given to all staff in environmental management
activities. These targets will need to be set to reflect the local resources available to each
hotel to undertake environmental management activities such as the existence of local re-
cycling depots.
4. Long-term approach
It would also be Kalam hotels’ long-term intention to work with the government of Fundunia
and the travel and tourism industry in the country to try to work together on improving the
environmental awareness in the whole industry.
Kalam hotels intends to take a pro-active approach to managing the social and environmental
impact of its activities in Fundunia. Experienced hotel managers from Kalam hotels will be
seconded to CLIFFTON hotels to ensure a smooth transition and to assist in the training of
local staff to run and manage the operations effectively. Although the CLIFFTON hotels are
located 10,000 miles away from the main operations of the business, they will be expected
to adhere to the corporate guidelines and standards set by Kalam hotels.
It is the intention of the management of Kalam hotels to invest in re-vitalizing the CLIFFTON
hotel chain to develop long-term employment opportunities for staff and to provide a great
location for international travelers to visit.
For any further information please contact our Sales and Marketing Department.
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Part 3 (a)
Tutorial Notes
This part requires practical knowledge about disruptive technologies impacting hotel
businesses to secure maximum marks. Students are expected to mention possible
challenges of disruptive technologies along with their impact on hotel business. The
possible challenges may include but not limited to, flexibility, personalization, wiser
choices of product offerings etc. Students are also expected to explain opportunities for
the organization through disruptive technology. At the end, a conclusive suggestion/way
forward is also required for Kalam Hotels to deal with the disruptive technologies.
To: The Board of Kalam hotels

From: Business analyst
Date: November 2021
The impact of disruptive technologies on Kalam hotels
Introduction
The following report will evaluate the potential strategic impact on Kalam hotels of the
disruptive technologies which are emerging in the hotel industry and will consider the range
of technologies emerging in the industry and the likely impact they could have on Kalam
hotels. The report will also highlight a number of potential applications of disruptive
technologies which Kalam hotels may consider implementing.
The emergence of disruptive technologies
A disruptive technology is a new emerging technology which unexpectedly displaces an
established one with the outcome of ‘re-shaping’ that industry, or indeed, creating a new one.
Today’s hotel customer is looking for a more unique and personal experience, valuing
variety, choice and individuality, which disruptive technologies are attempting to address.
So, what can we do to protect ourselves against disruptive technologies, and attract guests to
stay in one of our Kalam hotels? The answer would seem to be to offer a more personal,
individual unique service and experience, matching customers’ budgets and spending
patterns. The use of disruptive technologies may help us move some way towards achieving
this, or if we choose to ignore this development, may in fact be a considerable competitive
threat to our future. The comments made by the sales and marketing director, that the concept
of a hotel is under threat, may be considered to be somewhat pessimistic, but her overall
assessment of the growth and emergence of disruptive technologies must be taken seriously
by the board. It is unlikely to be an issue which will simply ‘blow over’, as suggested by one
of the board members.
The challenges posed by disruptive technologies
As discussions at the recent board meeting highlighted, there have never been more
alternatives to staying in a ‘traditional’ hotel, such as ours. Online accommodation providers,
such as ‘Rent-a-Room’ and perhaps more importantly, access to such a wide range of
alternative accommodation provision options through the internet, has never been easier or
more convenient for customers.
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Disruptive technologies such as ‘Rent-a-Room’ are a real threat to Kalam hotels, and the
comments made by the operations director at the recent board meeting should be challenged.
The belief that the threat is an ‘if’ rather than a ‘when’ is indeed incorrect and likely to be
dangerous to our long-term existence, as clearly Rent-a-Room is already a present and
growing threat to us.
There is clearly no ‘if’ as to the emergence of disruptive technologies and therefore this is a
threat we must address. We simply cannot wait for it to go away. This is evidenced by the
Hotel Industry Report which points to the changing competitive dynamics as one of the main
challenges for the hotel industry for 2021 beyond.
Flexibility
The hosts advertising with Rent-a-Room have the flexibility to be able to offer a wide range
of services, such as individually tailored breakfast requirements, local on-site knowledge to
offer up to the minute recommendations for highlights of the city or providing introductions
to local contacts which can get customers the best up to the minute offers. This provides
guests with a far more customer-focused and individualized service than a ‘homogeneous’
service provider like Kalam hotels could ever hope to successfully or economically provide.
In addition, the majority of hosts in this online ‘space-sharing’ environment, are likely to
have high speed internet and web-movies for their own use, so those benefits can
automatically be included in the price to guests, which is often considerably less than a hotel
room, due to the significantly lower overheads incurred by host providers. Therefore, these
alternative hosts are not only challenging us on product offering, but more importantly, on
price. As we are a low-price focus business, our whole basis of competitive advantage is
being challenged by disruptive technologies.
Wider choice of product offerings
The comments made by the finance director at the recent board meeting demonstrate a clear
and realistic understanding of the challenges faced by Kalam hotels from disruptive
technologies. We must not be complacent and think that our customers will be satisfied with
what we offer and will not be tempted by the offerings of disruptive technologies. We must
be aware that disruptive technologies such as Rent-a-Room can create some novel product
offerings and as the number of these offerings grow and the choice becomes wider, the more
the traditional mainstream hotel user will be tempted to try out these offerings.
Personalization
For a homogeneous product offering such as ours, we are likely to face significant challenges
in being able to personalize our customer experiences. For Rent-a-Room hosts,
personalization of customer experience is significantly easier, as they are only dealing with
one customer at a time, making the process straightforward. However, Kalam hotels manages
46,000 hotel rooms across 510 hotels, meaning that personalization of customer offerings is
not only likely to be logistically difficult but also very expensive. Our hotels run with low
levels of staff, albeit staff who are highly trained in customer services, but offering such high
levels of personalization will be a significant challenge.
Smartphone technology
Disruptive technologies do not only take the form of alternative product offerings such as
Rent-a-Room. The use of smartphone applications in a range of ways from customization
through to door entry technology is a major development in the industry and one which we
must consider. Although it is evident that customers are demanding greater flexibility, we
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would be faced with considerable obstacles if we changed the customer check-in process, to
enable greater customer flexibility through smartphone technology. New software would
need to be installed to manage the secure interface with customer smartphone apps with our
hotel property management system, bringing with this the risk of data corruption and external
systems access threats. The cost would also be significant.
There is also the problem of universal access for all of our customers, as many may not use
smartphone technology. Implementing new door entry technology will also be expensive
with the need for multiple entry and access systems including smartphone access and key
card access. Managing multiple access methods adds unnecessary operational complexity for
us which is likely to be a major barrier.
Potential for application of disruptive technologies by Kalam hotels
However, we could consider some less expensive adaptations of disruptive technologies.
There are opportunities for personalization in the form of smartphone apps capable of
providing information to guests throughout their stay in a destination, giving us the
opportunity to enhance the guests’ experience – such as local weather reports, local events
and ticket offerings and also restaurant, theatre or other visitor attraction booking facilities
through third party channels close to our hotels. We could also offer advance booking
facilities to local gyms or sporting events which are taking place nearby. Overall, we should
look into the possibility of offering an online and mobile interactive concierge facility for
our guests which provides the facility to book rooms, extra services and personal experiences
unique to them, on the move. This could be a starting point for Kalam hotels to move into a
more personalized service which moves us some way towards addressing the threats of the
disruptive technologies in the hotel industry. However, much more work and evaluation of
this threat must be done on an on-going basis. It can no longer be ignored.
Conclusion
Disruptive technologies present significant challenges to our business. As stated, we can no
longer simply offer hotel rooms to our guests – we need to become a relevant focal point for
destination experiences and tailor our offerings to more individual customer needs. This will
be a significant challenge to us and one which we simply cannot ignore.
Part 3 (b)
Tutorial Notes
This part is not very complex as main concerns related to IT/IS system have already been
mentioned in question. Students are required to evaluate impact of each risk along with
remedial strategy using their practical knowledge. Students are also advised to mention
points in bullets along with brief presentation notes to save time.
Risk 1: Lack of focus on IT/IS strategy
Outcomes
– Kalam hotels’ business strategy is not supported by IT/IS strategy, leading to failure
– Business opportunities missed due to poor IT/IS strategy
– Wasted resources due to lack of strategic leadership and direction
Recommended actions
– Employ an IT director
– Align the business strategy with the IT/IS strategy
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Notes:
Outcomes
A fundamental starting point of a well-managed and controlled information system is the
development of an information system strategy. A major risk to the long-term success of our
business is our lack of strategic focus on information systems and its importance to achieving
our overall business strategy. If our business strategy is not supported and integrated with
our information systems strategy, then it is likely that our overall business objectives will not
be successfully achieved. For example, our strategic focus of ‘growth through innovation’ as
defined in our chairman’s Statement, would be jeopardized if this innovation was not
considered alongside the appropriate technologies which can support and drive such
innovation.
Without adequate focus on the strategic importance of information systems then it is likely
that business opportunities such as innovation in product and service delivery could be
missed which may harm our competitive advantage and result in our competitors moving
ahead of us. Likely also to waste resources on ineffective systems which do not add value to
our business.
Recommended actions
A contributory factor towards this lack of focus on the importance of an information systems
strategy is the fact that we do not have an IT director who can lead our information systems
development needs. For a business of our size and the nature of the dynamic technological
developments occurring, an IT director would seem to be essential. We should therefore
consider the employment of an IT director who would then provide a strategic focus and
direction for our information systems to ensure that the information system strategy is
supported, and it enhances the overall business strategy.
As stated above, it is likely that business opportunities could be missed as a result of a poor
focus on IT/IS strategy. Therefore, a key recommendation is that we must ensure that any
strategy we consider in the future must be aligned to our IT/IS strategy.
We should consider how our IT/IS capabilities and activities can enhance or potentially
inhibit our strategic direction and how we must develop out IT/IS capabilities to support our
strategic direction.
Risk 2: Cyber and data security breaches
Outcomes
– Loss of key organizational and customer data
– Severe business interruption leading to loss of business
– Damage to reputation and financial cost due to compensation and legal claims
Recommended actions
– Invest in the latest cyber security systems and controls
– Implement and upgrade information systems physical and access control environment
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Answer Bank
Notes:
Outcomes
Cyber and data security breaches are a significant threat to modern businesses, including
Kalam hotels. As an organization, we could be vulnerable to the threat of external hacking
of our key organizational data. A considerable threat could also be that of virus infection
which could corrupt, or in the worst-case scenario, delete or disable our critical operating
systems. The consequences of such threats are that our business would suffer severe
interruption, particularly our online booking facility for customers which would be unable to
function, leading to loss of business and dissatisfied customers.
Similarly, internal physical and access control weakness in our information systems
environment could lead to system failure or corruption of data. Allowing unauthorized or
untrained staff access to our information systems could result in data breaches and incorrect
processing of bookings or transactions. Correcting these errors will be costly and time
consuming. Consequently, any breaches to the security of our information are likely to be
highly damaging to our reputation and also may result in costly compensation claims from
customers who have been affected by any such breaches.
Recommended actions
We must make sure that we operate the latest industry standard firewalls and virus protection
software and procedures. Regular testing of our security systems should be carried out and
back-ups of all our data undertaken regularly and stored separately. Access to our systems
internally should be given to only authorized and trained staff. Authority of systems usage
should be set and authorization controls such as passwords and user ID systems should be
used at all times. The system should produce regular reports on systems access and usage
which should be monitored by IT staff and any exceptions should be reported.
Risk 3: Business continuity threat
Outcomes
– Unable to operate effectively due to no disaster recovery plan
– Loss of business/damage to reputation
– Cease to operate
Recommended actions
– Implement a disaster recovery plan
– Strategic level focus on role of IT/IS in overall business activities
Notes:
Outcomes
There is a lack of awareness at board level of the importance of our critical information
systems on the continuity of our operations and the need to ensure that we have plans in place
to ensure business continuity, should a disaster event take place. With insufficient planning
and risk assessment it is likely that Kalam hotels will not be ready for a business-critical
event.
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This may result in the business being unable to operate for a period of time, within which we
will lose customers, and revenue will be severely affected. Our reputation is also likely to be
damaged if our disaster recovery plans are ineffective or inadequate.
In the worst-case scenario, the business may not be recoverable, and we could go out of
business.
Recommended actions
The board must implement a disaster recovery plan to encompass a range of potential threats
to our information systems including terrorist attacks, cyber-attacks, fire, flood or any other
potential critical systems threat. We need to assess which disasters may occur and assess
their level of threat to the business and ensure we have sufficient arrangements to manage
such an event.
This reiterates a point made in a previous slide that the focus of information systems should
be at the strategic/board level of the organization. Our information systems should be seen
not only as critically important business assets but also as key drivers of our business strategy
and therefore it is important that we have a strategic focus and direction for our information
systems.
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Answers to past exam questions
Question No 22 - TNS Textiles (June 17)

Marking scheme
(a) Asset-based valuation 3

 Up to 2 marks for extracting correct figures with a
suitable description of each component
 1 mark for comments relevant to pros and cons of net
asset valuation method or final valuation figure
Free cash flow valuation 12

 1 mark for applying correct assumptions to revenue, cost
of sales and operating expenses
 1 mark for correctly adding back depreciation on current
assets
 Up to 2 marks for correct treatment of tax on capital
items
 1 mark for computation of tax due
 1 mark for including additional capital expenditure
 1 mark for adding back finance costs as using WACC
 Up to 2 marks for correctly discounting cash flows
 1 mark for correctly subtracting value of debt
 Up to 2 marks for comments relevant to pros and cons of
free cash flow valuation method or final valuation figure
Comments – up to 3 marks (½ mark per point) for relevant 3

comments on the calculations including:
 Valuation is inexact
 Asset-based valuation sets 'floor'
 Forecasts very prone to error
 Perpetual growth seems unlikely
 Discount rate likely to change
 Valuation of debt uncertain
 Recommend discounting FCF figure as starting point
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(b)  1 mark per valid point
(c)  1 mark per valid point
 Maximum of 6 for each option
(d)  Up to 2 marks for correct calculation of cost using
forward contract
 1 mark for calculating saving compared to spot rate
 1 mark for recognising that TNS will only save if the
euro appreciates
 Up to 2 marks for discussion of alternatives
(e) Option 1
 ½ mark for revenue expenditure (marketing and process
design) deductible
 2 marks for losses (carry forward, time limit, relevance
and no carry back)
 1 ½ marks for intangible fixed assets (identify the
possibility/relevance, amortisation and time limit)
 1 mark for depreciation (accounts dep'n not
deductible, range of depreciation rates)
 1 mark for initial claim for new assets (including
conditions)
 1 mark for any other relevant and well explained point
Option 2
 2 marks for irrevocable election to be taxed as single
entity (possibility, effect and condition and relevance for
NTS
 ½ mark for capital transfers on NGNL basis
 1 ½ marks for group relief (possibility, condition and
restriction)
 1 mark for inter-company dividends (relevance and
impact)
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Answer Bank
 1 mark for explaining condition of obtaining tax benefit

on acquisition and impact
 1 mark for any other relevant and well explained point
Conclusion and Recommendation
 1 mark for concluding on Option 1 versus Option 2
 1 mark for recommendation with salient reason
(a) Valuation of Premium Fabrics

(i) Asset-based valuation
Rs'm Rs'm Comment
Assets
Owned land, buildings, plant and
machinery 6,500 1
Assets held under finance leases 150 2
Other non-current assets – office 474 3
equipment
Current assets 4,755 4
Liabilities
Loans (2,368) 5
Finance leases (45) 6
Current liabilities (4,604) 7
Total liabilities (7,017)
Forecast net asset valuation at
31 December 20X6 4,862
Notes for examiners

Comments
1 This is a key figure. The valuation assumes it is correct but
independent valuation of this will be needed.
2 The basis of this needs to be considered.
3 This is the carrying value but fair value will need to be assessed.
4 Most of this is stock, so this will need to be checked to ensure
that none of it is impaired.
On the other hand, holding it at the lower of cost and net
realisable value means that it may be understating the market
value.
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Comments
The terms of the sale will need to be checked to ensure that,
when the business is sold, the cash in the business will transfer
to the new owners, not remain with the current ones.
5 As these are secured on directors' guarantees, we will need to
check if repayment will be triggered by Mr Ahmad leaving
the business.
They may also be repayable in the event of the
business changing ownership.
6 Capital element of finance lease obligations.
7 These liabilities will need to be verified.
Based on these assumptions, estimated net asset value at 31 December 20X6 is Rs 4,862
million.
(ii) Free cash flow valuation of Premium Fabrics
Workings 20X6 20X7 20X8 20X9 and
(baseline) thereafter
Rs'm Rs'm Rs'm Rs'm
Revenue 1 15,764 15,764 15,764 18,917
Cost of sales 2 (14,114) (13,364) (12,614) (15,137)
Gross profit 1,650 2,400 3,150 3,780
Operating expenses 3 (702) (632) (632) (632)
Finance costs on loans 4 (23) (23) (23) (23)
Finance costs on 4 (5) (5) (5) (5)
finance leases
Add back accounting 223 201 181 300
depreciation on existing
assets
Adjusted profit before 1,143 1,941 2,671 3,420
tax
Subtract tax
depreciation on
existing assets (150) (100) (300)
Subtract tax
depreciation on
new investment 5 (163) (196) –
Taxable profit 1,143 1,628 2,375 3,120
Tax due 6 (489) (712) (936)
Add back tax 313 296 300
depreciation
Add back finance costs
(included in WACC) 8 16 16 16
Additional capital (500) (500) (300)
expenditure
Residual cash flow 968 1,475 2,200
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Answer Bank
Valuation of cash flow

968/1.15 = 842 Discounting for one year
Discounting for two years
1,475/(1.15)² = 1,115
(2,200/(0.15 – 0.03))/(1.15)2 13,863 Valued as a perpetuity, adjusted for
growth, then discounted for two
further years
Total enterprise value 15,820 Note. As valuation is at WACC, and
(equity and debt) excludes interest, then this valuation
is total market capitalisation
Less value of debt (W7) (2,368)
Value of equity 13,452 Rs 13.5 billion
Workings
1 As per question, assume this is constant for 2 years, then increases by 20%.
2 Allowing for reductions of Rs 0.75bn each year for 2 years, then increasing by
20%.
3 Allowing for expected reduction, then static.
4 Assume these are static. It may be that the profits will allow for repayment of debt
so we are being prudent here.
5 20X7: (Rs 500 m x 25%) + (Rs 375 m x 10%) = 163; 20X8:
(Rs 500 m x 25%) + (Rs 375 m x 10%) + (Rs 337.5 m x 10%) =
196. Tax depreciation is assumed 25% in the first year and 10% in the subsequent
year on a reducing balance basis.
6 Taxable profit at 30%.
7 Assuming market value of debt is the same as balance sheet value.
8 Post tax finance cost on loan 23 x(1 – tax 30%) = 16.
Conclusions and commentary
Our calculations suggest a value of approximately Rs 13.5 billion on a free cash flow
basis and Rs 4.8 billion on an asset basis. Valuation is not exact, and these calculations
can give guidance only, but they could set upper and lower boundaries for negotiation.
The ultimate value of the company will depend on the outcome of our negotiations with
the shareholders of Premium Fabrics.
The asset-based valuation reflects the amount realisable if the company was broken up
and the assets sold off. As such, the shareholders will definitely not be willing to accept
less than this. It is a good way of providing a 'floor' for negotiations but is not a realistic
estimate of the value of the business as a going concern.
The free cash flow valuation is more realistic as it considers the company as a series of
cash flows. However, the valuation is heavily dependent on the assumptions used and
even a small change in these will affect the valuation significantly. In particular, it seems
unlikely that revenues and costs will continue to grow by 3% forever from 20X9. This
also assumes the discount rate is constant, whereas it is also likely to change over time.
The calculations have been performed using WACC, so the entire enterprise has been
valued, and then the value of debt subtracted. As a simplifying assumption, the market
value of debt has been assumed to be the same as the value in the statement of financial
position, but this would need to be verified.
305
For negotiating purposes, and given the assumptions involved, it would be prudent to
discount the valuation of Rs 13.5 billion, at least as a starting point.
Tutorial comments
Overall in this question, there is a significant volume of information to assimilate in
this scenario and students are advised to invest sufficient time linking the scenario
and exhibits to each of the question requirements, as this will make the question much
easier to manage.
Requirement 1(a) requires both a net asset valuation and a discounted cash flow
valuation. Therefore it is essential that workings are complete, logical, easy for a
marker to follow and are narrated, where appropriate, to explain any assumptions
made. Students are advised to ensure that numerical information used from the
scenario is clearly visible and recognisable to the marker to ensure method marks can
be awarded. The impact of tax allowances on new and existing assets is a complicated
area to get fully correct, so students are advised to work this element carefully, and
keep separate in their calculations. Another complicated area is the treatment of
finance costs which are tax deductible when calculating the tax due on profit but must
be added back to achieve the net cash flow. This is because the cost of debt interest
already includes the WACC which is applied as the discount rate to achieve the
company valuation and this point is not always fully understood. A discounted cash
flow valuation using the WACC delivers a value of both debt and equity which is
referred to as total market capitalisation. Students often fail to deduct the value of
debt to determine the value of equity only. Students are also advised to list any
assumptions made during the calculation. This can help the marker, particularly
where a student’s calculations differ from the suggested answer. As a final point at
MSA, students are expected to interpret the final result to the reader and explain the
significance of the two values determined and why they might differ.
(b) Evaluation of two strategic options Option 1 – Marketing campaign Growth in
sales and profitability
This option will deliver growth more slowly than the second option
(acquisition), because the effects of getting customers to purchase more as a result
of the marketing campaign may take time to filter through. This will raise the risk
that shareholders may become impatient.
As TNS is selling into a number of different markets overseas, the marketing
campaign may need to be targeted differently in each country, which could be
very expensive.
Foreign exchange risk
Seeking to grow export markets will increase the foreign exchange risk TNS is
exposed to, as sales will be in a foreign currency and any depreciation of that
currency will reduce revenue. The purchase of machinery from Germany also
leads to foreign exchange risk, due to the time delay between agreeing the price
and making the payment for the machines.
Implications of failure
The marketing drive may not be successful, in which case it will represent
significant financial spend and management effort for no return.
306
Answer Bank
Option 2 – Acquisition of Premium Fabrics

Growth in sales and profitability
Strategically, the acquisition should result in rapid growth in TNS sales and
market share, which is likely to appeal to shareholders. By taking over existing
customer relationships, TNS is guaranteed to increase revenue. The retirement of
Mr Ahmad means that there is an opportunity to acquire Premium Fabrics,
possibly at a discount, and an opportunity to purchase a company of this type
without a hostile bid might be rare.
Foreign exchange risk
From a foreign exchange point of view, the acquisition will increase the
proportion of export sales, which will increase the risk of depreciation in the
currencies of revenue reducing the value of our revenue.
Implications of failure
Acquisitions always carry a risk of overpaying, which would undermine the
benefits originally envisaged. In addition, there are risks of failed integration,
culture clash and losing key management figures. This may be particularly
significant as Premium Fabrics is owner-managed, and given that TNS has a
mixed history of integrating acquisitions.
Recommendation
Overall, the risks of the acquisition are very significant and TNS has no
experience on this scale. The option of purchasing equipment and a marketing
drive is much less risky, and should see significant benefits. This is therefore the
better strategic fit and recommended course of action.
(Note. A different conclusion, if good reasons are given, should be awarded full
credit. Candidates could argue that the acquisition offers an opportunity to meet
growth objectives much more quickly than the marketing campaign. Here it is
important that a candidate's conclusion is in line with the analysis provided and
is commercially reasonable.)
Tutorial comments
This requirement requires a comparison between two strategic options. Students
should plan to provide sufficient evidence for each option by providing both pros and
cons. The strongest argument should then support a logical recommendation based
on the evidence provided as this will show good professional judgement. Providing
a consistent framework for analysis where allow for a better comparison so in the
suggested answer growth students are advised to include foreign exchange risk and
implications for failure to structure each of the scenarios. The markers are looking
for the strength of the arguments given, the quality of evidence provided and the
quality of the final recommendation so students are advised to spend time compiling
evidence considering internal and external market factors and avoid racing to
providing a recommendation only.
307
(d) Key implementation challenges and overcoming them Option 1 – Marketing
campaign and production process
Acquiring and supporting new customers in many different countries could be
difficult if we do not have enough trained account managers. If the sales team are
trained in more aggressive marketing techniques, there is a risk of alienating
customers in some regions. This could be overcome by careful training of staff to
adopt an appropriate sales approach for each market.
Key challenges relating to the production process would include making changes
to working practices in order to get the best value from the new machinery. It is
possible that staff will resist this, especially if it involves redundancies.
In order to overcome staff resistance within TNS, timely communication with
staff will be essential, including being open about redundancies required. Staff
should be consulted as far as possible on changes to ensure that they feel involved
in the changeover to new machinery. Any staff made redundant should be treated
fairly, with decisions about redundancy made according to agreed, transparent
criteria. Thorough training in the new processes will also be essential to ensure
that benefits can be gained.
Option 2 – Acquisition of Premium Fabrics
This would present many challenges, including integration of the two companies'
operations, in terms of both manufacturing and support functions, retraining of
staff and potential redundancies, and decisions about whether to retain the
Premium Fabrics brand.
Successful integration of Premium Fabrics will require a plan which sets out clear
steps and shows who will be affected at each point. Staff affected should be
informed as soon as possible and where possible offered options of retraining or
redeployment as an alternative to redundancy. It is important that all workers are
seen to have been fairly treated.
It is also important that a decision is taken quickly about whether to retain the
Premium Fabrics brand or rebrand it as TNS. Either way, the decision will need
to be communicated to customers of Premium Fabrics and, given that most of
them are overseas, it would be helpful to visit as many of them as possible in
person and explain what is happening.
Tutorial comments
The key to answering a strategic implementation question well is creating an answer
which focuses on practical barriers and problems which are likely to occur in this
scenario if each strategic option was followed in the real world, and then offer
practical solutions which the company is capable of implementing which could
overcome these. Often key stakeholders can react negatively to change, so
considering employees, business owners, customers and suppliers in the supply
chain will often generate a breadth of ideas to discuss. Also, further practical
challenges are likely to emerge by considering the impact on existing business
processes, IT systems and data requirements. Finally, cash flow, finance funding and
profit generation are other considerations which would need to be actively managed
once a strategic option is implemented. In this requirement, it is important that
students achieve balance in their answers when evaluating each of the two options
evenly as this demonstrates professional judgement and credibility.
308
Answer Bank
(f) Managing exchange risk

The purchase of the machinery means that TNS is exposed to transaction risk
– the risk that the euro will strengthen between agreeing the price and making
the payment, thus increasing the cost. This can be managed using a forward
contract. If TNS buys EUR20m on 1 January 20X7, it will ensure that it pays Rs
2,227 million on 30 June, thus locking in the price:
On 1/1/X7, buy forward contract for EUR20m.
Spot rate 112.44

Subtract premium (1.08)
6-month forward rate 111.36
Cost in Rs'm 2,227
Not using forward would mean using the spot exchange rate on 30 June:
Spot rate 116.45

Cost in Rs'm 2,329
Therefore, would cost an extra Rs 102 m
If the assumption given is correct and the actual spot rate on 30/6/X7 is 116.45, then if
the company had not used a forward contract, the cost would have been Rs 2,239 million,
an extra Rs 102 million. On the other hand, if the euro had depreciated, this would have
reduced the cost.
Alternative ways of managing this risk would be:
(i) Money market hedge – borrow in euros on 1 January, put the money on
deposit and then use it to pay the bill.
(ii) Do not specifically hedge the transaction, but use euro revenues from European
customers to pay this amount. As TNS has customers in Europe, it seems likely
that it will have sufficient euro income to do this.
Tutorial comments
In answering a managing exchange risk requirement, students are advised to keep
the calculations simple. So here, the impact between using and not using a forward
contract would convincingly demonstrate the monetary impact of not hedging which
is straightforward to put together. Students should then be the business advisor and
explain practical alternative hedging methods and their respective advantages and
disadvantages which are suitable for the nature of the transactions which TNS
Textiles undertakes. The advice should be clear and understandable to a non-
accountant director, so the advice offered can be correctly interpreted by the Board
of Directors. The marks available for this requirement are relatively small compared
to other requirements. Therefore students should ensure they keep to the time
allocation indicated by the marks available as there is the temptation to continue
writing which will impact negatively on the time available for the final requirement
in Question 1. Students should focus on the most important points from their answer
plan and move on to 1(e) when these points have been written.
309
(h) Option 1 – Tax implications of marketing campaign and production
improvements
Option 1: Tax implication under Marketing Campaign Marketing expenses
Cost of marketing campaign can be treated in either of the following ways by the
tax authorities:
1. Allowed as an expense in the year of incurrence. TNS would obviously
like this but the taxation authorities may not agree. The aggressive nature
of the campaign implies that the cost will be significant and if accepted by
the tax authorities, TNS would incur tax losses initially which may be
carried forward and offset against future profits generated by TNS once
its operations become profitable. However, the maximum carried forward
period allowed for tax losses is six years.
2. As per section 24(11) of the Income Tax Ordinance, 2001, marketing
expenses may be treated as intangible assets as the benefits are spread over
more than one year. For tax purposes, the maximum amortisation period
of the intangible assets is 10 years, though TNS may be able to have it
amortised in 3–5 years.
It is quite evident that the cash flows under the two alternatives would be
significantly different.
Purchase of plant and machinery from Germany
Any depreciable asset put into service for the first time in Pakistan during a tax
year will be entitled to an initial allowance of 25% of the cost of the asset.
Further, TNS is also allowed to claim depreciation at the rate of 10% annually
on reducing balance method. In case of taxable losses, TNS is allowed to carry
forward the tax depreciation for indefinite period.
Option 2: Tax implication of acquiring Premium Fabrics
It appears that TNS is currently a standalone company without any subsidiaries.
The acquisition of Premium Fabrics, given its size, is likely to result in a group
with TNS as a holding company. This gives rise to a number of options with
regards to its tax affairs, as under:
TNS is able to acquire 100% shareholdings of Premium Fabrics (Most Likely)
By default, both companies would be taxed separately but it is possible to make
an irrevocable election to tax the group as a single entity. In such a case, any
losses made by either entity would be automatically offset against the profit made
by other entity. However, the option of group taxation shall be available to those
group companies which comply with such corporate governance requirements
and group regulations as may be specified by SECP from time to time.
Any income derived by TNS on account of dividend from Premium Fabrics will
be exempt from tax subject to the condition that return of the group has been filed
for the tax year.
Subsequently if TNS decides to acquire the assets of Premium Fabrics as has
been its practice in the past, no gain or loss shall arise in case of such acquisition
subject to meeting the conditions specified in section 97 of the ITO-2001.
310
Answer Bank
TNS is able to acquire less than 100% shareholdings in Premium Fabrics

In case TNS acquires at least 55% of the share capital in Premium Fabrics it may
be able to surrender its tax losses (excluding capital losses) in favour of TNS, to
the extent of TNS’s percentage of holding in Premium Fabrics.
Inter-company dividend would not be exempt from tax and hence any profits
transferred from Premium Fabrics to TNS by way of dividend would be taxed
again.
On the basis of above information, it is obvious that TNS would be able to obtain
tax benefit under this option only if it is able to acquire 100% shareholding in
Premium Fabrics. However, this rule has no practical advantage for TNS as
Premium Fabrics has significant profits whereas TNS is at breakeven.
Conclusion
The tax benefit of acquisition is quite limited because it is only limited to
adjustment of losses whereas none of the company is expected to incur a
significant loss. On the other hand, at least in the case of a favourable stance of
the tax authorities with regard to marketing expenses, TNS would make a
significant tax savings in the initial years. Even if all the marketing expenses are
spread over more than one year, the marketing option would still be better from
a tax point of view because of the initial depreciation on imported machinery.
Tutorial comments
It is essential that students effectively plan for the tax requirement to complete the
breadth of points likely to be required in the time available. Students are advised to
create an answer plan for each of the options identified in the requirement and then
break each option down into factors which will affect the tax position, such as
marketing expenses, purchase of overseas plant for Option 1 and acquiring full or
part ownership of Premium Fabrics for Option 2. Students can then plan
approximately 2 marks for each identified area, leaving a mark for a conclusion for
the Board of Directors to consider as this approach will help to manage the time
available.
Question No 23 - YSJ Chartered Accountants (June 17)

Marking scheme
(a)  1 mark per relevant comment but must add value – 'x
has gone up' does not gain marks
 1 mark for identifying profit per partner as a key
measure and 1 mark for calculating it
(b)  Impact on recruitment – one mark per valid point up
to maximum of 3 marks
 Impact on motivation – one mark per valid point up
to maximum of 3 marks
 Impact on behaviour – one mark per valid point up to
maximum of 3 marks
311
(c)  Up to 4 marks for discussion of KPIs – 1 mark per
suitable KPI identified, and 1 mark for justifying each
(d)  Up to 3 marks for discussion of system benefits
 Up to 3 marks for discussion of implementation issues
(e) Capitalization Amount 0.5
Software life as per ITO 0.5
Amortization period 0.5
Amortization Amount 0.5
Total 25 marks
(a) Assessment of office performance
Both offices are generating a positive net income. Similarly, both offices
generate positive residual incomes (RI) and achieve returns on capital employed
(ROCE) of 15% or more. On the other hand, YSJ does not operate in a capital-
intensive business so ROCE and RI may not be the most relevant measures to
use.
There are significant differences in the performance of the two offices. The
Islamabad office has grown revenue by only 0.7% and operating profit has
declined by 4%. It appears that costs continued to rise despite a lack of growth
in revenue. The main cost is staff, and staff costs as a proportion of revenue have
risen from 51.4% to 52.1%. Staff costs have increased by 2% which may
represent pay rises, and which have not been matched by revenue increases.
By contrast, the Lahore office grew revenue by 20.5%, and operating profit by
50.8%. Staff costs increased by 11.1% but as a proportion of revenue fell from
56.6% to 52.2%, which is a similar proportion to Islamabad. In 20X6, Lahore's
operating margin is 30.3% compared to 26% in Islamabad, suggesting that costs
overall are under better control. The relatively strong performance of Lahore may
represent the difference in management or local business conditions, or both.
However, the figures also suggest that the growth in Lahore may be leading to a
strain on cash flow. The figures for current ratio and receivable days are stable
for Islamabad but in Lahore have deteriorated from 1.8 to 1.6 and 154 to 188
days respectively. Receivable days were already higher than in Islamabad, so this
suggests there may be some issues with credit control and possibly a provision
is required for bad and doubtful debts.
One measure often used in professional firms is profit per partner and here there
is a striking difference between the offices. Islamabad has dropped from Rs 13.8
million to Rs 12.3 million while Lahore has increased from Rs 14.3 million to
Rs 21.4 million. This disparity may cause some issues in terms of profit-sharing
among the partners.
312
Answer Bank
Overall, the Lahore office is performing very well and driving the success of the
firm. However, the partners will need to ensure that this growth does not lead to
a loss of control over and problems with cash flow. They will need to prioritise
cash collection to avoid this.
It is also notable that total head office costs have increased from Rs48.2 million
to Rs 67.5 million, which is an increase of 40%, a much greater percentage
increase than revenue. There seems to be a lack of cost control at head office,
which should be investigated. As the firm is growing fast, it seems that many
head office roles are being created to support it. This may well be driving the
significant growth in costs.
Appendix – Calculations
Management accounts for the two offices of YSJ for the years ended 31 December 20X5
and 20X6 – analysis
(Note. Marks are not specifically awarded for calculations but are they are supplied here
for completeness.)
Islamabad Lahore
20X6 20X5 % 20X6 20X5 %
Change Change
Rs'm Rs'000 change Rs'm Rs'000 change
Revenue 730,136 725,364 4,772 0.7% 436,044 361,917 74,127 20.5%
Staff costs (380,337) (372,730) (7,607) 2.0% (227,469) (204,722) (22,747) 11.1%
Other operating
expenses (159,790) (154,996) (4,794) 3.1% (76,570) (69,679) (6,891) 9.9%
Operating profit 190,010 197,638 (7,628) (3.9%) 132,005 87,516 44,489 50.8%
Allocated head
office costs (42,250) (31,688) (10,562) 33.3% (25,232) (16,534) (8,698) 52.6%
Profit before
interest and tax 147,760 165,950 (18,191) (11.0%) 106,773 70,982 35,791 50.4%
Current ratio 2.8 2.7 0.1 3.7% 1.6 1.8 (0.2) (11.1%)
Receivable days 139 137 2 1.5% 188 154 34 22.1%
ROCE 16% 19% (3%) (15.4%) 20% 15% 4% 29.5%
RI 56,502 79,256 (22,754) (28.7%) 52,273 23,567 28,700 121.8%
Capital employed 912,577 866,948 45,629 5.3% 544,995 474,146 70,849 14.9%
Staff costs as %
of revenue 52.1% 51.4% 52.2% 56.6%
Operating margin
26.0% 27.2% 30.3% 24.2%
PBIT
margin 20.2% 22.9% 24.5% 19.8%
Head office costs (67,482) (47,498) (19,984) 42.1%
Number of partners 12 12 5 5
Profit per partner 12,313 13,829 21,355 14,341
313
Tutorial comments
The challenge in this first requirement is achieving the balance of depth required in
explaining company performance, completing accurate calculations and writing a
report which explains and compares divisional performance in sufficient detail.
Therefore, students are advised it is not possible to calculate every performance ratio
possible, but they should be selective and choose those performance measures which
will be the most insightful. For any accountancy practice, revenue growth will be an
important measure as well as margin analysis, as this will explain whether the pricing
policy and cost budgets are reasonable to support a sustainable business. Staff costs
as a percentage of revenue and profit per partner are important KPIs to examine
effective cost control and revenue generation performance and potential,
respectively.
When writing up the report, students must include appropriate numerical evidence
they have calculated to support the statement being made, as the Board of Directors
will expect performance is quantified in each statement, rather than be left to piece
together a report and an appendix of calculations for themselves. Overall, the reader
of the answer should be left with a clear understanding of whether divisional
performance has been good or disappointing, given internal and external business
challenges and market opportunities available.
(b) Likely impact of proposed remuneration schemes Impact on recruitment
The current system of partners being paid equally will clearly be attractive for
those joining the partnership – they will be paid the same as long-established
partners. However, this approach will make existing partners extremely careful
about they admit to the partnership. Any new partners must be able to generate as
much income as the existing ones, otherwise all partners will see a reduction in
pay. This will remain largely the same if the proposal for a 25% bonus is adopted.
On the other hand, moving to a 'points system' may make recruitment harder, as
new partners will earn less than existing ones. Existing partners will be more
willing to admit new members, knowing that the risk of diluting their current
earnings will be reduced.
Motivation
Paying partners equally will motivate them to improve the firm's overall
performance, but, with 17 partners, there is a risk that the link between their own
behaviour and the performance of the firm as a whole is too weak to provide a
strong motivator.
Providing a bonus for exceeding the PBIT target is better in this respect, as
partners can see a closer link between their performance and their office results,
however PBIT is stated after deducting the share of head office costs which are
allocated to that office, and these are outside the office managing partner's control.
This could have a negative impact on motivation. It would be better to use
operating profit, as this is more controllable by the local partners.
A points system would provide motivation for partners to improve their
performance, provided the system was developed on a fair and transparent basis,
and rewarded revenue generation and cost control.
314
Answer Bank
Behaviour
If the partners are paid a bonus based on beating targets for profit before interest
and tax, there is a danger that the partners will focus on this short-term measure
and take action that will damage the business in the longer term. For example,
they might be reluctant to invest in training and development of their staff. It
would therefore be helpful to include other, more long-term key performance
indicators (KPIs) as part of their performance management.
The targets may also increase competition between offices. The desire to achieve
the target and trigger the bonus may mean that the two offices are less inclined to
help each other if doing so reduces the likelihood of triggering their bonus. For
example, they may refuse to second staff, or share knowledge of specialist
technical areas with partners from the other office.
On the other hand, a 'points' system also carries risks. Partners may focus entirely
on generating new business and extra work and neglect the existing business.
Tutorial comments
In considering the likely impact of proposed remuneration schemes, students should
first understand the rationale for a change and consider whether this is valid. Where
remuneration changes, there is likely to be a mixture of acceptance and dissent, and
the latter may result in existing talent exiting the business. However, in equal
measure, a fairer and more attractive scheme may attract new talent and have a
positive impact on motivation and employee performance, as those with talent strive
to achieve higher status within the company. Remuneration also has an impact on
how employees behave and where effort is focused, influencing decision-making. A
focus on short- or long-term aims can create bias in all of these areas which can have
both a positive and negative impact. So it is important students consider each of these
in turn and clearly explain the expected impact on employee and partner behaviours
and how this may also impact divisional and overall company profitability in the
short- and long-term.
(c) Additional KPIs

These KPIs could include:
(i) The firm should focus on maximising the productivity of its staff. Revenue
per member of professional staff, or revenue earned by each partner, could
therefore be a useful metric.
(ii) It seems that the growth in the Lahore office is causing problems in terms
of credit control. If not dealt with, this could lead to liquidity problems
and bad debts. It would therefore be appropriate to have a KPI relating to
cash collection for each office.
(Note. Full credit should be given for any other reasonable KPIs and
explanations.)
315
Tutorial comments
This final requirement of this question focuses on additional key performance
indicators (KPIs), which would enhance analysis of divisional performance by
improving the understanding on drivers for cost and revenue within the business and
improve decision-making. Here, students are advised to look to operational aspects
of the business by carefully reading the question scenario to determine suitable KPIs
and avoid repeating standard ratio analysis. In an accountancy practice, staff and
property are the significant costs and therefore staff utilisation and use of property
(staff per square metre) could help drive a more effective use of these resources. The
use of information in the question scenario should also be considered, for example,
potential credit control and cash flow problems in the Lahore office which could lead
to a KPI on billing frequency and aged debt analysis.
(d) Potential benefits of new database and executive information system (EIS)
Facilitates improved decision making – By summarising key information, and
providing partners with easy access to it, the EIS should help them to be better
informed when making strategic decisions. However, the EIS should also allow
management to drill down to the more detailed operational records to help
understand the reasons for any variances in performance, and to identify ways of
improving performance. For example, they will be able to analyse differences
between budgeted time to complete an audit and the actual time taken.
Amount of information available – The new system should increase the amount
of information that will be available to partners, and the speed with which it
becomes available to them. In particular, the system will allow the partners to
use more up to date (real-time) information than they are currently able to. In
turn, having more information available to them should increase the amount of
analysis that partners, and those supporting them, can perform in relation to any
strategic decisions. For example, if one office has a lot of financial services
clients with specialist requirements, a decision could be made to increase the
number of specialists employed in that office.
There may also be scope to develop new and more relevant KPIs which can be
used in determining bonus payments.
Consistency – Whereas summary data used to come from a range of different
systems, it will now come from a single database, which should again improve
the quality of data available to partners. For example, there should no longer be
any inconsistencies in the data being submitted by different locations, or any
need for manual reconciliations.
Reduced risk – If staff only have access to the parts of the system most relevant
to them, it will reduce the risk of errors or data being tampered with.
Practical issues connected with the introduction of new systems
YSJ's partners will need to consider the following:
(i) Cost – Sufficient funds will need to be available to make the investment,
and it will need to be justified by the expected benefits.
316
Answer Bank
(ii) Staff capability – Staff will need to receive adequate training to use the
system so time and money will need to be provided for this. There may
also be some resistance from staff so open communication is key.
(iii) Choice of supplier – This will be a critical decision and a thorough tender
process will need to be conducted. Considerations of the supplier's
stability and performance will be at least as important as cost and
functionality of the system itself in making a decision.
Tutorial comments
Executive Information Systems (EIS) are expensive to design and implement and
will, by their nature, significantly change business processes and always require a
level of change management to implement successfully. Therefore, this requirement
essentially asks students to present a business case to demonstrate how the benefit
of improved and integrated customer and company performance data can outweigh
the cost and risk of complex IT implementation. Students can often be intimidated
by IT in question requirements and the key to consider what benefits a system will
bring rather than being overly concerned with how the system will work.
Therefore, students are advised in this requirement to firstly explain what an EIS is
and then explain how an EIS system could be adopted in an accountancy practice.
This approach should ensure the answer is relevant to the scenario and written
towards informing the company’s board of partners. In the answer, students should
aim to explain that improved, consistent and timely information will lead to quicker
and more effective decision-making. Additionally, an explanation of the benefits of
improved planning and business processes can also be included. Students must not
avoid discussing the downsides of reliance on IT, the potential loss of data, cost, staff
capability and resistance to change. Practical points such as process of supplier
selection, managing the transition, training and project management are also areas
which will generate marks.
(e) Software purchased by YSJ will be capitalized at Rs 36.25m for tax purposes.
Since YSJ is unregistered for Sales Tax purposes, sales tax paid has been included
in the cost of the Asset. Although software has a life of 15 years, but due to
requirements of Income Tax Ordinance, Software shall be amortized over a 10
year period.
Amortization during the year ended 31st Dec 20X7 will be Rs 2.125m (a period
of 214 days from 1st June till 31st December).
Cost of Intangible Rs'm
Cost 25
Sales Tax @ 17% 4.25
Customization 5
Implementation 2
Total Cost 36.25
Amortization
(36.25/10)*(214/365) 2.125
317
Question No 24 - Chromium Mining Ltd (June 17)
Marking scheme

(a)  1 mark per correct line of the forecast – up to 6
marks total for calculations
 Additional mark for correct treatment of brought
forward losses
 Up to 3 marks for appropriate comments
 Up to 2 marks for stating appropriate assumptions
(b)  1 mark for correct calculation of post-tax cost of
debt
 Up to 4 marks for correct calculation of IRR,
additional 2 marks for post-tax IRR
 Up to 4 marks for correct calculation of cost of
equity
 Up to 4 marks for appropriate comments on
calculations
 Up to 2 marks for reasoned conclusion and
recommendation
(c)  1 mark for citation of relevant ICAP ethical
principles
 1 mark per relevant application of a principle (or
appropriate other ethical principles)
 1 mark for recommending not complying with
request
 1 mark for citation of appropriate corporate
governance principle
 1 mark for recommending that the CEO needs to
bring the matter for Board discussion as soon as
possible
DRAFT REPORT
To: Husain, Finance Director, CML
From: Zaheer Khan & Company, Chartered Accountants Subject:
Financing for Chromium Mining Ltd (CML)
Thank you for commissioning us to report on these matters. Our report is divided into
two sections which deal with the cash flow forecast and evaluation of the financing
packages.
318
Answer Bank
Tutorial comments
The first requirement of Chromium Mining is highly time pressured as students must
first complete a complex cash flow forecast and then use this information to explain
the forecast and how any funding deficits can be funded all in a required report
format. Therefore it is easy to run out of time if students focus too much on perfection
in the calculations. Students who complete the calculations only, and do not have
time to answer the report element, are unlikely to generate sufficient marks to pass
this requirement. Therefore, it is advised students plan the areas of the cash flow,
which need to be completed, and make a judgement whether to attempt areas of
complexity such as calculating the IRR or dealing with tricky tax elements such as
brought forward losses.
Students are always advised to state any assumptions made and to adequately label
each working so a marker can follow the flow and logic of the calculations presented.
A key element of the report is to evaluate different funding options. Here, students
can use pros and cons to provide an argument to support a final recommendation, as
this demonstration of judgement is a higher skill which markers will expect at this
level. This question also requires students to 'recommend how the firm should
respond' so answers should be clear in this respect, with well supported advice for
the Finance Director to discuss with the Chief Executive. Students are therefore
advised to ensure the language in their report is clear and professional.
(a) Cash flow forecast

We have completed a cash flow forecast on the basis of the assumptions provided
(Appendix 1). Unfortunately, this shows that, based on these assumptions, CML
will be unable to make repayments in full on the planned loan from 20Y0
onwards. Obtaining loan finance would therefore not be suitable, especially as
there is a risk that expected improvements in revenue and profitability may not
be realised.
CML could revisit these projections and consider ways of conserving cash. In
particular, the planned capital investment of Rs 800 million per year for 3 years
is very substantial. If this could be reduced or deferred, it would improve the
forecast cash position.
(b) Financing packages
We have calculated the overall cost of finance as follows:
The bank loan will cost 15% before tax, although taking account of tax this will
be 10.5% (15 × (1 – 0.3)). This does assume, however, that CML is making
sufficient profits to pay tax and realise these savings, or else carry forward losses.
The conversion is dependent on the expected increase of 5% per year in the share
price. If the market value of CML shares is below Rs 83 (1,000/12) at the time
of the conversion, the investors will choose to redeem their bonds at par and CML
will need to pay Rs 3 billion in cash. Given that share prices are always
unpredictable, particularly looking five years ahead, this is a significant risk.
CML's position and the uncertainty around its business will increase this risk.
However, if the conversion does take place and the price increases by 5% per
annum as assumed, the cost of the convertible bonds will be 16.9% before tax and
13.5% after tax (W1).
319
For the rights issue, we have used the Capital Asset Pricing Model to estimate the
cost of equity at 15.9% (W2). This will apply to all equity, including that raised
in the rights issue.
The riskiest form of financing will be the bank loan, as payments must be made
regardless of the cash position of CML at the time. On the other hand, a loan
means there is no risk of current shareholders reducing control.
The convertible bond will solve the repayment issue provided the share price is
above Rs 83 at the time of the option to convert. On the other hand, if the
conversion is exercised it will reduce the control of current shareholders. In
addition, no dividends can be paid while the bonds are held so shareholders may
become unhappy about this. On the other hand, the cash flow forecast suggests
that CML may not have sufficient cash to pay dividends during this period, at
least in the latter part of the period.
Given the cash flow issues which CML faces, it would be preferable to raise the
additional finance using a rights issue. This will allow CML to make the necessary
investments to improve the business without facing a short-term need to pay out
cash for interest and loan repayments.
We hope this report is helpful to you.
Appendix 1 – Cash flow forecast
Baseline:
Rs'm
Sales 15,875
Cost of sales (11,310) Gross margin
Gross profit 4,565 28.8%
Other costs (4,374)
Finance costs (390)
Net loss before taxation (199)
Taxation 0
Net loss after taxation (199)
20X8 20X9 20Y0 20Y1 20Y2

Sales 14,288 15,002 15,752 16,540 17,367
Cost of sales (10,030) (10,381) (10,743) (11,280) (11,844)
Gross profit 4,258 4,621 5,009 5,260 5,523
Other costs (3,937) (4,133) (4,340) (4,557) (4,785)
Interest on loan (450) (360) (270) (180) (90)
Other interest (120) (120) (120) (120) (120)
Taxable profit (249) 8 279 403 528
Less losses brought
forward 0 (8) (279) (263) 0
Adjusted taxable profit (249) 0 0 140 528
Tax payable 0 (0) (0) (42) (158)
Profit after tax (249) 8 279 361 370
Add back depreciation 350 350 350 350 350
320
Answer Bank
20X8 20X9 20Y0 20Y1 20Y2

Cash generated from
operations 101 358 629 711 720
Capital investment (800) (800) (800) (200) (200)
Cash from refinancing 3,000
Loan repayment (600) (600) (600) (600) (600)
Opening cash (500) 1,201 159 (612) (701)
Closing cash balance 1,201 159 (612) (701) (781)
Assumptions:
 Apart from capital expenditure, there are no material timing differences
between accounting entries and cash flow.
 This assumes brought forward tax losses can be fully utilised, as well as
losses incurred during the period.
Workings
1 Calculation of cost of capital of convertible loan stock
Work out cost of finance by doing internal rate of return (IRR) calculation
Annual interest payment will be Rs 3 billion x 12% = Rs 360 million.
Assuming shares grow in line with revenue and profits, market value in 5
years' time will be Rs 85 x (1.05)5.
Therefore, predicted share price is 108 and option will be exercised for 36
million shares (3bn/1,000 x 12).
Pre-tax IRR
DF @ 10% PV DF @ PV
15%
Rs'm Rs'm Rs'm
T0 (2,935) 1 (2,935) 1 (2,935)
T1–5 360 3.791 1,365 3.352 1,207
T5 3,888 0.621 3,048 0.497 1,932
1,478 204
IRR = 16.9%
Post-tax IRR
DF @ 10% PV DF @ PV
15%
Rs'm Rs'm Rs'm
T0 (2,935) 1 (2,935) 1 (2,935)
T1–5 252 3.791 955 3.352 845
T5 3,888 0.621 3,048 0.497 1,932
1,069 (158)
IRR = 13.5%
321
2 Cost of capital – rights issue
To calculate cost of capital using rights issue, first need to ungear current
equity beta.
D(1 − T)
βg = βu (1 + )
E
0.4(1 − 0.3)
1.7 = βu (1 + )
1
βu = 1.7 x 1/(1 + 0.4(1 − 0.3)) = 1.328
Regear it with gearing of 0.1
0.1(1 − 0.3)
βg = 1.328 (1 + ) = 1.421
1
Therefore, new cost of equity is 6 + 1.421(13 – 6) = 15.9%.
(c) Memo to manager
Unfortunately, we are unable to make the adjustments suggested in this memo in
order to show CML being able to meet its repayments. It would conflict with key
ethical principles to which we adhere as Chartered Accountants. In particular, the
principle of integrity means that we should not be associated with information
which we believe may be false or misleading. The principle of objectivity means
that we cannot be influenced in this respect by our relationship with CML as a
client. We also have a responsibility to exercise professional competence and due
care, which would not be the case if we knowingly adjusted forecasts in a way we
knew may be misleading.
We could make adjustments to the forecasts, provided the assumptions used are
reasonable and backed up with evidence, or circumstances change following the
initial preparation of the figures. However, in order to safeguard our reputation
and that of the profession, it is important that we do not comply with this request
as it stands.
Another issue raised by the memo is that the breach of loan covenants has not yet
been discussed with the Board of Directors. Section ix of the Code of Corporate
Governance states:
'The CEO shall immediately bring before the board, as soon as it is foreseen that
the company will not be in a position of meeting its obligations on any loans
(including penalties on late payments and other dues, to a creditor, bank or
financial institution or default in payment of public deposit), TFCs, Sukuks or any
other debt instrument.'
The CEO is therefore in breach of the Code and we need to recommend that he
should discuss the breach of loan covenants with the full Board of Directors as
soon as possible.
322
Answer Bank
Question No 25 - SGC Construction (December 17)

Marking scheme

(a) SGC's market environment 5
1 mark per valid point, which could include:
 Competitors
 Government policy
 Levels of government investment
 Economic outlook
 Interest rates and inflation
Key risks facing the company 5
1 mark per valid point, which could include:
 Project overruns – cost control/profitability/client
relationships (dependence on one client)
 Timing of cashflows
 Interest rate rises
 Project resourcing
 Supply chain management and relationships
with subcontractors
(b) Review of company performance 4
1 mark per valid point which could include:
Performance:
 Revenues and profits have declined during 20X7 –
give figures
 Need to control costs in time of declining revenue –
project delays have occurred which have added to costs
 Cash on the balance sheet has fallen sharply, which
could lead to liquidity problems in the future
3
 Question why dividends have been paid in the
circumstances
 Reaction of the private equity firm to the
losses Areas for improvement:
 Over-reliance on government contracts has meant that
when contracts come to an end or there are no
government projects planned, there is nothing in the
pipeline
323
 Question management ability to plan properly – is it
sufficiently entrepreneurial in the new trading
conditions?
 Dependence on a small range of sectors and clients
could limit its ability to grow – competitors are more
diversified and so less threatened by downturns in
particular sectors
 CEO's strategy to increase prices is not realistic
Strengths to develop: 2
 Long history, experienced workforce and well
regarded company
 Successful transition to large projects in the past
 Well placed to take advantage of future opportunities
(c) Strategic options for growth 3
1 mark per valid point which could include:
Diversification:
 How to finance? Include analysis of current gearing
 Strategic 'fit' of a firm of architects; feasibility of
returning to housebuilding market
Product development:
 A good option from environmental standpoint 3
 Any such investment would need proper appraisal in
light of cash outflows – likely resistance from
financiers
3
Market development:
 Investing overseas to grow market has risks –
management experience, control, costs of entry/exit,
foreign exchange
Market penetration:
 Strengthening links with existing customers through 3
winning new contracts
 Understanding and controlling costs will improve
competitive tendering, especially if prices need to be
lowered
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Answer Bank

(d) Recommendation: 9
Residential status and treatment of receipts – 1 mark
Discussion on Pakistan source income – 1.5 marks
Discussion on foreign source income – 3.5 marks
Tax implications of acquisition on SGC – 3 marks
(e) Brand valuation: 6
 1 mark for discussion of brand valuation bases
 2 marks for calculation of brand value using income
 2 marks for discussion of cost basis of valuation
 1 mark for conclusion
Brand management
strategy:
4
1 mark for each valid point covering issues such as:
 Brand identity to appeals to clients in new sector
 Investment in advertising
 Use of existing management team
 Trademark protection
(a) The market environment

The competitors that are described in Exhibit 4 are either more diversified than
SGC in terms of activities, or they operate in more than one geographical market,
or both. As a specialist in recent years in government infrastructure contracts,
SGC may have faced less competition in this sector than if it were targeting the
whole construction market, but the strategy of PDY described in Exhibit 4 may
begin to threaten its position. SGC's dependence on government contracts, with
two-thirds of its annual revenue coming from government infrastructure projects,
could become a threat to future growth if competitors with better cost control and
more competitive tender bids become more active in the market.
As well as being threatened by competitor activity, SGC's operations will be
affected by government policy in Pakistan. Future infrastructure and construction
projects might be restricted by local economic conditions and planning policies.
There is an ongoing threat to the construction market from any sustained
economic downturn, with low overall confidence leading to falling investment.
Pressure on government revenues (such as reduced tax receipts from falling
employment, which also affects consumer purchasing power) may lead to delays
in government investment, or the cancellation of future planned projects. In such
an environment clients are more resistant to price increases, and where projects
are undertaken they are likely to move to lower priced competitors.
325
The condition of the global economy impacts the construction and engineering
industry, with interest rates affecting the demand for projects, as well as SGC's
financing costs. Rates of inflation affect the cost of construction projects and their
long-term returns, creating uncertainty when bidding for new work.
Another important factor for SGC is the behaviour of interest rates, with its large
borrowings. Any increase in interest rates will add to its finance costs, and reduce
profitability. The fact that finance costs in 20X7 are nearly the same as in 20X6,
despite total borrowings being over Rs 12 million less in 20X7, indicates that
interest rates rose, either because of rising market rates, a deteriorating credit
rating for SGC, or a combination of both.
Key risks
For companies involved in long-term contracts such as those undertaken by SGC,
there can be a time-lag between bidding for a project, committing the costs and
then receiving earnings. Project over-runs are a significant risk; these have
occurred at SGC during 20X7 and can present a significant risk to cash flows and
project profitability. Delays in completing projects could deter clients from
working with SGC in the future, which could be a large problem when SGC is so
dependent on the government as its major client.
In 20X7 there was a net cash outflow of almost Rs 17 million relating to finance
flows. If SGC were to miss any of its interest payments or capital repayments this
could lead to the bank demanding repayment, and/or serious difficulties in
obtaining finance in the future.
In addition to the direct effect upon SGC's profitability, interest rate rises can also
have the effect of reducing demand for construction activity, as SGC clients might
not be able to afford to undertake large projects and might put their plans on hold.
Construction projects by their nature are very high risk. They have enormous
financial and resourcing requirements. SGC must make sure that it can guarantee
a supply of technically qualified people, tools and materials. Proper management
of supply chain risk is therefore fundamental to how well SGC performs in the
coming months as it seeks to return to profitability.
SGC needs to make sure that it has continued confidence in the systems that it has
in place to monitor the work of subcontractors and materials suppliers, and that
its procurement procedures are efficient. SGC faces significant risks from any
underperformance by suppliers which would jeopardise the completion of
projects on time and within budget.
326
Answer Bank
Tutorial comments
The priority for students here is to achieve a breadth of relevant and insightful points
in the time available. Given there are 10 marks available, then a split of 5 marks for
market environment points and 5 marks for risk, would be a reasonable assumption.
To do well, students need to actively plan their answers first then select the best five
points, each of which explaining a different aspect of the market. For the risks, again,
answer planning will help to select the most critical risks in terms of potential severity
which expose SGC Construction to financial or reputational loss. With risk, it is
important for students to provide some measure of how severe each risk is and what
the specific drivers creating each risk are. Time management is absolutely essential
to ensure coverage of all available marks, and it is important that students present
their answer as succinctly as possible to avoid running out of time.
(b) SGC is a company with a long history, and is a well-regarded company with a
good reputation. It appears to have been successful at managing change, with the
move from small/medium-sized private sector work to larger public sector
projects having worked well in recent years. It has a highly trained and
experienced workforce, established relationships with subcontractors, and
experience in controlling their activities.
However, there appears to have been an over-reliance on government sector
projects, which could be dangerous if the government cuts its spending and if
competitors such as PDY Ltd become more active in this sector. This already
seems to be happening. During 20X7, SGC lost out on some projects to
competitors and it also had to accept lower margins on certain contracts.
Although management has long experience, it may not be sufficiently
entrepreneurial in the new trading conditions and forecasts of a swift return to
profitability may be optimistic – is management too complacent? The
composition of the Board is small, and it lacks the independent directors that are
needed to challenge the strategic direction that it has taken.
The Board has stated that one reason for the poor financial results is that a number
of projects came to an end during 20X7, but the company must have been aware
in advance that this would happen. Why was the company unable to win new
contracts and fill its order book by replacing the projects that were ending? The
government did reschedule some contracts that SGC had hoped to tender for,
which is out of SGC's control, but there may be some question over SGC's ability
to adequately plan its pipeline of work in advance of projects coming to an end.
Competitors are known to be more diverse in their activities than SGC, and so
may be less threatened by downturns in the public construction sector. SGC's
revenue declined by 30% during 20X7, and its gross profit margin has fallen
from 21.6% to 15%.
The company's overall loss for the financial year 20X7 has contributed to a
substantial fall in its holdings of cash and cash equivalents, down from Rs 19
million to Rs 9.5 million. If the company continues to make losses in 20X8, it
may run out of cash and face a liquidity crisis that could result in insolvency. The
cash flow position was made worse by a dividend payment of Rs 1.5 million,
which seems difficult to justify in the current trading conditions, even though it
is much reduced from the dividend payment in 20X6.
327
The suggestion of the CEO to counter the revenue downturn with price rises on
new contracts will impact future business. The construction market in Pakistan
is very competitive, and higher contract prices are likely to mean that revenues
decline even further as tenders are not won. Additionally, the company's major
customer is the government, which will be aware of its buying power and
therefore likely to resist price rises by accepting tender bids from rival
companies.
Delays on two major projects resulted in higher costs during 20X7. The reasons
for the delays should be investigated, to establish why the delays and the excess
spending occurred. It may be the fault of suppliers, subcontractors or even SGC's
own processes. A high level of costs is likely to be common throughout the
construction industry, but cost control appears to be an issue that needs
addressing by SGC, with its fall in gross margins. PDY Ltd has implemented a
rigorous cost control programme that it believes will make it more competitive,
and more of a threat to SGC.
SGC should ensure that it has contingency plans in place for when subcontractors
or suppliers are unable to perform their obligations, meet standards or otherwise
cause project delays in the future. Failure to do this could result in significant
unanticipated costs, because if a project is delayed or disrupted, significant
resources are tied up and SGC management time consumed.
The private equity firm will want to see a return on its investment, probably
within the next three or four years, and so is likely to become actively involved
in turning the business around from its loss making position. This could mean
SGC losing some control of strategic decisions, the imposition of further cost
control initiatives and possible changes in the senior management team.
Action has already been taken to identify where operating costs can be reduced,
but this should not be at the expense of SGC's reputation for quality. Its proven
ability to deliver on large and complex projects should set the company up for
success when economic conditions improve and the Pakistan government invests
in large new projects in the future.
Tutorial comments
In 1(b), the requirement asks for the main aspects of company performance. Here,
students need to plan to analyse and explain the most important headline points
which are driving SGC Construction’s performance and link these to identified areas
for improvement. A good candidate will cover important aspects such as return on
investment, and cash flow management, as well as revenue growth and margin
analysis. It is vital that accountants use key ratio analysis and use this numerical
evidence in their explanations, which gives their answers professional credibility.
(c) The growth expectations of SGC appear to be unrealistic, particularly if they are
based upon the CEO's tactic of simply increasing prices to offset the revenue
downturn. In the current economic conditions, and with the awarding of contracts
based on a tendering process, it is hard to see how more contracts could be won
in this way.
328
Answer Bank
We do not know whether the banks will be willing to provide additional finance
to support the ambitions of a loss-making business, unless prospects for profits
and cash flow are good, or adequate security is available for any new loans. There
may be too much risk for lending banks, and if banks do agree to lend to finance
expansion, they may demand a very high rate of interest.
Looking at the options identified:
Diversification:
It is not clear how much financing would be needed for an acquisition. Where
will SGC obtain any additional financing that it needs? At the end of 20X7, total
borrowings were Rs 79.5 million, and the balance sheet value of equity was Rs
172 million. These figures suggest that the gearing ratio is not excessively high
(79.5/(79.5 + 172) = 31.6%), and in theory the company has the capacity to take
on extra debt if it wishes to invest in strategies for growth.
The report appears to suggest that acquiring a firm of architects would be an easy
fit with SGC's business, and could help with any expansion plans that it might
have, especially if it decides to move back into residential housebuilding. This
view may be questioned, given that SGC moved away from residential
construction several years ago; it may not be easy to move back into this market,
especially with large barriers to entry in the form of capital requirements and the
presence of competitors such as PDY and RTP with established housebuilding
operations. SGC may no longer have the management expertise in housebuilding
that it once had. It is therefore not clear how an acquisition of a firm of architects
on the back of a return to housebuilding would be easily achievable. Given the
recent poor performance of SGC it is likely to face difficulties in funding a move
back to a previously abandoned market and a related acquisition.
For these reasons, a strategy of diversification into architectural consultancy and
a return to private sector housebuilding is not recommended at this time.
Product development:
Investment in new techniques and solutions is another high-risk business strategy,
given the economic conditions and contraction in SGC's main market. SGC
would need a good reason not to be a part of new investment in materials,
technologies and practices, particularly if its competitors are investing in order to
protect their business reputations, grow their revenues and comply with
increasing global awareness and regulation of environmental issues. However,
SGC does not have sufficient information at the moment to give serious
consideration to a strategy of investing in assets supporting new technologies, and
the commercial viability of new types of construction in its current markets.
Any proposed investment should be subject to rigorous financial analysis. A
major factor in the deterioration in the cash position in 20X7 was Rs 39 million
paid for non-current asset purchases. The company may need to impose a
temporary ban on new asset purchases for at least the year ending 20X8, in order
to limit cash outflows.
With a strong adherence to traditional methods, there is likely to be a certain
reluctance to adopt innovative technologies in the industry, particularly from
SGC's financiers who may not wish the company to invest in unproven methods.
329
In the current economic conditions, such investment by SGC does not appear to
be feasible.
Market development:
The CEO believes that SGC's competitors have been performing better because
they are more diverse geographically. This insulates them to some extent from
local market downturns. However, revenue growth via expanding operations
overseas through the acquisition of BKM does carry some risks for SGC.
While trading conditions remain weak, market development in such
circumstances is a risky strategy to pursue. With the SGC management not having
any experience of overseas markets, there would be a high level of dependence
on the existing BKM team in managing the Malaysian operations, with
implications for control and potential difficulties if there are any problems with
integration of the two businesses. There may be high costs associated with
developing this new market, and high exit costs if there was a need to withdraw.
Risks of expansion in Malaysia via the BKM acquisition would also include
foreign currency translation, as revenues would occur in overseas currency. This
is, however, naturally hedged at least partially by the fact that costs would also
partly be incurred in the same currency. Along with foreign exchange risk
associated with foreign currency payments or receipts, there is potential for
'remittance risk', as some countries will not allow money to be freely moved into
or out of the country.
Market penetration:
Strengthening existing links with the Pakistan government and other existing
customers via successful tendering for new projects represents a strategy of
market penetration. This is likely to be the most viable strategy for SGC at the
present time. However, it would seem important to obtain more information about
the company's current success rate in winning new construction contracts from
the government.
SGC usually participates in a tendering process for new contracts, so a full
understanding of its costs is also very important, particularly as gross margins
have fallen over the past year. SGC must make well-informed decisions on which
projects to tender for, and the prices that are to be charged, and this should lead
to improved profitability. It should be noted that market penetration may involve
the lowering of prices, which contradicts the CEO's wish to increase them, so this
conflict will need to be resolved.
Nevertheless, in SGC's current market climate a strategy of market penetration
would appear to be the best option for the company. If SGC can strengthen its
reputation as a company that is able to deliver quality projects, this should
contribute to achievement of its growth targets over the long term.
By contrast, expansion into new markets, investment in new technologies and
diversification into new activities all appear to be risky strategies, given the
trading conditions and SGC's cash flow position.
330
Answer Bank
Tutorial comments
This requirement requires students to evaluate different strategic options for growth
and use a suitable model, such as The Ansoff Matrix, which provides an effective
framework to efficiently plan and present a good answer. In completing the answer,
students should focus on specific points about how SGC Construction is currently
operating in the industry and avoid general points which could be relevant to any
business. It is very important that the answer includes a recommendation which is
supported by a positive rationale and includes reasons why the other options as less
superior.
(d) Under the Income Tax Ordinance 2001 (ITO 2001), BKM is the resident taxpayer
for the purpose of income tax liability as it is a locally registered company in
Pakistan. Being the resident taxpayer, the following tax provisions apply on
BKM:
1. The receipt of payments (revenues) is considered as 'execution of contract'
within the meaning of section 153 of ITO 2001.
2. BKM is taxed on its worldwide income. Business income of BKM is
Pakistan source income to the extent to which income is derived from any
business carried on in Pakistan. All income derived from Malaysia for
building shopping centres is considered foreign source income.
3. In the case of Pakistan source income, the tax withheld @ 7% under this
section is considered as final tax. If BKM is a listed company, then tax
withheld @ 7% is adjustable against its final tax liability.
4. In case of foreign source income, BKM enjoys the reduction in tax rate.
According to clause 3(a) of Part II of 2nd Schedule of ITO-2001, the tax
in respect of income from construction contracts executed outside Pakistan
is charged at the rate 50% of the specified rates if income from contracts
are brought into Pakistan in foreign exchange through the normal banking
channel. Furthermore, BKM is also entitled to avail foreign tax equal to
the lesser of the following, if it has paid tax in Malaysia:
a. Foreign income tax paid
b. Pakistan tax payable in respect of the income
Tax implications of acquisition on SGC
It appears that SGC is currently a standalone company without any subsidiaries. The
acquisition of BKM is likely to result in a group with SGC as a holding company. SGC
may opt to be taxed as one fiscal unit, subject to meeting the specified conditions.
If SGC opts for group taxation under section 59AA, SGC will be exempt from tax under
clause 103(a) of Part I of 2nd Schedule if BKM pays any dividend. However, setting off
of losses will not be available to SGC as it falls under final tax regime and consequently
attracts the restriction imposed by section 169 of the ITO-2001.
331
Tutorial comments
For the tax requirement, students are advised to explicitly answer the requirement
as stated and remain within its scope. Students can plan a range of answer points
with approximately half of the marks available, to explain the taxability of BKB
Buildings and the remaining marks for the tax implications of the acquisition of
SGC. Residential status and the difference between Pakistan and foreign source
income, are key areas which should be included when planning an answer. Students
are advised to assume the audience for this report are not tax accountants and clearly
explain the relevance of each point.
(e) There are three possible valuation bases which SGC may use to value the BKM
brand:
The market basis – This uses market price and other market transactions. Given
that the nature of a brand is unique and intangible, this would be difficult to apply.
The income basis – This would consider the present value of the incremental income
generated by the brand. Based on the information provided for BKM, this gives a value
of:
Rs'000
Contribution (Rs 33.44 m* x 15%) 5,016
Advertising costs (3,200)
Net contribution 1,816
* Contribution for year per the forecast provided

PV = Rs 1,816,000/0.1 = Rs 18.16 m (using 10% as the discount rate)
The cost basis – this is the current replacement cost of the brand, which is the PV of the
estimated advertising expenditure that would be required, being Rs 3.2 million per
year and with a stated PV of Rs 40 million. The basis on which this value was determined
would need to be considered, including allowance for risk and how the expenditure could
be expected to replace the effect of the BKM brand. With annual advertising
expenditure of Rs 3.2 million, the implied discount rate to give a PV of Rs 40 million is
8%. Further investigation is appropriate regarding this estimate to make sure that it is
realistic.
Given these uncertainties, the BKM brand's current use is its highest and best use,
indicating a value of at least Rs 18.16 million.
Brand management
The current economic climate is challenging for SGC in its local market, and effective
branding to distinguish its construction business from that of its competitors is very
important if it is to manage to achieve growth and new business opportunities in Pakistan
via the acquisition of BKM.
However, the BKM brand is less well known in Pakistan, and if it was to be used by
SGC in a move into building shopping centres, then a local brand management strategy
would be required.
332
Answer Bank
The first requirement would be to establish a brand identity for BKM that will appeal to
SGC's target market in retail construction. SGC's current success in infrastructure
construction is built on its relationships with its clients, materials suppliers, employees,
architects and subcontractors. The brand needs to reflect the image that new clients in retail
construction will want to buy: key features are likely to be contract price and product and
service quality, along with reliability and on-time and on-budget contract performance.
In creating a brand image, SGC must be able to deliver the service and product that its
new BKM brand will promise to clients. New brand initiatives are unlikely to succeed
without substantial investment in advertising. Some reference should be able to be made
to the success of the BKM brand in Malaysia. BKM has spent significant amounts in
recent years on B2B advertising, and SGC might consider applying BKM's existing
advertising strategy to promote the brand and create awareness and recognition.
Strategies may be able to be copied in Pakistan if they translate well to the Pakistan
market and the messages are suitable for standardisation. BKM has a strong management
team – its own brand marketing expertise could be a useful source of experience and
ideas for SGC.
Tutorial comments
Brand valuation can be a difficult topic for students and the key is to consider a brand
to be an asset with a value, like any other asset. A brand will increase the earnings
potential for a business, so valuing this potential increment in profit using DCF
techniques or the cost required to create the brand, will present a range of potential
values which will help management in understanding their brand value. This will create
a business case to invest in brand maintenance in the future thereby safeguarding the
brand’s continuing power to realise its profit potential. It is also important that students
are able to critically evaluate different brand valuation techniques, as the arguments ‘for
and against’ will help a business to determine the most realistic brand value.
The company should also take measures to protect the BKM name, through legal
protection (trademark protection), to prevent rival businesses using the same name or
logo in Pakistan.
Question No 26 - TTA Airlines (December 17)
Marking scheme

(a)  Revenue per week – 2 marks for the calculation
under each configuration up to a maximum of 4
marks
 2 marks for appropriate discussion of the
limitations of the figures and other factors to
consider when deciding upon which configuration
to adopt
 1 mark for a reasoned recommendation
333
(b)  Lease versus buy calculation – 3 marks
 Tax implications under each option – 4 marks
 Factors to consider aside from NPV – one mark per
valid point up to maximum of 4 marks
 Recommendation – 1 mark
(c)  Up to 6 marks for discussion of the three KPIs – 1
mark per suitable KPI identified, and 1 mark for
explaining each one
(a) Seating configuration – revenue generation
15 first class (FC), 90 business class (BC) and 240 premium economy (PE):
First class = (15 x 7 days x Rs 300 k)
= Rs 31,500 k
Business class = (90 x 3 days x Rs 150 k) + (80 x 2 days x
Rs 150 k) + (70 x 2 days x Rs 150 k)
= Rs 85,500 k
Premium economy = (240 x 3 days x Rs 80 k) + (210 x 2 days x
Rs 80 k) + (200 x 1 day x Rs 80 k) + (220 x 1 day
x Rs 80 k)
= Rs 124,800 k
Revenue per week = Rs 241,800 k
20 first class (FC), 70 business class (BC) and 250 premium economy (PE):
First class = (15 x 5 days x Rs 300 k) + (20 x 2 days x Rs 300 k)
= Rs 34,500 k
Business class = (70 x 7 days x Rs 150 k)
= Rs 73,500 k
Premium economy = (240 x 3 days x Rs 80 k) + (210 x 2 days x
Rs 80 k) + (200 x 1 day x Rs 80 k) + (220 x 1 day
x Rs 80 k)
= Rs 124,800 k
Revenue per week = Rs 232,800 k
334
Answer Bank
Over a whole year, the first configuration would generate Rs 469,286 k (Rs 9,000 x
365/7) additional revenue.
The reliability of these revenue figures depends upon the demand forecasts that have
been used. No information has been given on how the market research was conducted,
or where – was it conducted just in Pakistan, or were Australian and other international
travellers also asked for their views?
It may be possible to increase demand for both first class and premium economy seats
under the second configuration, perhaps with targeted marketing promotions to each
group, so as to increase demand. However, any cost of such promotion would need to
be offset against the potential revenue gains.
There could be a bigger problem with the second configuration, however, because
business class is always at full capacity, with demand regularly exceeding the available
seats. It is possible that business class passengers will avoid TTA if the perception is that
TTA does not cater adequately for business class demand. Having experienced some
problems with business class services in the past, TTA needs to make sure that business
class passengers are satisfied with the TTA service on this new route.
Recommendation
For the reasons above, it is recommended that the configuration of 15 first class, 90
business class and 240 premium economy seats be used, as it generates more revenue
per week and has greater flexibility to take on more business class passengers and more
closely cater for market demand within this group.
Tutorial comments
This requirement is a complex calculation, so presentation of logic, source data and
key workings are very important to ensure markers can award method marks as well
as marks for the final answer. Students should consider how easy it is for the marker
to follow their workings, and where in doubt, add notes of explanations, so each step
of the calculation is clear. Here, students should clearly differentiate between First
Class, Business Class and Economy in the presentation of their answers and leave
sufficient time to explain the reliability of their answer and possible ways to improve
the final outcome for the business by enhancing the business model. Students are
advised to use numerical evidence when making the final recommendation, so it is
clear which elements of the calculation directly support the recommendation being
made, even if this feels like repetition.
(b) Financing the new aircraft Lease or buy decision Buying
Cash flow DF PV
Outlay (Rs 5,500 m) 1.0 (Rs 5,500 m)
Residual Rs 2,000 m 0.3855 Rs 771 m
Tax savings (W1) Rs 904.09

NPV (Rs 3,825 m)
335
W1: Tax savings
YEARS
1 2 to 10 10
Rs'm Rs'm Rs'm
Initial depreciation (5,500 x 1,375.00 – –
25%)
Annual normal depreciation –
[(5,500 – 1,375) x 10%] 412.50 412.50
Gain on disposal – – (2,000.00)
Total tax allowance 1,787.50 412.50 (2,000.00)
Tax savings (30%) 536.25 123.75 (600.00)
Discount factor @ 10% 0.9090 5.2355 0.3855
Present value 487.45 647.89 (231.30)
Total PV of tax savings 904.09
Leasing – no break clause
PV rentals (paid in advance) = Rs 700 m x (1 + (AF 9 years 10%))
= Rs 700 m x (1 + 5.759) = (Rs 4,731 m)
PV of tax savings of lease = Rs 700 m x 30% x (AF 10 years 10%)
rentals
= Rs 210 m x (6.1446) = Rs 1,290 m
NPV (4,731 m – 1,290 m) = (Rs 3,441 m)
Leasing – break clause
PV rentals = Rs 700 m x (1 + (AF 4 years 10%))
= Rs 700 m x (1 + 3.170)
= (Rs 2,919 m)
PV of tax savings of lease = Rs 700m x 30% x (AF 5 years 10%)
rentals = Rs 210 m x (3.7908) = Rs 796 m
PV penalty (net of tax of 30%) = Rs 1,900 m x 0.7/(1.1)5
= Rs 826 m
NPV (2,919 – 796 + 826) = (Rs 2,949 m)
Comparison
The full lease term of 10 years is comparable with the expected useful life of the
asset if it is purchased. Over this period using the assumed discount rate of 10%,
leasing the aircraft is the lower NPV option, and on this basis should be the option
that is chosen.
In both options, TTA would achieve significant tax savings due to admissibility
of depreciation and lease rentals over the useful life.
However, the decision should not be taken on the basis of NPV alone. There are
a range of other factors that should be taken into account, particularly as the
difference in the two NPVs is relatively small and may be sensitive to changes
(e.g. in the interest rate or in the tax rate).
336
Answer Bank
Liquidity may be a key consideration. The purchase of aircraft requires an initial

payment. This may be possible from available cash reserves (we have no balance
sheet information on this) or the total of Rs 11,000 million for the two aircraft
needs to be financed (for example by bank borrowings). If the company does not
have the available cash, and is near debt capacity, then leasing may be the only
available choice, notwithstanding the higher NPV associated with this option.
Risk is also a key factor. If demand for the Karachi to Sydney route is not
popular, it may be possible to use the aircraft on other routes. If however the
aircraft are only really suitable for this route, or if there is a general fall in demand
for TTA flights globally, then the costs of grounding the aircraft for substantial
periods or disposing of the aircraft needs to be considered.
In this respect, the break clause offers an exit route after five years which gives
a lower NPV than both leasing and ownership. However, the penalty cost is
substantial. In addition, while the lease break clause is available after five years,
anticipated demand is likely to be examined again before that time (in the
scenario, it is stated that demand will remain consistent for the next few years
only). If such an analysis of demand after, say, three years shows that demand
does not justify the leasing of the aircraft, then the lease contract would be
regarded as onerous for two years. An 'onerous lease' is one where the cost to
fulfil the lease terms are higher than the financial benefit that is received.
Recommendation
There are benefits to both methods. Unless the preliminary market research that
has been undertaken has a high degree of certainty regarding strong levels of
demand, then the purchase of one aircraft and the leasing of the other with a
break clause may give TTA some flexibility if demand is lower than expected.
Tutorial comments
There are two critical aspects in the lease or buy decision which students need to
include. The first is ensuring all tax consequences of each decision are included,
whether this is tax allowances available on purchase, or tax savings on leases as the
expense is tax deductible. The second is to apply the same discount rate to both the
lease and buy decisions as this is a comparison between two options. This can feel
counter-intuitive to students as the source of finance for each decision can be
different. Often the cost of borrowing is used as the discount rate to evaluate both
the lease and buy decision. However, non-financial factors and added risks need to
be considered as well as the financial argument, therefore students are advised to
invest sufficient time in ensuring the discussion of non-financial factors and added
risks have breadth and depth, so the resultant recommendation is supported by a wide
angle of supporting factors.
(c) Strategy drivers and key performance indicators (KPIs)

KPIs should be quantifiable measures that can be used by TTA for setting
strategic targets and monitoring actual performance by comparing actual with
target.
It is assumed that the board has identified appropriate strategy drivers for the
business, and the only requirement in this report is to suggest measures of
performance that may be appropriate for these drivers as KPIs.
337
Geographic expansion
This strategy driver refers to geographical expansion of operations, since TTA
already operates flights to several parts of the world. Geographical expansion
should be planned and targeted at particular countries or regions. However,
suitable KPIs might be:
 Growth in annual sales revenue in specific geographical areas (such as
Australia)
 A measure for total sales growth in geographical areas where TTA has
established new routes within the previous three to five years
 Number of new routes launched
Promoting the TTA brand
Successful promotion of the TTA brand should result in growth in ticket sales as
well as growth in the packages described above. This strategy driver therefore
overlaps with selling holiday packages. The success of a brand is evident in sales
revenue and profit; but the strength of the brand also depends on customer
perceptions, which may change over time. Success in selling the TTA brand
should also be measured to some extent in terms of customer feedback.
Recommendations for KPIs are therefore:
 Percentage annual growth in sales
 Operating profit margin
 A suitable measure of customer response to the TTA name, such as brand
awareness, as measured by an annual market research survey or even
research into perceptions of TTA's performance on the new route between
Karachi and Sydney
Selling holiday packages
The board of directors presumably believes that there is potential for future sales
growth with holiday packages where passengers can book a hotel as well as their
flight, possibly because such a service provides a higher profit margin.
Recommendations for KPIs are therefore:
 Percentage annual growth in sales revenue from these packages
 Average operating profit margin on these packages
338
Answer Bank
Tutorial comments
It is vital when answering part 2c, that students avoid a generic discussion of key
performance indicators (KPIs). Students must consider what other management
information is crucial to understanding company and product performance, besides
the usual ratio analysis which all companies tend to use. The key is to consider the
critical success factors which drive consumer demand for the company’s products
and its specific costs drivers which will drive down margins. Students should then
aim to create KPIs using company operational and financial data which measure if
a company is currently achieving its potential. Additionally, focusing on the
different possible growth strategies will help identify different KPIs the company
should be measuring. Students are advised to be clear in their identification of each
KPI and explain why measuring each KPI is helpful to management in its decision-
making.
Question No 27 - Paragon Fitness Ltd (December 17)

Marking scheme

(a)  1 mark for calculation of working capital in 20X5,
20X6 and 20X7
 Up to 3 marks each for an appropriate discussion of
each of the three options, up to a maximum of 9
marks in total, to consider the effect on working
capital cycle (2 marks) and appropriate financing
options where relevant (1 mark)

(b)  1 mark for explaining the importance of human
resources management in an acquisition
 Up to 7 marks for appropriate identification and
discussion of the human resources issues that would
be important in this situation

(c)  2 marks for citation of the relevant ICAP ethical
principles
 1 mark for discussion of each principle, up to a
maximum of 4
 1 mark for commentary upon appropriate courses
of action
339
(a) The working capital of PFL is calculated as follows:
20X5 20X6 20X7
Rs'm Rs'm Rs'm
Inventory 1.8 2.1 2.0
Receivables 3.5 3.2 3.4
Cash 8.6 16.0 16.7
Payables (16.5) (15.2) (14.0)
Advance membership income (9.0) (9.5) (10.0)
Working capital (11.6) (3.4) (1.9)
PFL has negative working capital for each of the years under consideration. If
we look at the components of working capital we can identify that this is partly
the result of large balances of advance membership income (income received
where PFL has not yet provided the related service). This is consistent with the
fact that monthly memberships are paid for by members in advance.
The negative working capital figure reduced to Rs 1.9 million in 20X7, as a result
of the company choosing to significantly reduce its capital expenditure which
significantly improved its cash balances.
Management of centres
This possible new business venture has a very different cash operating cycle. If
the proposal is taken up by PFL, it is important to recognise that this is a very
different business model to PFL's current activities.
PFL receives its membership revenues in advance of paying the related operating
costs at the fitness centres, and therefore has a negative cash operating cycle as
described above. The new proposal would be very different, as the revenue would
consist of a management fee which would be payable six monthly in arrears. It
is assumed that property related occupancy costs would not be the responsibility
of PFL under the arrangement (as can be seen from the statement of profit or
loss, these can be significant) but staff related costs would be.
The total staff related costs for PFL are Rs 26.5 million for 20X7. This is based
on 15 staff per fitness centre together with head office staff. If we assume that
there would need to be a proportionate increase in staff as a result of the new
arrangement, then an estimate of the annual level of additional staff costs
required to manage these six gyms can be established.
Six additional sites would require an additional 15 x 6 = 90 staff. However, the
new sites are only half the size, so 45 staff would be required. This would
represent additional costs on a pro rata basis 45 staff/150 staff x Rs 26.5 m = Rs
7.95 m.
Given that the management fee will be payable six monthly in arrears, PFL will
need to finance an increase in working capital equal to half of Rs 7.95 million,
which is Rs 3.98 million. In reality this figure is likely to be somewhat larger, as
it is likely that some proportion of other operating costs will also be incurred. On
its own the figure of Rs 3.98 million represents 24% of year end cash, and this
may be difficult for PFL to finance while also maintaining a sufficient buffer of
cash and continuing to pay down the revolving credit facility.
340
Answer Bank
This effect would be mitigated if the terms were altered such that management
fees were payable monthly. PFL may be allowed to offer personal training
services through the gyms, which would also improve cash flow as fees are
received in advance.
Accelerated investment
In order to meet the competitive threat, the COO believes that PFL needs to
accelerate its capital expenditure plans. At the 20X7 year end, the company had
Rs 16.7 million in cash and unused revolving credit facilities of Rs 14 million.
Although this might cover the anticipated additional capital expenditure spend,
the full amount of Rs 30.7 million of available cash cannot be used as the
company needs cash as working capital. Current cash resources are therefore not
going to be sufficient to meet the cash needs that accelerated investment would
necessitate.
Therefore the options are to scale down the level of accelerated level of capex to
the point at which it can be met by available resources (which may not be enough
to counter the competitive threat), or seek additional sources of finance. The
company currently has a low level of gearing (26/(26 + 74.3) = 26%, and a high
level of interest cover (20.2/1.1 = 18 x), so raising additional debt may be a viable
option.
A simple option that could be considered would be to approach PFL's current
bankers and seek a term loan. The amount borrowed could also include the
outstanding amount of the revolving credit facility which is due for renegotiation
in 20X9.
Another alternative would be to raise additional equity from shareholders
/sponsors, which is typically a quicker way of arranging finance and is
comparatively less costly than arranging a loan.
Acquisition
The purchase of the Prime Performance Ltd (Prime) fitness centres for Rs 45–
55 million would represent a very significant transaction. Clearly PFL would be
unable to fund this from existing cash resources. Therefore the company would
need to raise a significant sum, either by raising debt (such as a loan) or an issue
of equity.
Beyond the purchase price of the clubs there are a number of other factors that
will have an impact on PFL's cash flow. It is a common mistake for businesses
to fail to take into account the additional cash requirements that acquisitions and
significant asset purchases cause.
 There will be additional finance to service, either through additional
interest or dividends.
 There will also be one-off costs of raising finance. In the case of an equity
issue there will be fees paid to advisors. In the case of a loan it is likely
that some level of arrangement fee would be payable.
 Therefore it is essential to perform a due diligence exercise on the
potential acquisition to uncover any unexpected cash outflows that might
be required and also to appraise the budgets and forecasts that have been
prepared by Prime's management.
341
 As PFL would be buying the fitness centres and not the business, there
would be a need to refurbish the clubs in order to rebrand them.
 There will be a need to hire staff for the clubs. This is likely to be effected
by transferring the employment contracts of existing staff, but there is
likely to be a level of costs to achieve this.
 Additional management resource will be required to manage the acquired
operations.
 Clearly there will be a need for PFL to meet the ongoing costs related to
the acquired clubs, but the business model is likely to be similar to that of
PFL, with a negative cash operating cycle. This will, in effect, represent
additional funding for PFL from the acquired business.
Tutorial comments
The measurement and explanation of working capital management is an area many
students are prone to over complicate. The key is understanding the severity of the
impact on cash flow when holding inventory and offering sales on credit terms.
Students are advised to consider how the time lag between working capital
investment and receiving revenue cash flows is currently being funded. The longer
the funding period, then the greater the costs in terms of actual interest paid in
borrowings and also the lost opportunity of not being able to use this finance to fund
further revenue growth activities. There is also the added risk that the company will
run out of cash. By adding together the net cash, receivables, payables and inventory
over time, it provides a trend of the required capital to maintain the required working
capital.
At a strategic level, management should always consider creative ideas to reduce

the working capital requirement through more efficient inventory management
systems and changes to credit terms offered and received. A change in strategy will
impact the working capital requirement. Therefore, it is important to consider this
as part of the strategic decision making process, particularly if a change in strategy
results in high working capital levels which are difficult to maintain and may change
the profitability of the strategy being considered.
Students are advised to place more weight in the discussion of strategic options and
the impact on working capital rather than overly focus on the calculation of working
capital trends over time.
(b) Importance of HR in the acquisition process

The Chairman's concern about the 'people' aspect of the deal appears justified,
because a number of the key issues involved in an acquisition relate directly to
human resource issues. Although in this case the people-related issues may have
a higher profile due to ongoing disputes at Prime Performance, human resources
are important in relation to any acquisition. 'People' issues – poor cultural fit, or
poor communication – can often be the reason why acquisitions do not prove to
be as successful as had been hoped.
342
Answer Bank
The following issues could all be important when trying to integrate Prime with
PFL if the acquisition goes ahead.
 Communicating to staff in both companies, and addressing any concerns
they may have about the acquisition. Staff (particularly at Prime) might
even resist the acquisition, and the change and uncertainty associated with
being employed by a new company.
 Dealing with any redundancies which may be necessary. The issue of
redundancies is likely to be particularly sensitive at Prime, given the
redundancies which have already been suffered following the introduction
of new working methods. PFL will have to give careful consideration to
how it handles any future redundancies.
 Integrating the organisational cultures of the two companies. At this
point, little is known about the culture within Prime, but it is known that
it operates at the premium end of the market. PFL has, by contrast,
restricted investment in its centres in recent years, so it is unlikely to be a
premium brand. If PFL's organisational culture contrasts sharply with that
of Prime, then Prime staff could feel threatened, particularly if working
methods and expectations of staff in terms of skills and performance are
very different between the two companies, or if Prime staff do not want to
be associated with lower quality facilities.
 Retaining key members of staff and key managers. Although
acquisitions often cause staff redundancies, it is also important that key
members of staff are retained wherever possible. In this case, it could be
particularly important for PFL to retain key centre managers and staff who
are known and trusted by members while the transition to PFL branding
and operations takes place. This might be difficult, given the likely cultural
differences between the companies and their respective offering to
members.
 Aligning the remuneration and reward systems of the two companies
as far as possible. For example, if there are differences between typical
salaries and training programmes received by Prime staff and those
received by PFL staff for the same job, and the employees become aware
of these differences, this could lead to discontent if systems are not aligned
to some extent (although there may be limits to how far they can be exactly
matched). PFL pays some centre managers well, with a generous bonus
scheme and remuneration above the industry average, but there is also a
high level of turnover of junior staff and investment in training appears to
be lacking.
 Deciding on HR policies and practice for the new centres. For example,
if Prime and PFL currently have different policies in relation to holidays
or reward systems, it seems likely that these will have to be made
consistent as far as this is possible.
343
Tutorial comments
Many students can miss the point that organisations need a HR strategy in order to
achieve a company’s strategy for growth. The HR strategy is devised in parallel with
the company’s strategy so to supply the required employee numbers and skillsets in
the required locations at the right time as the business grows. The HR strategy must
therefore include objectives for training and retraining to achieve changing
workforce skill requirements, talent retention through appropriate reward and
remuneration mechanisms, recruitment of key skills to meet skills gaps, and
potentially the removal of skills no longer required by the business through a
redundancy process. Often cost or profit centres can operate differently so can have
different HR policies, particularly, if these are situated in different parts of the world
where the labour market is different. Students are advised to keep differences in
employment terms to a minimum across a business so the organisation has a
consistent approach to all its employees on the basis of fairness.
(c) As ICAP chartered accountants, Faisal and Izad Malik should demonstrate
adherence to the ICAP Code of Ethics, and the five fundamental ethical principles
that are laid out. The principles of integrity, objectivity, professional competence
and due care and professional behaviour are all relevant here.
Integrity
The principle of integrity involves being straightforward and honest in all
professional and business relationships. Integrity also implies fair dealing and
truthfulness.
 Faisal and Kashif Malik are faced with a dilemma: should they be open
and honest about the issue, or should they suppress it? They have a
responsibility to be straightforward and honest with the information
contained in the report. By keeping the report private, they are keeping
important information out of the public domain, even though they believe
that the report is unfair in its depiction of PFL.
 Izad Malik's behaviour in complying with the decision not to act upon the
information has also brought his integrity as a chartered accountant, and
that of PFL, into question. He has also told his daughter not to make
any public comment on the situation. However, he has subsequently
disagreed with Faisal and Kashif, believing that the report should be
published, that PFL can legitimately defend itself. He is now conducting his
own enquiries into what improvements are required. This represents a more
ethical course of action than suppressing the report.
Objectivity
The principle of objectivity means that bias, conflict of interest or undue influence
should not be allowed to override professional or business judgment. In addition,
relationships that may impair objectivity should be avoided.
 Faisal was allowing bias and a conflict of interest to influence his
behaviour when he decided not to close the affected centre, and, along
with his brother, to consider covering up the critical report.
344
Answer Bank
 Izad contravened this principle by appointing his daughter as interim

manager when she was not qualified for the role. He continued to show a
certain level of bias in certain subsequent actions to cover-up the situation
(for example by asking his daughter not to make any public comment) but
as the situation has developed he has become more concerned about
dealing with the situation objectively. He has advocated that the report be
published, and launched an investigation of his own, demonstrating a
more ethical stance.
Professional competence and due care
The principle of professional competence and due care implies the need to act
diligently and in accordance with professional standards.
 Faisal has contravened this principle because he did not take appropriate
action on the letter when it was originally received, concerning possible
damage to the building. It could be argued that he failed to carry out his
duties diligently, or to exercise professional competence, even though
there was no firm evidence that there was a safety issue.
 Faisal has an obligation to act diligently on behalf of employees,
shareholders, the board, customers and the general public. Faisal and
Kashif both have a responsibility to conduct themselves in a manner
consistent with the reputation of PFL, and in Faisal's case, the standards
expected of a chartered accountant.
Professional behaviour
This is the requirement to comply with laws and regulations, and avoid action that
discredits the individual's profession.
 By deciding to keep the report private, Faisal and Kashif could be
covering up negligence that has potentially been committed by staff of
PFL in failing to act upon information received.
 By contrast, Izad's belief that the report should be published, and that PFL
should defend itself openly against allegations of a poor approach to
safety, is a more ethical stance to take.
345
Tutorial comments
The final requirement focuses on the company’s compliance with the ICAP Code of
Ethics and therefore it is vital students use the ICAP Code of Ethics to plan and
structure their answer. Students should be using evidence from the scenario to
consider how well the company is demonstrating integrity, objectivity, professional
competence and due care and professional behaviour; or whether there is evidence
of perception risk through its activities that the company’s ethics, as less than would
be expected by key stakeholders. It is also important students explain the implications
of the company’s actions, and where appropriate, provide an explanation of each
alternative course of action the company could pursue.
Question No 28 - XYZ Industries (June 18)

(a) (i) NPV calculation
 Outlay 0.5
 Operating profit excluding depreciation 0.5
 Discount factor 0.5
 PV in RM 1
 Exchange rate 0.5
 PV in Rs 1
Recommendation and conclusion based upon NPV 2
Total marks available 6 marks
Maximum awarded for this section 5 marks
(ii) Exchange rate risk and sensitivity analysis
 Transaction exposure
2
 Economic exposure 2
 Translation exposure 1
Strategy 1
 All operating cash flows in ringgit – effect of 2
strengthening or weakening
1
 Revenues will arise in other currencies
2
 Sensitivity calculation and interpretation
Strategy 2
1
 Smaller outlay reduces the risk
2
 Mismatch between costs in rupees and revenue
in ringgit challenge the assumption that there
would be no ringgit costs 2
 Sensitivity calculation and interpretation
346
Answer Bank
(iii) Benefits and risks of each strategy

Strategy 1
Benefits:
 Benefits associated with strategic presence in
customer location
2
 Closer communication with customers
 Transport links quicker/cheaper
 Local production 1
1
Risks:
1
 Ability to cope with demand
Strategy 2
Benefits: 2
 Benefits associated with the established
factory in Hyderabad
Risks:
 Both made to order and standard equipment
needs to be transported from Pakistan first 2
 Transport issues identified as the
major differentiator between the two strategies
 Fewer maintenance staff to carry out both
routine and emergency tasks
Recommendation as to preferred strategy taking account of 1
NPV and other factors
2
2
(b) Proposed debt finance methods for Strategy 1

Currency:
 Preferable to borrow in matching currency
 Borrowing in ringgit will match cash flows with the 2
liability and provide a 'hedge'
1
347
Parent or subsidiary:
 Reasons why it is likely to be easier for XYZ to
access the required finance 2
 XYZ able to negotiate cheaper borrowing rate
 MEI may encounter more difficulty in
1
borrowing Terms of loan agreement:
1
 Differing lengths of loan and implications of this
 Effect of local laws
Recommendation on which method to adopt, with reasons 2
1
2
(c) Discussion of income tax implications

 Sales of made to order equipment 2
 Restrictions 2
 Computation of export profits 3
 Repair services 3
(d) Ethical concerns:

 Family relationship 1
 Threat to commercial interests of MEI 2
 Director's duties to other stakeholders 2
 Transparency of any arrangement 1
 Effect of any arrangement 1
 Fairness of any arrangement 1
 Appropriate safeguards 2
348
Answer Bank
Alternative strategies
(a) (i) NPV
Strategy 1
1 Jan 31 Dec 31 Dec 31 Dec 2021
2019 2019 2020 and Total
thereafter PV
Investment (195,000)
RM'000
Operating CF RM'000 * (305) 27,475
DF 10% 1 0.826 8.264 **
PV RM'000 (195,000) (251.9) 227,053.4 31,801.5
Exchange rate 25 25 25
PV Rs'000 (4,875,000) (6,297.5) 5,676,335 795,037.5
* Operating loss/profit, adjusted for depreciation
** 8.264 = (1/1.12)/0.1
Strategy 2
1 Jan 31 Dec 31 Dec 2020
2019 2019 and thereafter Total PV
Investment RM'000 (12,500)
Operating CF 2,750
RM'000*
DF 8% 1 11.574 **
PV RM'000 (12,500) 31,828.5 19,328.5
Exchange rate 25 25
PV Rs'000 (312,500) 795,712.5 483,212.5
* Operating profit, adjusted for depreciation
** 11.574 = (1/1.08)/0.08
The NPV of Strategy 1 is Rs 795,037.5k while that of Strategy 2 is Rs 483,212.5k.
While it is important in investment appraisal to take a range of factors into
account on initial indications of relative NPV's, Strategy 1 is to be preferred.
(ii) Exchange rate fluctuations Strategy 1
The initial outlay is at a known exchange rate and is therefore, in effect, fixed in
Pakistani rupee terms. All subsequent operating cash flows are in Malaysian
ringgit for Strategy 1. A significant depreciation of the Malaysian ringgit against
the rupee would make cash inflows to XYZ less valuable and therefore make it
more difficult to recover the initial outlay. It is also possible that the ringgit could
strengthen against the rupee over time, which would increase the NPV of the
strategy.
This risk is known as 'economic exposure', being the risk that the present value
of cash flows arising in Malaysia might be reduced by adverse exchange rate
movements over the longer term and in the normal course of business.
349
'Transaction exposure' is used to describe changes in near-term cash flows that
have already been contracted for. This arises when amounts are fixed in foreign
currency terms (say, a remittance from Malaysia to XYZ) and there is movement
in the rupee/ringgit exchange rate between the date when the ringgit amount is
agreed and the date when the cash is received and translated into rupees.
Hedging activities may be undertaken to fix the applicable exchange rate in
advance, and so be certain of how many rupees will be received. There are a
number of factors for XYZ to consider before getting involved in hedging
activities, such as their cost (many hedges require use of a bank or an exchange,
which means transaction costs) and the size of the exposure that XYZ is
expecting.
Simple hedges, such as forward contracts, are not expensive, but it is also worth
noting that XYZ may not have the necessary expertise to undertake hedging
activities, as its operation has so far been concentrated in Pakistan. Many
companies choose not to hedge, making spot foreign currency transactions, as
the need arises.
Such exposures can also be hedged by matching assets and liabilities. XYZ can
hedge against the possibility of a declining ringgit by borrowing in ringgit and
using ringgit sales receipts to repay the ringgit loan.
The sensitivity calculations (see below) show that a one-off exchange rate shift
of 14% depreciation of the ringgit against the rupee would generate a zero NPV.
Other exchange rate considerations for Strategy 1 are that revenues will be
generated from other south-east Asian countries, and this revenue will also be
subject to fluctuations of their currencies against the ringgit, and ultimately
against the rupee, thereby increasing the exchange risk.
Strategy 2
As in Strategy 1, the initial outlay is at a known exchange rate and therefore fixed
in rupee terms. The key difference is that the outlay is much smaller for Strategy
2 at RM 12.5 million, compared to Strategy 1 at RM 195 million. The risk of
future cash flows not covering this outlay is therefore reduced.
However, the working assumption is that the operating cash outflows are all in
rupees, whereas the revenues are generated in ringgit. There is therefore a
currency mismatch, because if the ringgit depreciates against the rupee, then
revenues in rupee terms fall, while costs remain constant. As with Strategy 1,
hedging activities could be undertaken to reduce the economic and transaction
exposure that could arise.
The sensitivity calculations (see below) show that a one-off exchange rate shift
of a 5.9% depreciation of the RM against the rupee would generate a zero NPV,
based on the data provided.
This makes Strategy 2 more sensitive than Strategy 1 to exchange rate
movements, based on the assumptions that have been made.
350
Answer Bank
Sensitivity calculations Strategy 1

Initial outlay = Rs 4,875,000
PV inflows = RM 226,801.5 (227,053.4 – 251.9)
Break even exchange rate = Rs 4,875,000/RM 226,801.5
= 21.4946
This represents a 14% depreciation of the ringgit against the rupee ((25 –
21.4946)/25)
Proof (not required for answer)
1 Jan 31 Dec 31 Dec 31 Dec 2021
2019 2019 2020 and thereafter Total PV
Initial outlay (195,000)
RM'000
Operating CF
RM'000 (305) 27,475
DF 1 0.826 8.264
PV RM'000 (195,000) (251.9) 227,053.4 31,801.5
XR 25 21.4946 21.4946
PV Rs'000 (4,875,000) (5,414.5) 4,880,422.0 7.5
Note. The PV is not exactly zero, as the calculation is subject to rounding as a

result of the number of decimal places used in the exchange rate.
Strategy 2
All costs are incurred in rupees and are therefore unaffected by exchange rate
movements.
Note. Some professional scepticism must be applied to the assumption that all
costs are incurred in rupees. Some costs are likely to be incurred in Malaysia, in
ringgit.
Only revenues are affected:
PV revenues in RM= (RM 28,170 x 0.926***)/0.08 = RM326,067.75
NPV in RM = RM 19,328.5
The PV of the costs (being RM 326,067.75 – RM 19,328.5) is Rs 7,668,481.25
(at RM 1 = Rs 25)
For revenue of RM 326,067.75 to be worth Rs 7,668,481.25 (i.e. at break-even)
then the exchange rate will be RM 1 = Rs 23.518
% Sensitivity (25 – 23.518)/25 = 5.9% depreciation of RM against the rupee
*** 1 year discount factor at 8%
351
(iii) Benefits and risks associated with each strategy
Both Strategy 1 and Strategy 2 offer the opportunity for XYZ to enter new
geographical markets. However, XYZ offers a range of different types of
products and services which contain different risks, and so will require different
management. This is where the suitability of each strategy for each product and
service needs to be evaluated. Summarising the information in the scenario, XYZ
offers made-to- order equipment that is specified by customers, as well as
standard items that are supplied from inventory. Servicing and maintenance
comprises routine maintenance and servicing, and unplanned emergency
situations.
Strategy 1
MEI, operating under Strategy 1, will have a greater strategic presence in the
geographical location of the customer (Malaysia and south-east Asia) and this
may constitute an advantage over Strategy 2, as it is likely to be more closely
aware of the risks that are presented by the specialist needs of mining companies
in the region, and the need for specialist equipment. MEI is also likely to be in
closer regular communication with customers than it could be maintained by
XYZ head office in Pakistan with its greater geographical distance, time
differences etc.
XYZ will need to make sure that it can cope with forecast demand, and that it
will be able to find the skilled staff and develop the supply chains that will be
required.
Assuming that such concerns can be addressed, and production is successful in
Malaysia, the finished equipment is closer to many of the potential customers, so
transport links by sea will be comparatively quicker and cheaper than under
Strategy 2, reducing the risk of delayed delivery. This represents a significant
advantage.
For standard equipment, holding sufficient inventory to reduce lead time and
guarantee a certain level of service will reduce the risk of not being able to fulfil
an order. Having a local manufacturing facility and local suppliers will enable
MEI to adjust inventory levels quickly from local production. This will be more
flexible and adaptable, and levels of inventory and holding costs are likely to be
lower.
To supply emergency maintenance there needs to be local and skilled staff, and
this is supplied under both strategies. However, it seems more achievable with a
factory that makes the equipment being located in Malaysia, particularly if some
components are needed as part of the maintenance.
Strategy 2
Agile and adaptable manufacturing systems are key to being able to commence
manufacturing as soon as a request for an item of made-to- order equipment is
received. The current Hyderabad factory which would be used in Strategy 2 is
both larger and longer established, and this may therefore provide an advantage
in terms of adaptable manufacturing over the new factory that is to be established
under Strategy 1, especially when considering that the new factory has a smaller
capacity.
352
Answer Bank
However, in order to supply Malaysia and the rest of the south-east Asian market
under Strategy 2, both made to order and standard equipment will need to be
transported from Pakistan first, probably by sea, as air transport is not feasible.
Standard items can be held in the distribution centre for later delivery to
customers, as orders arise, while made to order items could be delivered directly
to the relevant customer. This all involves considerable distance, cost and time,
and may lead to the risk of delayed deliveries for made to order goods. The
transport of the goods to customers, particularly those that are made to order, is
the major differentiator between the two strategies.
As previously noted, the number of maintenance staff is much lower under
Strategy 2. This is probably reflective of lower forecast sales, but lower staff
numbers could affect the ability of XYZ to carry out routine and emergency
maintenance and repairs effectively.
Preferred strategy
The NPV of Strategy 1 is Rs 795,037.5 k while that of Strategy 2 is Rs 483,212.5
k. It has already been noted that it is important in investment appraisal to take a
range of factors into account, in addition to the NPV. Having done this, Strategy
1 is favoured here.
For both made to order and standard equipment, Strategy 1 is preferred, unless
the customer knows significantly in advance of delivery which items of
equipment will be needed. If a piece of equipment breaks unexpectedly and needs
to be replaced it would be difficult, under Strategy 2, to make and supply it
rapidly from Pakistan.
While the initial cost of Strategy 1 is much greater than Strategy 2, it is closer to
customers in Malaysia and south-east Asia, and reduces transport costs for the
delivery of finished equipment. Materials and components are also supplied
locally. Revenues are higher under Strategy 1, presumably because more types
of product can be supplied.
As far as maintenance services are concerned, both strategies would involve the
recruitment of additional staff, but Strategy 1 may be preferred because it
involves the recruitment of more staff, supported by operations at the local
factory.
353
Tutorial comments
There are two net present value (NPV) calculations in the first part of this
requirement which will be disproportionately time consuming if perpetuity factors
are not used and a consistent presentational framework is not applied. Students are
reminded at MSA level, that markers will expect that all numerical results are
explained.
The second part of this requirement is to explain exchange rate fluctuations. Here,
complicated re-calculations are strongly advised against. Instead students are advised
to re-measure the NPV if the rate moves adversely say by 15% or 20%. This will
provide some information as the sensitivity of each strategy to exchange rate
volatility. Remaining time can then be applied to advising how exchange rate
volatility can be minimised either through offsetting measures within the business or
by suitable hedging techniques.
The final part of this requirement is to explain the strategic importance or benefit of
each strategic option which in some ways is the most straight forward part. However,
it is likely to be the case that significant time has already been spent on the first two
parts of this requirement and therefore the challenge is to present a sufficient answer
in the time remaining. Students are advised to focus on ensuring there is balance
between the two options in their answer and to cover briefly as many points and very
importantly, leaving time to present an argument for the preferred strategy and make
a recommendation.
(b) Methods of finance

The key differences in the methods of debt finance for Strategy 1 are:
• The currency in which the debt is denominated
• Whether XYZ or MEI should take out the loan
• The terms of the loan arrangements
Currency
Under Method A, the loan is raised in Malaysian ringgit, while with Method B,
it is raised in Pakistan rupees.
Strategy 1 generates operating profits in ringgit, and this presents a currency risk
to XYZ with its functional currency being the Pakistan rupee.
Borrowing in ringgit means the currency of the loan will be matched against
ringgit denominated net operating cash inflows. Assets are based in Malaysia and
are valued in ringgit. Having a ringgit denominated liability will therefore also
provide a hedge against exchange rate movements that would affect asset values.
Moreover, borrowing in rupees would involve more frequent foreign currency
inflows and outflows, which would involve transactions costs and taxation issues.
Thus borrowing in ringgit (Method A) is a more effective method than borrowing
in Pakistan rupees (Method B).
354
Answer Bank
Parent or subsidiary?
XYZ, as an established company, may be more able to raise a loan (Method B)
than MEI, which will not have any track record. Its forecast income stream is also
deferred for at least one year. In fact, with MEI taking out a loan on 1 Jan 2019,
but not earning any revenue until 2020 (and even then making an operating loss),
it could have difficulties making repayments in the early years of the loan. The
working assumption in the NPV calculation is that all cash flows are remitted by
MEI back to Pakistan. However, once its cash flows are established, decisions
will need to be made as to how much is actually remitted by MEI back to Pakistan
with enough left in Malaysia to meet the required loan repayments.
XYZ is likely to have established a long-term relationship with its bank. This
factor, coupled with XYZ's trading history, might reduce the cost of borrowing,
as lending to XYZ is lower risk.
The fact that XYZ is offering the bank guarantees under Method A, would also
reduce the bank's risk, but the precise terms of any guarantee would need to be
considered.
Terms of the loan agreement
Under Method A, the term of the loan is 15 years, while under Method B it is 10
years. This favours Method A, as there is no need to refinance after 10 years
(assuming that refinancing is necessary at the end of the loan period).
Under Method B, XYZ is borrowing over 10 years but relending to MEI over 15
years. The terms of the two loans are not matched, and XYZ could be exposed to
repaying a loan in 10 years without receiving the repayment of its loan from MEI
for a further 5 years.
There may be other differences that may arise from different national laws,
different tax allowances and reliefs and different conditions in the loan
agreements.
Recommendation
Based on the information available, finance Method A is preferred, despite the
slightly higher interest rate, and assuming that MEI is able to arrange it. The key
reasons for this are:
• It provides better matching with the Malaysian operations, denominated
in ringgit
• The longer term provides more long-term liquidity
• The issue of the mismatching term of the loan for XYZ is avoided
(although this could be avoided at the outset by changing the internal
arrangement between XYZ and MEI to a 10-year repayment).
355
Tutorial comments
When advising on funding an overseas investment strategy, students should consider
two key elements. Firstly, students should plan to quantify the company’s gearing
level or capacity for further debt and discuss credit availability to assess whether or
not the company is able to borrow any further. Secondly, students are advised to
explain the potential advantages and methods of borrowing in the same foreign
currency the company has invested. This creates a natural hedge where investment
profit can be used to directly pay foreign currency loan interest, leaving only the net
profit exposed to exchange rate fluctuations. Also, the foreign currency debt itself
will hedge the foreign currency asset investment.
Further discussion points should include the benefits of the parent company
undertaking the borrowing versus the subsidiary, and a consideration of the likely
terms of a loan agreement, particularly where the company is already highly geared
so is unlikely to have asset-based security available to secure it.
With any advice type requirements, students are reminded to present a clear
summary and detailed recommendation which the Board of Directors could discuss
and implement.
(c) Under the Income Tax Ordinance 2001 (ITO), XYZ is the resident taxpayer for
the purpose of income tax liability, as it is a locally registered company in
Pakistan.
Sales of made to order equipment
As XYZ has opted under Strategy 2 to establish a distribution centre in Malaysia,
all supplies made to the distribution centre in Malaysia shall be treated as exports,
and all proceeds of exports shall be taxed at the rate of 1%. Furthermore, this
payment of tax shall be treated as final tax.
Restrictions as per section 169 of ITO
The export income of XYZ shall not be chargeable to tax under any head of
income in computing the taxable income. No deduction shall be allowable for any
expenditure incurred in deriving the export income. The amount of the export
income shall not be reduced by any deductible allowance e.g. zakat, Workers
Welfare Fund, Workers Participation Fund and setting off of any loss. The tax
deducted shall not be reduced by any tax credit allowed. There shall be no refund
of the tax collected or deducted unless the tax collected or deducted is in excess
of the amount for which XYZ is chargeable.
Computations of export profits attributable to export sales (Rule 231 of ITO)
Where XYZ exports goods manufactured in Pakistan, XYZ's profits attributable
to export sales of such goods shall be computed in the following manner:
(a) Where XYZ maintains separate accounts of the business of export of goods
manufactured in Pakistan, the profits of the export business shall be taken
to be such amount as may be determined on the basis of such accounts; or
(b) The profits of XYZ's export business shall be taken to be an amount which
is in the same proportion to its total profits as XYZ's export sales of goods
is to its total sales of goods.
356
Answer Bank
Export sales shall be the freight on board price of the goods exported. Total sales
shall be the aggregate of export sales and the ex-factory price of goods sold in
Pakistan.
Repair services to mining equipment in Malaysia via the Malaysian
distribution centre
Under the ITO-2001, consideration against repair services shall be treated as a
'fee for technical services' because it includes any consideration, whether
periodical or lump sum, for the rendering of any managerial, technical or
consultancy services including the services of technical or other personnel.
However, revenue from repair services shall be exempt from income tax as per
2nd schedule Part 1 Clause 131, which states that the income of the taxpayer shall
be exempt from income tax if it is earned by way of fees for technical services
rendered outside Pakistan to a foreign enterprise.
The condition to avail this exemption is that such income is received in Pakistan
in accordance with the law regulating payments and dealings in foreign exchange.
Tutorial comments
The risk with a tax-based requirement is the propensity for students to write too
much or include information which is not particularly relevant to the scenario. This
can be overcome through answer planning. This tax-based requirement can be
managed effectively where an answer is planned to cover the following four main
components: (1) Sales of equipment (2) Section 169 restrictions (3) Export profit
computations under Rule 231 of ITO; and (4) Repair services in Malaysia. Ensuring
two or three valid points per section will ensure a reasonable coverage of marks in
the time available.
(d) Ethical issues – proposed collaboration between XYZ and AUG

The ethical principle in this case is a perceived conflict of interest on the part of
the CFO, given her family relationship with an AUG board member. She could
be potentially influential in determining whether the invitation to become AUG's
preferred supplier is accepted, and a conflict could be perceived if AUG obtains
more favourable terms and treatment than would be available on an arm's length
commercial basis to other potential customers (such as an agreement for MEI to
sell to AUG for cheaper prices, either for the purposes of securing AUG's
business or directly because of the personal relationship).
There does appear to be a danger that AUG is expecting lower prices in return for
guarantees of a certain level of business for MEI – which needs to be agreed on
by the whole board as being in the best interests of MEI, as a sound commercial
decision.
It could therefore be perceived that Saira Kundi as CFO has a conflict of interest
between her role for XYZ and her personal family relationship. Saira has duties
as a director towards the company. Ethically and legally she has a duty to other
stakeholders (e.g. if customers are not paying enough, then there may be less cash
available for debt holders in future and for employees).
357
A number of questions arise from the matter.
Transparency – would MEI and AUG be happy if the details of any future
arrangement became more widely known, for instance to other customers of
MEI?
Effect – whom does the issue affect? If agreed terms are unduly favourable to
AUG then some stakeholders may be disadvantaged. An alternative, more
valuable customers may be lost.
Fairness – would the arrangement be considered fair by those affected? If any
commercial agreement is influenced by personal relations, then those adversely
affected may regard this as unfair in not satisfying arm's length conditions.
As Saira Kundi is an ICAP Chartered Accountant, she is bound by their ethical
code. Ethical safeguards demand transparency and openness so that the XYZ
board is aware of the relationship, and the CFO has already done this. Also, the
role of the CFO in the decision as to whether the arrangement goes ahead should
be minimised.
Tutorial comments
With an ethics based requirement, the following structure can be applied which
should cover most of the available marks:
 Explain the facts and drivers resulting in the current problem. State any
questions which need to be asked to address any uncertainties or lack of
information.
 Explain why this behaviour is potentially unethical.
 Explain the potential consequences if the company takes no action.
 Explain the potential options that companies can take to resolve the issue.
 Present the argument for the best solution, make a recommendation and if
appropriate, explain if any reassuring statement or apology needs to be issued
in the public domain to key stakeholders, such as customers.
 Explain the next steps that must be implemented to cease current unethical
behaviours and prevent reoccurrence elsewhere in the business.
Not all of the steps will be relevant to every ethical question, however applying this
approach to Q1c will help to structure an effective answer.
Question No 29 - KIT Solutions (June 18)

(a) (i) Financial and strategic implications of the KIT
board's decision to close the Hardware division 3
 Ratio analysis – profitability and gearing
3
 Appropriate commentary on ratios reflecting
the poor performance of the Hardware division
and overall impact on KIT
2
 Effect of disposal on future strategic
performance of KIT – whether to reduce
gearing or expand operations
358
Answer Bank

 Other likely effects of disposal 2
(ii) Effects on risk and share price of each alternative
use of the net cash proceeds from disposal
Alternative 1:
 Effect on financial and business risk
3
 Increased required return on equity
for shareholders 1
 Return on project and cost of capital – effect 2
on share price
1
Alternative 2:
 More conservative – reduced gearing 1
 Effect on cost of capital 2
 Benefit of increased borrowing capacit
(b) Improvements that could be made in the governance
structure
 Explanation of importance of independent element in 2
board composition
1
 Need to appoint more independent and non-executive
directors in order to comply with Code
 Appropriate spectrum of skills 1
 Description of role of subcommittees 2

(c) Additional information to be made available to assist
decision making
 Too aggregated – balance needed between detail and 2
manageability for decision making
2
 Potential application of data analytics techniques e.g.
for marketing purposes
 Uses of more detailed information – e.g. by product 3
line, customer type, sales returns
359
(a) (i) Sale of the Hardware division
Financial performance for the year ending 31 December 2018
Training Hardware Software Total Software
Rs'm Rs'm Rs'm and
Training
Revenue 2,100 690 3,500 6,290 5,600
Operating profit 650 95 700 1,445 1,350
Interest 100 75 200 375 300
Profit before tax 550 20 500 1,070 1,050
Net assets at carrying
amount 3,200 2,650 6,100 11,950 9,300
Total assets at carrying
Amount 5,700 4,200 9,100 19,000 14,800
Current liabilities 2,000 1,000 2,000 5,000 4,000
Non-current liabilities 500 550 1,000 2,050 1,500
ROCE (OP/total
assets – current
liabilities) 17.6% 3.0% 9.9% 10.3% 12.5%
ROE (PBT/net assets) 17.2% 0.8% 8.2% 9.0% 11.3%
Operating profit
margin 31.0% 13.8% 20.0% 23.0% 24.1%
PBT margin % 26.2% 2.9% 14.3% 17.0% 18.8%
Gearing (liabilities/net
assets) 78.1% 58.5% 49.2% 59.0% 59.1%
The Hardware division appears to have underperformed the other two
divisions. The return on equity (ROE) for the Hardware division is also
only just positive at 0.8%, and so is making little contribution to
shareholder return. This can be contrasted with the better ROE rates of
8.2% and 17.2% for the Software and Training divisions respectively.
The ROCE of the Hardware division is better than the ROE, at 3.0%, but
this is still much lower than the other two divisions. However, if the
Hardware division is still quite new, and with new assets, its ROCE is
likely to be deflated anyway, because of the high carrying value of those
assets.
The profit before tax margin is only 2.9% for the Hardware division
which is very small when compared to those of the other two divisions at
26.2% for Training and 14.3% for Software.
While excluding the Hardware division's figures has some impact on the
group results, it is only by one or two percentage points in each measure
of profitability. The Hardware division is much smaller than the other two
divisions, and therefore its poor performance has a low weighting and a
low impact on the results of the group as a whole.
360
Answer Bank
With the sale of the Hardware division taking place on 31 March 2019,
by reference to the analysis above the impact of its operating performance
for KIT overall for the year ending 31 December 2019 is likely to be
relatively insignificant. Following the disposal, the performance of the
Software and Training divisions will not be unaffected: according to the
scenario, the cash proceeds received from disposal are likely to be used
either to expand production in the Software division or to reduce debt.
There are likely to be other effects arising from the disposal – for
example, there may be lost synergies in terms of operating costs, and the
other divisions' revenues could be affected (if customers want to buy
hardware and software from a single supplier). In addition, any central
costs that are allocated to the divisions will have to be split across two
divisions, rather than three, impacting the relative performance of the
remaining divisions.
(ii) Alternative uses of net proceeds
Alternative 1 – Purchase new production equipment for the Software
division
This strategy is simultaneously a new operating investment and a new
financing arrangement. The operating strategy is further investment in an
existing line of the business and so may be lower business risk than an
investment in a new line of business. However, the increased borrowing
represents additional gearing and financial risk.
The sale of the Hardware division, involved repaying liabilities
amounting to Rs 1,550 million. However, the project involves borrowing
a further Rs 3,000 million and thus the net effect is to increase borrowing,
which raises financial risk. The increase in gearing as a result of
borrowing will mean that the required return on equity will rise.
The hurdle rate for the investment, will be KIT's marginal weighted
average cost of capital, after allowing for changes in KIT's financial risk
and business risk associated with the investment. KIT's share price will
rise if the risk adjusted marginal cost of capital is lower than the
investment's return of 9%, and it will fall if the risk adjusted marginal
cost of capital is greater than 9%.
Alternative 2 – Degearing
This is a lower risk and more conservative approach than purchasing new
production equipment for the Software division.
After the Hardware division has been sold and its liabilities paid off, the
total liabilities of KIT amount to Rs 5,500 million. Using the Rs 3,000
million net sale proceeds to repay debt would therefore more than halve
the company's debt and reduce gearing substantially.
The impact would be to reduce the cost of equity, as there is lower risk
due to lower financial gearing. The impact on the weighted average cost
of capital would be difficult to determine – it would depend on the
market's view of whether KIT had previously been over geared.
361
The equity beta of the shares would be lower as the gearing is lower, and
so the shares may generate a lower return (but at a lower risk of share
price volatility).
Another advantage of repaying debt now is that if profitable investment
opportunities were to present themselves, then the borrowing capacity of
KIT would be greater.
Tutorial comments
In the first part of this requirement, students are advised to consider the financial
implications separately to the strategic implications as these are quite different
aspects of the close down decision. Strategically, students should consider the impact
on the brand, consumer demand, the impact on any complementary products, and the
likely reaction of key competitors. Financially, students should consider any close
down costs, the loss of ongoing revenue and cost cash flows impact on profitability,
and the impact on debt if the company chooses to grow elsewhere in the business.
Key ratios must be carefully selected to ensure there is sufficient time to complete
the calculations and provide a sufficient explanation of their meaning and
implications. Therefore, it is advised that students limit the ratio analysis to gross
profit margin, return of capital employed and gearing which will cover profitability,
and the impact of debt finance. This analysis will also enhance the presentation of
the pros and cons of purchasing new production equipment or using the sale proceeds
to reduce gearing.
(b) Data for divisional management

The types of data made available to divisional management need to be able to
support the types of decisions being made at that level.
While it is true that too much data may create an inability to evaluate the key
strategic issues facing the business, the indicative data that has been provided for
the Software division as it currently stands, appears too aggregated and lacks in
sufficient detail to be useful.
Sales and customer management
The report does not contain detail about customers – being split into 'individual'
and 'business'. There appears to be no use of the data available from the KIT
database to support marketing to the specific needs of the various types of
individual user, or type of business.
However, the comment that there is 'too much data to be useful' on individual
customers' needs to be treated with some scepticism. While there may indeed be
a large amount of data at KIT's disposal, companies are increasingly using data
analytics to identify patterns in their sales (such as the seasonality of games sales),
and improve commercial and strategic decisions. Identifying such patterns could
enable target marketing by KIT, according to the type and frequency of past
purchases and customer characteristics (whether individual or business). The
businesses on the database that have not made a purchase from KIT for several
years, could constitute a target group that could be contacted with promotional
offers.
362
Answer Bank
Sales are only broken down by product type (software packages and games) rather
than by product line (there are hundreds of types of individual product). More
information on the performance of individual product lines is necessary. Showing
revenue and gross profit for hundreds of different items will of course be too
detailed to present at divisional management level. However, providing
information about key product lines (e.g. best sellers, or lines which are selling
poorly) could help management decide whether to discontinue a poorly selling
product line, or support further sales of a successful product, which would be the
type of decision that is appropriate at that level.
Sales return information is also poor. While the level of returns was consistent at
around 9% during 2017, the reason for the returns needs to be understood, perhaps
by asking customers to provide such information at the point of return) – for
example, are they due to faults, or do they arise from a customer simply changing
their mind? If faulty returns can be identified, management can decide whether
the fault is due to manufacturing processes at KIT, or because of faulty
components, in which case it becomes a question of whether contract terms have
been fulfilled by the relevant supplier.
Using the information provided by each customer when they return the goods, it
may be found that certain types of customers have a higher propensity to return
goods within the 14 day period (for example related to age, gender, location or
the type of products they buy). Once identified, sales to these customers may need
to be monitored, or KIT's returns policy made less flexible.
Tutorial comments
In this requirement, students are advised to carefully scrutinise the information in the
scenario and look for information gaps provided which may hinder effective decision-
making at a divisional product and cost level. Students are also advised to look at the
quality and quantity of operational data which is routinely collected, as this will help
to explain the drivers for increasing costs and how well each company division is
performing against its critical success factors. Such operational data can include:
number of customers; volume of sales produced or sold; number of shipments; or
number of employees. Finally, students should consider the quality of customer-based
information which is collected and routinely analysed. Many companies are now
focusing on data analytics to anticipate the demands of key customer segments or even
individual companies, and adapt their product offer to meet this predicted demand.
(c) Corporate governance
There should be a strong independent element on the board, so that there is no
concentration of power in the hands of one person or a small group of individuals.
One aspect of this is that the Chairman and CEO of the company cannot be the
same person.
KIT currently has seven directors, of whom three are non-executives. The Code
of Corporate Governance states that one-third of directors should be independent,
and no more than one-third of the board should be executive directors (i.e. paid
executives of the company, drawn from senior management). KIT should
therefore appoint more independent and non-executive directors, establishing a
board structure that is consistent with the requirements of the Code of Corporate
Governance. There must also be female representation on the board.
363
Non-executive directors with the right skills and experience need to be appointed
(preferably knowledge of the IT industry, as KIT is an IT company) to advise
executive directors and to monitor and manage their performance.
New executive members of the board may even be appropriate to ensure that it
has the spectrum of skills necessary. However, the provision that no more than
one-third of the board should be executive directors must be kept in mind when
establishing the new board structure.
Subcommittees need to be set up. Establishing an audit committee, consisting of
non-executive directors, is important when examining internal performance and
information flows, as well as dealing with external auditors and monitoring the
work of the internal audit department. The board must also be satisfied that the
Head of Internal Audit, Sami Ahmed, satisfies the eligibility criteria for his role.
He must be appropriately qualified and have five years' experience of audit,
finance and compliance functions.
The Human Resource and Remuneration Committee will ensure that, as part of
performance management for the executive directors, they are motivated by their
remuneration package to promote the performance of KIT.
Tutorial comments
Students are advised to avoid listing their knowledge of all corporate governance
requirements and instead use the scenario to identify where the company is
compliant and where compliance can be improved. By taking a suggestion based
approach, students can focus on explaining what improvement is required, why it is
beneficial to the company to invest in a solution, and how a recommendation can be
implemented practically at KIT Solution, as this is where the marks are likely to be
awarded.
Question No 30 - Farid Textile

(a) (i) Tutorial Comments
It is simple requirement and students can easily attempt this requirement with
efficient planning. It is very important to comment on maximum information
provided in NPV calculation. Students are also required to understand the data
trends provided in NPV working and identify working assumptions used to
build these trends i.e., growth rate and to challenge the trends/ assumptions in
context of business information.
Evaluation of the NPV calculation
Forecast revenue from the online business in the first year of operations would
be Rs. 50 million, which is only 3% of FT’s existing revenues. It is forecast to
grow by 50% per year in the first two years but thereafter the growth rate slows
to 10% in 2025 and 5% in 2026. Revenue growth is often high for new
businesses, so the revenue growth in the first two years would not be
unreasonable, and the sudden decline in revenue growth from 50% to 10% in
2025, and then 5% in 2026, may well be overly conservative. Overall, the
revenue forecasts do not therefore appear to be unrealistic.
364
Answer Bank
The gross profit margin is 60%, which seems a little too high. The sales
director has suggested that the company’s existing customers sell for twice the
price that they pay to FT, suggesting a mark up of 100%, which relates to a
gross profit margin of 50%. If an assumption is made that the online retail part
of the business is buying from the existing manufacturing division at cost, then
the 60% may be reasonable.
Marketing expenses are Rs. 1.5 million during the first two years, but then fall
to 1 million in year 3. This is reasonable, given that more marketing activity
will be required initially as the website is launched but will fall as the website
becomes established.
Staff costs increase by 47% between 2022 and 2023. It is not clear why such a
large increase in staff would be required. Although revenues are increasing by
50%, it would be expected that some efficiencies would mean that the level of
staffing would not increase so much.
Regarding overall expenses, it would be useful to have benchmark data from
existing online retailers to enable a valid assessment of these. The pre-tax cash
flows, as a percentage of profits, are 32% initially, suggesting that other costs
are 28% of revenue, which does appear high. Pre-tax cash flows increase as a
percentage of revenue, achieving 41.8% in 2026, which may be due to
economies of scale, as fixed costs fall as a percentage of revenue.
It is assumed that the investment cash flows are valid, as the investment is to
be made fairly soon, and it is easier to forecast cash flows that are closer to the
current period.
Working capital investment is also included. This appears to be 10% of
revenue, which may be low, since it will be necessary to finance both
inventories and trade receivables.
There is also an assumption that from the year ended 30 September 2026
onwards, there will be no further growth in the cash flows generated, which
also appears conservative.
The cost of equity has been used to discount the cash flows. This is appropriate
for a company that is 100% financed by equity. It is assumed that the finance
director has used appropriate benchmark companies in ascertaining an
appropriate cost of equity.
Generally, the cash forecasts appear to be conservative, which does suggest
that there is less risk that they will not be achieved.
Appendix – calculations
Year ended 31 March
2022 2023 2024 2025 2026
Revenue growth: 0 50% 50% 10% 5%
(130/123.8)-
– (75/50)-1 1
Gross Profit margin 60% 60%
(30/50) (78/130)
Pre-tax cash flows
as a % of revenue 32% 35.6% 41.3% 42.% 41.8%
(16.1/50) (26.7/75)
365
(ii) Tutorial Comments
Strategy evaluation is the most important factor in a strategic decision. Strategy
evaluation models such as Suitability, Acceptability and Feasibility
Framework could be used to ensure all the factors have been discussed.
Suitability (strategic sense), Acceptability (to stakeholders – including the
financial returns for shareholders) and Feasibility (can it be done).
Suitability - Will the strategy achieve what the business wants it to achieve?
Does the strategy address key opportunities and threats? Suitability
encompasses a broad range of criteria such as environmental, market, and
expectational suitability.
Feasibility – can the business execute the strategy effectively? Can it be
financed? Are the right skills or expertise in place? Can resources be obtained
in adequate quantities? Is the structure of the organization a good fit for the
strategic plan? Are there moral, ethical, or legal concerns?
Acceptability – does the proposed strategy meet stakeholder expectations? In
other words, is the level of financial or reputational risk acceptable? Do
potential project outcomes justify the expense?
Evaluation of proposal to diversify into online retail
The proposal to diversify into online retail can be evaluated using the
Suitability, Acceptability and Feasibility criteria of Johnson, Scholes and
Whittington.
Suitability
The suitability criterion relates to whether a proposed strategy will move the
business towards achieving its mission and objectives. The objectives of FT
have not been formally stated, but it appears that Farid has ambitions to expand
the business. The move into online retail would be consistent with that
objective.
The movement into online retail is an example of vertical integration, as the

company would be moving into a later stage of the value chain. As such, it
would be a strategy that would complement the existing business and would
enable FT to enjoy the higher margins that retailers enjoy.
Acceptability
Acceptability relates to how a proposed strategy would be viewed by the
different stakeholders of the organisation.
Existing shareholders
The project is forecast to provide a net present value of Rs. 81.3 million, so
would increase the wealth of shareholders. However, it brings a high level of
risk, as it requires a relatively large investment of around Rs. 100 million. If
the project fails, this would represent a significant loss for FT. The existing
shareholders of FT, particularly Farid, appear to have a high-risk appetite, so
the project may still be acceptable to them.
366
Answer Bank
The project requires the company to raise new finance, and this will be raised
by issuing new shares on the stock exchange. This will dilute the holding of
the Farooqi family, who until now have owned 100% of the shares of the
company. This may cause concern as the actions of the management will be
scrutinised by external investors.
New shareholders
Given the intention of FT to list on the stock market, potential new
shareholders should be made aware of the proposed project so that they can
decide whether it meets their own risk preferences.
Existing customers
FT’s existing customers may be concerned that FT’s move into online retailing
may lead to additional competition. If they consider FT to be a competitor in
the retail market, they may no longer use FT as a supplier, and this could
threaten FT’s existing business. FT must ensure that it manages this threat by
reassuring customers that it is operating in different retail markets and would
not therefore be a threat.
Employees
Existing employees would most likely be unaffected by this new line of
business as it would require the recruitment of new staff. If employees feel that
the project is too risky, they may be concerned about their own job security.
Feasibility
Feasibility relates to whether FT has the resources, time and strategic
capabilities to execute the new strategy. FT does not currently have the
financial resources, and the Farooqi family do not have additional capital to
inject. Should the company be successful in listing on the stock exchange, then
the financial resources for the project would become available.
In terms of strategic capabilities, FT is lacking key skills and resources. The

company has no experience of e-commerce, which is a complex undertaking.
It would require setting up the appropriate IT systems as well as the logistics
to support the business. FT would have to employ staff or consultants with the
required knowledge to provide advice to set up the business and this would
most likely involve high costs.
While retail would represent an expansion within FT’s existing value chain,
the capabilities required for successful retail are very different from the
capabilities used in FT’s existing business activities. Retailers in the fashion
industry must identify changing trends in the industry and identify suppliers of
clothing to meet these needs. These activities are very different to FT’s existing
activities, as FT manufactures based on designs provided by its customers. FT
must not underestimate the importance of these capabilities and it must
consider realistically how it will obtain them.
367
Conclusion
The move into retailing using e-commerce may be an attractive opportunity
that could provide opportunities for FT to grow and enjoy higher margins.
However, it is a high-risk venture that would require FT to respond to the fact
that they lack experience and expertise of both e-commerce and retailing.
Should the company decide to go ahead it would be wise to engage external
consultants to assist.
(b) Tutorial Comments

The requirement is time pressured so effective approach is required to address
numerical component of this question. Students are required to determine fair value
for the new shares using the price earnings ratio and free cash flow to equity
methods. Additionally, commentary on pros and cons of both price calculation
methods is also required from the students.
Valuation of new shares to be issued
The average PE ratio of textiles companies listed on the Pakistan Stock Exchange is
six. Applying this to the most recent profit after tax of FT of Rs. 74 million gives a
value of Rs. 444 million to the whole company. This is the value before the new
shareholders increase the capital of the company, so would represent 80% of the
value of the company after the issue of shares. The new shareholders would own
20% of the company, so their shareholding would be worth Rs. 111 million (444m
20%/80%).
The weakness of the PE ratio method is that it is based on profits of one year and
does not take into account growth in profits that would be likely to result from
investing the funds raised. In the case of FT, the PE ratio based on the profits for the
year ended 30 September 2020 does not take into account the impact of the new
project on future profits.
Using the free cash flow to equity method, the value of the company’s equity is
equal to the net present value of the free cash flows to equity. The net present value
of the existing operations is Rs. 433.55 million (Appendix), and the NPV of the
proposed online retail store is Rs. 81.3 million (Exhibit 2), giving a total value of
Rs. 514.85 million. The new shareholders would own 20% of the company, so the
shares issued would be worth Rs. 102.97 million.
The advantage of the free cash flow to equity method is that it is consistent with the
principal that the value of any security is equal to the present value of the future cash
flows that the security will generate. In the case of FT, the free cash flow to equity
method includes the value of the forecast cash-flows from the online retail business,
while the PE ratio does not. It is therefore a more complete valuation.
The disadvantage of the free cash flow method is that the valuation is only as reliable
as the estimates of the future cash flows. For the new e-commerce project, the
estimates are clearly subject to a great deal of uncertainty. Small changes in the
underlying estimates can lead to a large change in the value. This problem can be
overcome by making several forecasts – a best, most likely and worst-case scenario,
from which different valuations can be calculated.
368
Answer Bank
A further disadvantage is the discount factor used. It can be very difficult to establish
the cost of equity for any company. Changes in the discount rate can have a big
impact on the valuation.
The new shareholders of FT will hold a minority share of 20%. As such, they are
likely to be more interested in the dividends that they will receive than the free cash
flows generated by the company. Minority shareholders cannot make decisions
about how free cash flows will be used, so may be less interested in these than in
dividends. As such, the value of the company using the free cash flow to equity
method may provide a value that is higher than the new shareholders would be
willing to pay.
Appendix – valuation of FT’s existing business using the free cash flow method
The free cash flows for the year ended 31 March 2020 are as follows:
Year ended
31 March 2020
Rs. in million
Profit after tax 74
Add depreciation 139
Changes in working capital:
Increase in inventories (289 – 246) (43)
Increase in receivables (230 – 205) (25)
Increase in current liabilities (142 – 131) 11
Operating cash flows 156
Less acquisition of non-current assets (91)
Free cash flows 65
Free cash flows are expected to remain at the same level as the year ended 31
March 2020, in perpetuity. The present value of the cash flows is therefore
1 1
calculated by multiplying the cash flows by the perpetuity factor: 𝑟 = 15% = 6.67.
The present value of the free cash flows = Rs. 65m × 6.67 = Rs. 433.55
(c) Tutorial Comments
Big data is very topical, both in the ‘real word’ and in examinations. The requirement
of question is to highlight importance of use of big data for the business. Considering
FT would be running online business and would be interacting with retail customers
so students may comment on how the business will use customers data for
customized marketing, customer segmentation and market trend analysis.
Big datas
The increasing use of IT devices such as computers and mobile devices has led to a
large increase in the data that is available, and this provides businesses with
opportunities to analyse the data to find these insights. The challenge of analysing
big data is that it includes both structured data, such as analysis of sales, and
unstructured data, such as comments about a company’s products on social media.
Big data can come from both internal and external sources. In the case of FT, the
sales manager has mentioned that the new online business will provide data about
customers’ preferences.
369
Once the online business is up and running, FT will acquire information about retail
customers. Under the current business model, FT sells only to other businesses, so
has no contact with the end retail customers. The proposed online business will
provide FT with a new source of Big data. Internal sources of data will be
information about customers. The website will collect data about customers’ names
and addresses, and customers may be asked to disclose other information, such as
their gender and age. External sources of data will be discussions on social media.
The most obvious use of this big data would be to analyse changing fashion trends.
This would enable the company to see which types of clothing are becoming more
popular and therefore to increase production of these to ensure demand can be met,
or conversely, to reduce production of clothing that are becoming less popular. This
will help FT to increase its sales because they will be producing what customers
want. It will also reduce obsolete stock as FT can stop producing products where
demand is falling.
Analysis of data will also enable FT to understand better the different market
segments. Within the fashion industry, there are many potential bases for
segmenting the market, such as age, gender, geographical location and socio-
economic groups. By analysing sales by segment, FT will be able to understand
better the needs of these different segments, and this will enable the company to
adopt a focussed approach to its marketing so that it appeals to chosen segments. It
might even be appropriate to establish two or more brands to appeal to different
market segments. In this way the company can establish brand loyalty that will lead
to repeat sales.
Data can also be collected about the performance of FT itself that can be used for
performance management. For example, a ‘website conversion rate’ could be
calculated to assess how effective the website is at converting visits to the website
into sales. Time taken from customer order to dispatch can be used to ensure that
customer orders are being dealt with within an acceptable time.
More personalised services can be provided to customers from an analysis of the
data. Messages can be sent to customers on their birthday, and special promotions
can be focussed, so customers only receive promotions about clothing that they
might be interested in based on previous purchase history. This will ensure that
promotions are more likely to be successful as they appeal to individuals.
(d) (i) Tutorial Comments
The requirement is quite tricky. Identification of ethical stance (sole focus on
maximization of shareholders’ wealth) is critical to appropriately address the
requirements of the question and how this incorrect approach will affect the
business in long term i.e., decrease in shareholders’ wealth
Arish Clothes’ ethical stance
The UK broadcaster’s documentary 'Ghost Workers in Pakistan’s Textiles
industry' alleges that Arish Clothes avoids providing staff with employment
contracts to eliminate additional employment-related costs such as
contributions to pensions and sick pay. It also alleges that the company
terminates the temporary staff contracts at the end of each month, and then
renews them the following month to avoid forming a legally enforceable
employment relationship.
370
Answer Bank
If the allegations are correct, then it would seem that Arish Clothes’ actions
are taken in order to increase the company’s profits. In doing so, the company
is behaving in a manner that is unfair to its workers, and therefore unethical. It
also breaches employment law.
Arish Clothes’ ethical stance can be described as short-term interest of

shareholders. In so doing, the company is only considering shareholder
interests and may not appreciate that by ignoring the interests of other
important stakeholders (in this case employees) it may actually harm the
interest of the shareholders in the longer term. This is because unhappy
employees will be demotivated in their work and could also bring legal action
against the company if their employment practices are found to be illegal.
Arish Clothes’ behaviour is already harming its reputation. The UK

programme is likely to raise concerns for Arish’s customers (at least in the UK)
and they may decide to take their business elsewhere if they are concerned
about the poor treatment of workers. In addition, potential investors often
avoid investing in companies with a poor ethical reputation, which could harm
Arish’s ability to obtain additional finance in the future.
There may be legal implications in treating employees unfairly. If disgruntled

employees take the company to court, the company may incur fines or other
sanctions that could reduce the its profitability.
Employees could potentially take other action, such as going on strike if they
feel they are being treated unfairly, which could lead to delays in production.
The likelihood of this depends on how well organised the staff are for example,
if they belong to a trade union. Even if staff do not strike, demotivated staff
could produce poor quality output. Many businesses recognise that the people
who work for them are an asset, and that if they are treated well, they will
contribute much more to the company. Arish Clothes may well have failed to
understand this.
(ii) FT’s actions in the light of the film 'Ghost workers in Pakistan’s Textile
industry'
While there is no suggestion that FT has been involved in any of the practices
that Arish Clothes has allegedly been involved with, the film has the potential
to harm the reputation of all textile exporters in Pakistan. Customers in the UK
may incorrectly believe that Arish’s practices are common throughout
Pakistan, and as a result there is a risk that some of these customers may
consider sourcing their clothes from other countries.
In order to avoid this, FT could take several actions. The directors of FT may
encourage an ethical culture by setting the tone at the top.
Staff who shows a commitment to ethics should be promoted, while those who
behave unethically would be sanctioned.
Further, it may contact all of its customers to make it clear that the practices
mentioned in the film are not used by FT and that FT condemns such practices.
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(e) Tutorial Comments
This is tricky requirement in which examiner asked to identify sales tax implications
on FTL of proposed strategy. The approach to resolve this requirement is to identify
the specific changes in the operating model as a result of implementation of
proposed strategy. For example, FT would be a retailer after implementation of
strategy and retailers are required themselves to registered with tax authorities under
Sales Tax Act. Additionally, brief discussion regarding input claiming process was
required in relation to amended business context.
The setting up on an online store would attract the following sales tax implications
for FT:
 FT would have to apply to the sales tax authorities for registration as a retailer.
 After registration, FT has more than one registration under Sales Tax Act i.e.
manufacturer, exporter and retailer. It would apply to LTU for single
registration, which would provide it the ease of submission of return and
payment to the sales tax authorities.
 On receiving the revised certificate from sales tax authorities, FT’s status
would be changed from ‘manufacturer cum exporter’ to ‘manufacturer cum
exporter cum retailer’.
 Since FT has combined the business of manufacturing with retail, it would
need to notify an advertisement for retail price and declare the web address .
 The retail price should be the price fixed by FT, inclusive of all charges and
duties (other than sales tax) at which its products are sold in the market.
However, in the case of more than one price for any variety is fixed, the highest
of such price will be taken for the purpose of sales tax.
 Name, address and CNIC of all those ordinary customers should be required
to be kept where value of sales inclusive of sales tax made to them through
online store exceeds Rs. 50,000.
 As FT is registered as a manufacturer subject to requirement of Sections 8 and
8B, there is no additional requirement in respect of claiming input tax and
refund of input tax.
 There will not be any change in the amount as well as procedure for claiming
the output tax.
 Since FT will be registered as retailers, there will not be any withholding tax
implications on it.
Question No 31 - Faisalabad Surgical

(a) Tutorial Comments
The requirement is not very complex. Students are required to identify risks by
analyzing what can go wrong as a result of proposed strategy. Students are also
required to rate the risk and give the mitigation controls. Risk rating is product of
multiple of both likelihood (the chances that a particular risk can happen or occur)
and impact (quantum of risk). For mitigation, students may comment on what can
be done in terms of controls to reduce or eliminate the risk.
372
Answer Bank
Risk assessment
Being sued for the provision of faulty equipment:
 Probability – Low
This has not happened historically with FSSL, and has only happened once
that we know of elsewhere. FSSL products are premium quality, reducing the
chances of an issue even further.
 Impact – High
Given the nature of the product, a fault could potentially lead to the death or
injury of a patient undergoing an operation. This could well lead to significant
legal costs, and damage to reputation.
 Action – An insurance policy should be obtained to cover this hopefully
unlikely eventuality.
Steel prices:
 Probability – High
Steel is a global commodity, so the market price is bound to fluctuate, and at
times quite significantly.
 Impact – High
Steel is a major raw material, so fluctuations in its price will affect FSSL costs
significantly.
 Action – Avoid exposure by either buying steel forward if suppliers will accept
the risk, or formally hedging using, for example, derivative contracts such as
futures or options.
Myanmar operation does not work as expected
 Probability – High
FSSL have not outsourced manufacturing before, so the risk of mistakes and
problems is relatively high.
 Impact – High
75% of FSSL inventory is planned to be outsourced immediately. If the
outsource provider does not perform as expected, this would result in
significant costs and damage to reputation.
 Action – For the first year, only outsource a limited amount to Myanmar – say
10% of FSSL total requirements or consider running the Myanmar operation
in parallel with the Faisalabad factory for a limited period to act as self-
insurance.
(b) (i) Tutorial Comments
The requirement is simple to calculate the impact of financing on the cost of
capital of the company. Students are required to de-gear and re-gear the cost
of equity. Only complexity is to account for share split while calculating the
growth rate. Time management is critical to complete the answer within time.
Students are also required to provide commentary on calculation and conclude
the answer.
373
Current weighted average cost of capital
Cost of
Source Market value Cost  MV
finance
Rs. in million
Working 1 Equity 17.89% 875 156.54
Working 2 Bonds 5% 443.75 22.19
Total 1,318.75 178.73
Current WACC = 178.73/1,318.75 = 13.55%
1. Equity
Compound annual growth rate: (25/15.5*)0.2 – 1= 10.03% per annum
*Share split would have halved dividend per share so to get a fair view
of growth, the W6 dividend has been halved.
Cost = [Do(1+g) / Po] + g
Cost = [25(1.1003) / 350] + 0.1003 = 17.89%
Market value = price (ex div)  number of shares
= Rs. 350  2.5m = Rs. 875m
2. Irredeemable bonds
Cost = I(1 – t) / Po = (500  (1 – 0.29))/7,100 = 5%
Value = 7,100/10,000  625m = 443.75m
Post borrowing weighted average cost of capital
Cost of Market value

Source Cost  MV
finance Rs. in million
Working 1 Equity 24% 875.00 210
As before Bonds 5% 443.75 22.19
Bank
Working 2 loan 5% 950.00 47.5
Total 2268.75 279.69
WACC = 279.69/2,268.75 = 12.3%
Assuming:
 Modigliani and Miller with tax applies – this means additional

borrowing will reduce the WACC due to the tax deductibility of
interest.
 The cost of debt is unaffected by the gearing level. In reality, this is

unlikely given the increased level of gearing overall.
374
Answer Bank
 Share price is unaffected by the issue of debt – this is unlikely to be true

but is a reasonable assumption in the absence of other information.
Working 1: Equity
Degeared cost of equity using Kg = Ku + (1 – T) (Ku – Kd)(Vd/Ve)
Where:
Kg = Cost of equity in the geared equivalent firm
Ku = Cost of equity in the ungeared equivalent firm
Kd = Pre-tax cost of debt = 5%/(1 – 0.29) = 7.04%
T = Corporate tax rate
Vd = Value of debt
Ve = Value of equity
So, based on current capital structure:
17.89 = Ku + (1 – 0.29) (Ku – 7.04)(443.75/875)
17.89 = 1.36 Ku – 2.535
Ku = (17.89 + 2.535) / 1.36 = 15%
Under the new capital structure:
Ve = 875 (assume unchanged per above)
Vd = 443.75 + 950 = 1,393.75
So regearing the cost of equity for the new capital structure:
Kg = 15 + (1 – 0.29) (15 – 7.04) (1,393.75/875)
= 24%
Working 2: Bank loan
Cost = I% (1 – t) = 7.042% (1 – 0.29) = 5%
Value = Rs. 950 million
Conclusion:
Further borrowing has reduced the weighted average cost of capital from
13.55% down to 12.3%. This is principally due to an increased proportion of
relatively inexpensive debt. The interest on this debt is tax deductible.
375
However, this assumes (amongst other things) that there is no ‘financial
distress’ caused by excessive gearing. This is unlikely to be the case here as
the revised gearing level would be (1393.75/(875 + 1393.75)) = 61% which is
significantly in excess of the industry average of 30% by market values.
Financial distress could well be significant therefore, increasing the cost of

debt, the cost of equity and the WACC possibly beyond the 13.55% WACC in
place before the bank loan.
(ii) Tutorial Comments

Hedging
This is a simple requirement, and the suggested approach is to relate the
hedging knowledge with the given scenario.
FSSL will pay / receive a regular amount to / from the Myanmar supplier.
Assuming that they will be paid / received on a regular date, and the amount is
reasonably predictable in advance, then a few alternatives present themselves:
 Futures
 Options
 A money market hedge whereby cash is deposited in Myanmar
immediately to pay them later
 Forward contracts negotiated with the bank
Futures and options are for standard amounts so it is unlikely that they would
be available in the currency required for the exact amount required. In addition,
options are expensive. Futures and options are therefore not appropriate.
A money market hedge would involve a cash flow disadvantage as cash is paid
immediately to put on deposit in Myanmar. This is therefore not a preferred
alternative.
On balance, forward contracts should be negotiated with the bank. Although

they are binding obligations and the rate may not be particularly attractive,
they can be tailored to the needs of FSSL most precisely. Therefore, it is
recommended to hedge by means of a forward contract.

This is application-based requirement and students are required to identify changes
required to implement proposed strategy i.e., relocation of human resources and
machinery, considering the business dynamics mentioned in the question.
Key change management issues
 A large proportion of the workforce will lose their jobs in Pakistan
 Some Pakistani workers to transfer to Myanmar
 New processes and controls needed to monitor the performance of the
Myanmar subcontractor
376
Answer Bank
 Potential image/reputation issues as a result of outsourcing manufacture

The key challenge will perhaps be managing the existing Pakistani workforce during
the transition phase. They are likely to be demotivated and productivity/quality may
suffer in the interim period.
Recommended action for inclusion in the change management programme
Change management processes should ideally be consultative to improve motivation
and ownership of change. However, consultation is only a valid approach if the
change is ever likely to be perceived positively by at least some of the Pakistani
workforce. This is unlikely to be the case given so many will lose their jobs as a
result.
So, to assist with this difficult process:
 Interim financial incentives should be provided to maintain productivity and
quality.
 Thought should be given to assisting co-operative employees with training for
job applications and interviews.
 Face-to-face consultation and support should be provided by management at
all stages.
 Human resources experts should be consulted to ensure the redundancy
programme accords with the law and best practice.
(d) Tutorial Comments
This requirement is simple. Correct knowledge of relevant ITO-2001 provision
is required to attempt this requirement.
FSSL will be able to claim all expenses incurred in relation to import of its
product range including payment to outsource partner, custom duties, ancillary
import expenses, etc.
The income tax paid at the import stage will be considered as minimum tax.
Further, FSSL has provided loan to the outsource partner for setting up the loan
at 8% mark up. If any tax is deducted by the outsource partner in Myanmar,
FSSL can claim lower of foreign tax paid and the Pakistani tax payable on
interest income.
Question No 32 - Karachi Pharmaceuticals Limited (KPL)

This requirement is not very complex; however, identification of correct ratios is
very important to ensure that maximum marks would be awarded. Here, students
should clearly comment on operating Margins and Dividend pay-out ratio as key
Income Statement ratios based on the information provided in the question. In terms
of statement of financial position, students should comment on intangible assets and
liquidity position. Based on the calculations, discussions are also required to
critically evaluate the prospects of KPL. Students are expected to use numerical
figures to support their arguments. At the end, brief conclusion is also expected to
finalize this requirement.
377
Key issues of note
Income statement
Operating margin: The operating margin of KPL is lower than that of MPL (35%
compared to 64%). This is driven by two factors:
 A lower gross margin (90% compared to 95%) – this could be driven by the
fact that MPL has a higher proportion of its product portfolio in ‘Class 2’
protected by patents – allowing them to command a higher margin.
 Higher amortisation and depreciation charge (Rs80 billion compared to Rs40

billion). This is due to having a significantly higher intangible non-current
asset base. This in turn is probably driven by the fact that KPL has significantly
more products under development: 174 as opposed to 40.
Dividend pay-out ratio: this is 0% in KPL compared to 100% in MPL. This likely
reflects the cash position: MPL is cash rich while KPL has a significant overdraft.
Statement of financial position
Liquidity:
There is a marked difference in the liquidity positions of the two companies. KPL’s
current ratio is 0.2 compared to 9.1 times for MPL. This is driven almost entirely by
the cash position of each company. KPL has a large overdraft, while MPL has
significant cash reserves.
Intangible assets:
KPL has a significantly higher investment in intangible assets. KPL’s ratio of

intangible assets to total non-current assets is 80%, compared to MPL’s 64%. This
could be driven by the fact that KPL has significantly more products under
developments, resulting in more development expenditure being capitalised.
The poor cashflow position can be explained by examining the respective product
portfolios using the BCG matrix.
KPL:
Class 1 products (those under development) may be considered ‘problem children’,

requiring investment. These are a significant drain on cash resources, resulting in
high investment in research and development.
Class 2 and Class 3 products are in growth phase, and KPL is the largest provider in
its markets. This makes most of the other products ‘stars’ which may be cashflow
positive, but still require investment in advertising, and in factory productivity to
keep up with growing demand.
MPL on the other hand:
Class 1 products – relatively few. This reduces the strain on liquid resources as
research and development expenditure will be accordingly lower.
378
Answer Bank
Class 2 and Class 3 products are in mature markets. These are therefore ‘cash cows’
or cash-positive ‘dogs’, both generating surplus funds.
Conclusion
The cashflow positions reflect the state of each business’s portfolio. In essence, KPL
is investing in the future – reinvesting funds generated into the products of
tomorrow.
MPL, on the other hand, has a cash generative portfolio which allows for large
dividends and significant cash reserves currently. However, with little investment in
new products, when the Class 2 products come out of patent and Class 3 products
eventually get replaced, MPL may struggle to survive in the longer term.
KPL’s current cashflow crisis is a short-term rather than a long-term concern.

It is an application-based question. Students are required to apply marketing 6 Is
concept to the scenario. Strong logical relation of relevant concept with information
given in question is critical to secure maximum marks.
Digital marketing
The current marketing strategy is traditional in its approach. This could be

supplemented by e-marketing – the use of emails, social media and websites backed
up with big data analytics to improve targeting.
Digital marketing has benefits over and above traditional marketing, which can be
summarised using the ‘six Is’:
 Interactivity: Digital marketing may allow for interaction, such as clicking to

see further statistics or details, or to allow the user to research the aspects of a
drug they are interested in through the use of web-based media.
 Intelligence: KPL could gather market intelligence on how people respond the
adverts to help improve their approach. They can also gather information on
trends and sentiment, for example through the analysis of social media or
forum posts. This could also be used to tailor marketing approaches and
messages, for example by using PR if people are making false claims about the
dangers of the drugs.
 Individualisation: The use of cookies and profiling could allow marketing to
hospitals, or individual pharmacies/practitioners that is tailored to their
particular circumstances and preferences.
 Integration: Digital advertising can be integrated into other aspects of our
service, for example, click-through ordering, which would allow customers to
buy the drugs online.
 Independence of location: Digital advertising has potentially global reach,
whereas KPL currently use face-to-face salesmen which will typically have a
limited geographical reach.
379
 Industry restructuring: Digital marketing could be used to disintermediate,
and sell direct to individual practitioners, as opposed to via the large
intermediaries. This may reduce the incidence of offering having to offer
discounts for bulk sales.

This section requires very strong command on Corporate Social Responsibility
(CSR) concept and how it is linked with shareholders’ wealth in short term and long
term. Students are also required to identify relevant measures to ensure CSR
objectives will be achieved.
Corporate social responsibility
Corporate Social Responsibility (CSR) is an organisation’s programme to go ‘above

and beyond’ their immediate obligations to meet the needs of a wider range of
stakeholders, and society at large.
The finance director is adopting a 'pristine capitalist’ perspective, or assuming a

position of shareholder supremacy.
It is true that directors do have a duty – morally and legally – to protect and promote
the interest of shareholders.
However, it could be argued that the proposed CSR is ‘expedient’, or would

represent ‘enlightened self-interest’. Supporting developing countries could well be
good for the KPL brand, which could lead to more sales and increased shareholder
wealth in the future.
In addition, even if the CSR proposal proved to be neutral to shareholder wealth,

there is an argument it would represent sound corporate citizenship to support the
developing countries.
However, care would need to be taken with at least two aspects:
 The risk of ‘leakage’ from the supported markets to the developed world. Care
would need to be taken that free drugs are not sold on the black market,
cannibalising profitable sales.
 Customers paying full price may resent the fact that drugs are being given
away elsewhere.
It is true that charging high prices for drugs helps to fund research and development.
However, it appears unlikely that giving these drugs away in developing countries
would lose revenues as the drugs would not be purchased at all otherwise.
In summary, there is an element of truth in the finance director’s assertions,

however, the positive impact on the brand and concerns for broader corporate
citizenship should not be ignored in the final decision.
380
Answer Bank
Question No 33 - RhanaPharm
The requirement is not very complex; however, it is timely pressured. Selection of
right KPIs considering benchmarking company data is critical to secure maximum
marks. Students should also include ratio related to working capital in their
evaluation to ensure completeness. Students should also focus on non-financial
performance ratios considering availability of information given in the question. At
the end, students are also required to give conclusion.
Financial performance
Revenue growth was only 2% between 2020 and 2021, which is low. AsilPharma
managed to achieve 6% growth over the same period. Growth is usually taken as a
sign of success and leads to growth in the wealth of shareholders. Poor growth
suggests that the company is failing to develop new products or customers, and
more effort should be put into growing the company to achieve its objectives.
The gross profit margin increased slightly from 51.21% in 2020 to 51.52% in 2021,
which suggests that manufacturing costs are being controlled and prices are not
being squeezed. Operating profit margins are also fairly stable, improving slightly
from 29.98% in 2020 to 30.61% in 2021. These compare favourably with
AsilPharma, which achieved an operating profit of 19%. It could be questioned
whether achieving higher margins is consistent with the mission of providing
medicines at affordable prices. It can be said that Rhanapharm appears to have good
control of costs.
Return on capital employed was 34.45% in 2021, which compares very favourably
with the 17.3% achieved by AsilPharma. While this is a very good performance, it
should be noted that there has been a decline in the return from the 37.2% achieved
in 2020. Given that profit margins have improved, the decline in return on capital
employed must result from falling asset turnover, which means that assets are
increasing more than revenue. This is partly caused by the company's high cash
balances, which represent assets on which no return is provided.
The value of inventory has increased by 52% between 2020 and 2021. This is
extremely large, given that revenue rose by only 2%. Inventory days have increased
from 61 days to 91 days. This could suggest a fall in demand for the company's
products leading to a rise in finished products. Given that pharmaceutical products
have a limited shelf life, there is a danger of stock obsolescence, which would be a
large cost to the company. If inventory days had remained constant, the value of
inventory at 31 March 2021 would be Rs. 14.480 million lower than the value
stated, and a write off of inventory values of this amount would represent a decline
of 8% in the gross profit margin.
Liquidity does not appear to be a problem at RhanaPharm, as can be seen by the
large increase in cash between 2019 and 2020. The quick ratio was 1.68 times at
31 March 2021, suggesting that RhanaPharm has sufficient liquid assets (not
including inventory) to pays its current liabilities 1.68 times. While this is good
from a liquidity perspective, it does reinforce the point made above about the
company not investing sufficiently in new products and actually having too much
cash that is not being invested to make a return.
381
RhanaPharm's gearing was 25.2% at 31 March 2021, compared to 13% for
AsilPharma. While higher gearing leads to higher financial risk, RhanaPharm does
not appear to be in danger of not being able to meet its interest. Interest cover was
11 times during the year ended 31 March 2021. The interest rate on the loan is 12%
(Rs. 4,800 ÷ Rs. 40,000).
Total shareholder return of 7.6% is better than the 5.0% achieved by AsilPharma.
However, it is below the cost of interest on the debt, which is 12%. Normally,
shareholders require a return on their investment that is higher than the cost of debt
finance, as shareholders take on more risk. Total shareholder return is more
meaningful when calculated over a longer period of time, as the returns from
individual years may fluctuate due to volatility in stock markets. For this reason, it
is not possible to make any definite evaluation of the return from one year.
The number of new products launched during the year is only two, compared to ten
for AsilPharma. Investment in intangible assets, which includes licenses and
development of new drugs, has risen by 5% between 2020 and 2021, but given the
large increase in cash, the company could have invested much more than this. It is
essential that the company increases the investment in new products to ensure the
company continues to be successful in the longer term. It will also ensure the
company is able to achieve its objective to develop and grow a diverse portfolio of
products.
The employee engagement score of 50% appears low. AsilPharma managed to

achieve a score of 65% which is significantly better. Such scores may be unreliable
as some employees may be skeptical about whether the survey is truly anonymous
and, therefore, they might be scared to give their true opinion of whether they feel
supported by their employer for fear that the employer will find out, leading to
adverse consequences such as no pay rises or promotions. It is therefore likely that
less than 50% of staff feel satisfied at work, which is not a good situation. If staff
are not happy at work, they will not put effort into it, and the company will not
achieve its full potential.
In summary, therefore, we can say that Rhanapharm's performance has been

adequate but not great. Revenue growth has been low, and the company has not
invested sufficiently in developing new products that will lead to sales growth in
the long run. The company has controlled costs well, leading to slightly improved
profit margins, which suggests that management focus is on internal matters rather
than on the longer-term external market, and this will most likely lead to poorer
performance in the future.
Workings:
178,712
Growth in revenue = ( − 1) × 100 = 2%
175,207
92,069
Growth in gross profit margin = ( – 1) × 100 = 3%
89,729
54,696
Growth in operating profit margin = ( – 1) × 100 = 4%
52,529
382
Answer Bank
21,661
Increase in inventory balances = ( − 1) ×100 = 52%
14,246
Inventory 21,661
Inventory days = ( ) × 365 : 2020 = ( ) × 365 = 91 days
Cost of sale 86,643
14,246
2021 = ( ) × 365 = 61 days
85,478
Current assets − inventory
Quick ratio = ( )
Current liability
61,602 − 21,661
At 31 March 2021 = ( ) = 1.69 times
23,702
Long term debt
Gearing = ( )
Equity + Long term debt
40,000
At 31 March 2021 = ( ) = 25%
118,763 + 40,000
Interest cover = Operating profit ÷ interest expense
In the year ended 31 March 2021 = 54,696 ÷ 4,800 = 11 times.
Dividend yield = (dividend per share ÷ share price at the end of year) × 100
= (177.13 ÷ 4,723) × 100 = 3.8%
Share price at end of year

Capital growth = ( − 1) × 100
Share price at start of year
4,723
=( − 1) × 100 = 3.8%
4,548
Total shareholder return = 3.9% + 3.8% = 7.6%.

Strong subject matter knowledge is required to address the requirements of this
question. Students are required to comment on selection of KPIs under each perspective
and its relevance and applicability. It is very important that students may consider
corporate objectives of the organization while evaluating the balance scorecard.
A good performance measurement system provides management with a measure of

how well the organisation is achieving its objectives, and encourages managers and
staff to work towards achieving those objectives. RhanaPharm has formulated its
mission, which is to provide essential medicines at affordable prices, and to provide
a good return to shareholders. This is supported by two corporate objectives to
develop a diverse portfolio of products and to continuously achieve efficiency in
production.
383
Financial perspective
The financial perspective of the draft balanced scorecard produced by Mr. Nawab
includes return on capital employed and total shareholder return. Both of these
are useful measures of the return that is provided to shareholders, which is one
part of the mission, so these are appropriate measures. Some consideration should
be given to the period over which total shareholder return is calculated. It should
be measured over a longer time period, as decisions made by managers today may
take several years to lead to increased shareholder wealth. Annual shareholder
returns are also distorted by short-term fluctuations in stock markets. It would
therefore be desirable to measure total shareholder return over a longer period –
for example, five years.
The financial perspective also includes revenue growth. This may encourage the
directors to focus on growing the business, not just controlling costs. However, it
is an inwardly focused metric that does not consider the growth of the market, and
it does not show how the revenue has been increased.
Customer perspective
Within the customer perspective, the net promoter score is a useful measure for a
business such as RhanaPharm, where the company is not selling directly to the final
customer (the patient). Net promoter score will reflect all aspects of the customers'
dealings with RhanaPharm, and the score should highlight any problems, if any arise.
The first part of the mission, to provide essential medicines at affordable prices, is
measured to some extent by the average prices compared to competitors, which would
give some indication of how competitive RhanaPharm's prices are. However, even if
RhanaPharm is charging prices that are lower than competitors, this does not
necessarily mean that the medicines are affordable.
Internal business processes
Within the internal business processes, the objective "to continuously achieve
efficiency in production" is not measured.
Time to gain approval for products may be a factor that is somewhat outside the control
of RhanaPharm.
The number of rejected batches will influence quality, as it will highlight any problems
with the production process.
Learning and growth
Within learning and growth, the training days per employee may be a good way of
monitoring how well the company tries to keep the skills of its workforce up to date.
The weakness of this score is that it does not reflect how relevant the training was to
the staff.
The objective "to develop a diverse portfolio of products" is measured by the metric
number of new products. While that metric takes into account the size of the portfolio,
it does not take into account how well the new drugs are performing commercially.
384
Answer Bank

Strong command of code of corporate governance is required to adequately address the
requirements of this question. The students are required to highlight strong areas as well
as improvement areas while assessing the effectiveness of the board.
The board structure appears to comply with the Listed Companies (Code of Corporate
Governance) Regulations, 2019. The roles of chairman and chief executive officer are
not held by the same individual. The number of executive directors (three) is not more
than two third of the total number of directors. There is at least one female director, and
the number of independent directors (five) is more than one third of the total number of
directors.
However, as per Companies Act, 2017, no director shall be considered independent if,
he has served on the board for more than three consecutive terms from the date of his
first appointment. Dr. Tokhi joined the board in 2010 and has already served three terms
therefore, she is no more independent director. Similarly, Dr. Khan, the chairman of
board is serving third term and would not be remain independent on completion of third
term.
In spite of mostly complying with the regulations, the board is not well balanced. In
particular, only one of the directors is under the age of 55. While it is useful to have
directors with plenty of experience, it is also good to have younger people on the board
too. Young people often tend to be more aware of latest trends in areas such as
technology, which would help RhanaPharm to keep up to date.
Most of the directors have a background in pharmacy. This is relevant for a
pharmaceutical company, but the board would benefit from more expertise in other
areas, such as marketing and IT. Two of the directors have finance backgrounds, so that
area does seem to be covered.
There are only two female board members. Having a better gender balance will lead to
a wider pool of potential talent, and more balanced decision making, since it will lead
to a greater diversity of opinions. It is noted that one of the female members of the
board is wife of the CEO, which could suggest that she has been put on the board due
to her connections rather than due to any relevant experience and knowledge that she
has.
The majority of the board are independent and have no financial interests in the
company. While this makes the directors more likely to scrutinise the actions of the
executive directors, there is a risk that the lack of financial interest will lead to these
directors not being sufficiently motivated to contribute up to their full potential.
Implications for the performance of the company
Having predominantly older directors who are probably close to retirement may make
the directors take a shorter-term view of the business. They may not wish to take on the
risk of investing in new products as this may lead to cash outflows and possibly
reduction in profits in the short term, and only bring benefits of increased revenue in
the longer term, by which time the directors may have retired.
Having a lack of younger directors may mean that the company loses customers
because it is not moving with the times, for example adopting technologies such as
electronic data interchange that would enable closer contact with customers, and this
may lead to loss of customers.
385
(d) Tutorial Comments
The requirement is simple; however, strong subject matter knowledge is required to
address this requirement. Students are required to highlight both positive and
improvement areas in existing scheme.
The remuneration scheme appears to provide a good balance between fixed and
performance-based remuneration, as up to 37.5% of the remuneration would be based
on performance. This should motivate the directors to do more than "just turning up
to work".
The bonus element contains a mix of different areas on which the bonus will be
awarded. However, all of these are financial in nature, with three out of four measures
based on profits. There are no measures related to one of the company's two main
objectives "to develop and grow a diverse portfolio". This may be one reason why the
company has only launched two new products during the year. This focus on financial
measures can harm the business, as the directors would not focus on the long-term
drivers of business success such as customer and employee satisfaction.
Financial measures based on profit may encourage excessive cost cutting. While
operating efficiently is desirable, if costs are cut too dramatically, it may harm the
business, as costs that may increase revenues in the future, such as advertising, may be
cut back in an attempt to meet current year's profit targets.
The targets themselves do not appear to be challenging. Revenue growth of 2% appears
to be a very low target. The other targets have all been met during the current year,
suggesting that the targets will not lead to further improvement.
(e) Tutorial Comments
Strong subject matter knowledge i.e., ITO-2001, is required to handle the breadth of
requirements. Students are required to mention all relevant provisions considering the
given scenario to achieve maximum marks.
A subsidiary company may surrender its assessed losses for the tax year in favour of its
holding company. Provided that one of the companies in the group is a public company
listed on the stock exchange in Pakistan and the holding company shall directly hold
55% or more of the share capital of the subsidiary company. RhanaPharm Limited
fulfils the criteria for a listed company but it would need to acquire at least 55% of the
share capital of HPL to qualify for group relief.
Secondly, Mr. Sharif's assumption is incorrect regarding the adjustment of the brought
forward losses of HPL against the income of RhanaPharm Limited.
Under the ITO-2001, the surrendered loss of HPL (other than capital losses) for the tax
year shall be allowed only to the extent of percentage share capital held by RhanaPharm
that may be claimed for, set off against its income under the heading ‘income from
business’ in the tax year and the following two tax years. This is subject to the following
conditions:
 There is a continued ownership for five years of share capital of HPL to the extent
of 55% or more. If there has been any disposal of shares by RhanaPharm during
the period of five years to bring the ownership to less than 55%, RhanaPharm
shall, in the year of disposal, offer the amount of profit on which taxes have not
been paid due to set off of losses surrendered by HPL. However, the transfer of
shares between companies and the shareholders would not be taken as a taxable
event, provided that the transfer is to acquire share capital for formation of the
group, and approval of the SECP has been obtained for this.
386
Answer Bank
 The loss surrendered and loss claimed shall be approved by the board of directors
of RhanaPharm and HPL.
 HPL continues the same business during the said period of three years.
 Both companies shall comply with such corporate governance requirements as
may be specified by the SECP.
Thirdly, HPL shall not be allowed to surrender its assessed losses for set off against the
income of the RhanaPharm for more than three years. Where the losses surrendered by
HPL are not adjusted against income of RhanaPharm in the said three years, HPL shall
carry forward the unadjusted losses for not more than six tax years immediately
succeeding the tax year for which the loss was first computed.
Question No 34 - Razaport
The requirement is straightforward, however, a good practical understanding about the
big data/data analytics is required to suggest improvement in marketing strategy
through introduction of big data analytics. Students are required to cover all domains
(i.e. CRM, Inventory Management, ROI, strong branding and wider reach) to secure
maximum marks.
Data analytics is the process of analysing raw data in order to draw conclusions from
the information. Data analytics techniques can reveal trends and patterns that may not
be immediately obvious when dealing with large amounts of data. Such patterns can
help Razasport to refine its product offering and customer base to improve
performance.
By better using data and introducing a CRM system in line with Gem Consulting's
recommendations, Razasport could see a range of benefits that would help to improve
long-term financial performance.
Targeted marketing
Analysing customer data will help Razasport to build customer profiles, understanding
customer behaviour in terms of frequent purchases, timings of purchases and value of
average spend. Rather than use the mass marketing approach currently favoured,
Razasport can tailor the marketing message to different market segments, thereby
increasing the impact and effectiveness of the message. Through the use of digital
marketing (see below), Razasport can reach specific customer groups using the most
suitable media channel, whether that is by email, website advertisements or social
media contact. Overall, this approach is likely to reduce the marketing cost and improve
the likelihood of a marketing campaign generating increased sales.
Inventory management
Data mining and data analytics will reveal purchasing patterns that Razasport may not
have been aware of. This will enable Razasport to better manage inventory, thus
minimising inventory holding costs, which will help to improve profitability. In turn,
effective inventory management and stock availability will lead to greater customer
satisfaction and an improved chance of repeat business.
387
Customer profitability analysis
Analysis of data will enable Razasport to identify which customers are most profitable.
It is clear from Gem's analysis that Razasport has a core group of customers (20%) that
represent 63% of sales. Analysis of the remaining 80% will identify those customer
groups who are unprofitable to retain, due to the low sales volumes and/or the high
relative cost of servicing them. By switching the focus away from such customers
towards higher margin customers, Razasport will be able to improve long-term
profitability.
Improved customer loyalty and retention
Analysis of customer data and the creation of customer profiles will facilitate seamless,
coherent and consistent customer service across the full range of communication
channels. Razasport can build better relationships with customers resulting in improved
customer satisfaction and long-term customer retention.
New product development
Through analysis of customer data, Razasport can better identify gaps in the market for
sports equipment and sportswear. This could lead to greater product innovation and
new product development, which is necessary in such a competitive market and will
help to protect Razasport's future revenue streams from competitor products.
Digital marketing to improve long-term financial performance
Razasport currently relies on traditional marketing approaches such as billboards and

television and print advertisements.
A digital marketing campaign could provide the following benefits to Razasport,

enabling them to increase long-term profitability.
Lower cost
Razasport's current mass marketing approach is expensive with an average ROI of only
5.5%. A properly planned digital marketing campaign can target specific customers,
using the data stored in the database, at much lower cost than traditional methods.
Digital marketing will enable Razasport to reduce costs whilst increasing the sales
conversion rate.
Personalisation
If Razasport's customer database is linked to the website, customers can be greeted with
targeted messages and promotions whenever they visit the site. In turn, this will build
customer loyalty, thereby supporting long-term sales growth.
Strengthen the brand
Digital marketing can be used to support the branding message by providing additional
support services to the customer. For example, via a website and/or social media,
Razasport can provide 24/7 online customer support to make customers feel valued.
The ability to post feedback will create a dialogue between Razasport and its customer
base, and any negative feedback can be acted on quickly to improve customer
satisfaction.
388
Answer Bank
Ability to track and measure outcomes
As Gem Consulting points out, Razasport's data does not allow for an assessment of
current marketing effectiveness. Gem's analysis reveals that 76% of sales are derived
from repeat customers, which casts doubt on the effectiveness of current marketing in
attracting new business. Digital marketing enables Razasport to measure metrics such
as the number of page views, the clicks or the general increase in web traffic arising
from a campaign. An understanding of the ROI will help Razasport to refine its
marketing strategy, reducing long-term cost.
Wider reach
A website can reach anyone in the world who has internet access. A digital marketing
campaign can increase global awareness of Razasport's products, leading to increased
revenue with very little additional investment.

Strong attention is required to comprehend exiting business performance and to identify
benefits/ risks to answer the requirement. Numerical calculation is also required to
logically support the augments. Students are required to weigh the identified benefits/
risks so strong recommendation could be drawn to conclude the answer.
Benefits:
Reduced shipping cost
The current costs of shipping from Lahore to the UK are prohibitive. Small packages
(10kg) make a loss on average of Rs. 24,000 and regular sized shipments only break
even. Oversized items shipped from Lahore generate a profit of Rs. 58,000 on average
but these only represent 16% of all shipments to the UK. By operating out of a Polish
warehouse, the profit on small, regular and oversized parcels increases to Rs. 2000, Rs.
63,000 and Rs. 319,000 respectively (see Workings).
Lead time reduction
In a world where customers expect their products the next or even the same day, it
is important that Razasport is able to ship products quickly. Currently, 52% of all
shipments (regular and oversized) are sent by sea freight from Lahore with a lead time
of 25 days. Having a warehouse based in Poland will reduce the lead time to four days
on regular and oversized shipments, providing improved customer service.
Furthermore, customers are given the option to receive faster delivery for a small
additional cost of €0.08/kg (Rs. 16/kg) enabling Razasport to provide rapid delivery
services to compete with other online retailers.
Efficient facilities to support e-commerce
Razasport's current Lahore warehouse was set up 40 years ago before the advent of
e-commerce. Consequently, the warehouse is unlikely to be laid out in the most
efficient way to permit rapid fulfilment of customer orders. Using a specialist 3PL
provider will give Razasport access to the most efficient processes and up-to-date
technologies to help control the cost of order fulfilment whilst meeting customer
demand effectively.
389
Simplified border transactions
Currently each individual shipment from Lahore to Europe will be subject to border
checks and import tariffs. If Razasport uses a European warehouse, these checks will
be greatly reduced and apply to larger warehouse replenishment shipments rather than
one off items. Once goods are within European Union borders there is freedom of
movement, resulting in reduced administrative burden and lower cost.
Better reputation
European presence may serve to strengthen Razasport's reputation, since customer
orders can be processed quickly. Setting up a European base also demonstrates a
commitment to European customers and may influence larger customers to purchase
from Razasport more often.
Risks:
Increased fixed cost
Razasport profitability is declining, so it is important to either reduce cost or increase
sales. The contract with the Polish warehouse is for a minimum duration of five years
with an exit cost of six months’ rental. This will increase the fixed cost and therefore
increase operating gearing, which will hamper profitability in a time of volatile sales.
Increased working capital requirement
To gain the benefits of having a European warehouse, Razasport will need to ensure
that they hold sufficient inventory to satisfy demand. Due to the lead times of 19 days
involved in shipping from Lahore to the Polish warehouse, inventory days will increase,
requiring a significant capital injection from Razasport.
Reduced control
Razasport has no experience of outsourcing to third parties and is not used to the loss
of control that this brings. Because the warehouse space is co-shared and Razasport will
be using the 3PL technology, there will be a greater need to follow the procedures of
the 3PL provider, rather than developing bespoke procedures. Razasport may find it
difficult to adapt to a change in the way of working.
Hidden cost
Although the outsourcing arrangement provides cost savings in terms of delivery
savings, Razasport needs to be aware of additional hidden costs that may make the
arrangement unprofitable. These could include legal costs during contract negotiations,
service level agreement (SLA) monitoring costs and exit fees of six months' rental if
the contract is terminated before the end of the five-year agreement.
Recommendation
Taking the above factors into consideration, it is recommended that Razasport

outsources its warehousing to provide a more efficient warehousing and delivery
service. This will enable Razasport to compete effectively with other online retailers,
improving both Razasport's profitability and reputation in a global market.
390
Answer Bank
Workings
Profit per average shipment
SMALL – 10kg
Poland Lahore
Shipping cost/kg 3 18
Average net revenue (6  10kg) 60 60

Cost of shipping (10kg  shipping cost) (30) (180)
Warehouse replenishment cost (20) -
Profit (euros) 10 (120)
Profit (Rs.) 2,000 (24,000)
REGULAR – 35kg
Poland Lahore
Average net revenue (12  35kg) 420 420

Cost of shipping (35kg  shipping cost) (35) (420)
Profit (euros) 315 0
Profit (Rs.) 63,000 0
OVERSIZE – 145kg
Poland Lahore
Average net revenue (14  145kg) 2,030 2,030

Cost of shipping (145kg  shipping cost) (145) (1,740)
Profit (euros) 1,595 290
Profit (Rs.) 319,000 58,000

The requirement is time pressured. Students are required to address numerical part in a
timely and efficient manner so that strong commentary can be made within given time
followed by solid fact-based recommendation.
391
Arguments in favour of factoring:
Improved cash flow
If debt is factored, according to the terms proposed by the financial controller,

Razasport will receive an increase in cash flow of Rs. 272.47 million (W1). This cash
flow will reduce the pressure on liquidity and enable Razasport to continue as a going
concern until sales pick up once again.
Quick to arrange
Whenever Razasport recognises the need for a rapid injection of cash, debt factoring is
simple and quick to arrange. Debts can be factored over the short or medium term,
making it a flexible form of finance when required. Due to the uncertainty in the
economic environment, factoring of trade receivables could be a useful tool in helping
Razasport to manage cash flow on a short-term basis.
Focus on making sales
Razasport is struggling with sales volumes as a result of the global pandemic. It is this
issue that has resulted in a liquidity problem rather than a sudden increase in receivables
days. If Razasport factors debts, the business will free up time to attract and retain
customers through marketing (digital and traditional) and product innovation.
Drawbacks of factoring:
Cost
The cost of using a factor is Rs. 3 million greater than the current overdraft finance
(W2) which will put further pressure on Razasport's profit. Both the debt factor and the
overdraft are expensive ways of financing receivables, which will not achieve the
board's goal of increased profit.
Damaged customer relationships
Razasport has established good relationships with customers, which are important to
protect sales, particularly in times of economic uncertainty. Using a debt factor will
potentially damage those relationships, since customers will lose the personal contact
they currently have with Razasport employees and are likely to feel under increased
pressure to pay early.
Recommendation
Using a debt factor will lead to a small increase in cost as well as having the potential
to harm the good customer relationships established over many years. It is therefore not
recommended that Razasport uses debt factoring. To reduce cost and improve profit,
Razasport should consider better management of trade receivables in line with the 30-
day policy, as well as cheaper forms of finance such as loans.
Workings
392
Answer Bank
W-1: Cash inflow if factoring used
Rs. in
million
Without debt factor: Receivables – 90 days sales (per Appendix 3) 320.55
With debt factor:
Receivables – 45 days sales (1.3bn  45/365) 160.27
70% cash advance (112.19)
Outstanding receivables 48.08
Cash inflow (320.548 – 48.082) 272.47
W-2: Cost of factoring vs overdraft financing
Annual sales Rs. 1.3 billion
Receivables Rs. 321 million
Rs. in million
Cost of overdraft to fund receivables 320.55m  12% 38.5
Cost of factoring
Annual factoring fee 1.3 bn  2% 26.0
Annual interest charge on 70% cash advance (1.3bn×70%×10%×45/365) 11.2
Annual overdraft interest on remaining 30% (1.3bn×30%×12%×45/365) 5.8
Less credit control savings (1.5)
Total annual cost 41.5
Question No 35 - A2Z
Students are required to carefully read the given information to identify possible risks
based on the financial information provide in the question. Strong analytical skills are
required to identify and evaluate possible risks i.e., Reliance on one division/ single
customer, competition risk, intellectual property and technology failure. Strong
business acumen and commercial sense is required to suggest mitigation strategies.
Key risks and mitigating strategies
Data Analytics Digital Solutions
2020 2019 2020 2019
% % % %
Profit margin 24 28 21 24
ROI 17 19 12 12
Revenue from division 64 68 36 32
Revenue from largest customer 61 55 30 37
Change in customers 24 - 50 -
Customers lost since end of previous year 15 - 38 -
393
Risk Evaluation Mitigation
Intellectual Both divisions are exposed to intellectual property Analytics division –

property issues. Clear contracts of data
ownership should be
drawn up to reduce the
Analytics division – Ownership of customer data is legal issues and
currently unclear once it has been processed by intellectual property
A2Z. Lengthy and likely expensive legal uncertainties when a
procedures can therefore arise when customers client leaves A2Z.
move to new suppliers.
Digital solutions – Competitors are able to copy the
Digital solutions division
division's innovative solutions, reducing the
– Patents should be
possible returns that A2Z can generate on their
sought for new
investment. The impact can be seen in the current
ROI of 12% in 2020 compared to the analytics technologies in order to
protect the division's
division return of 17% for the same year.
investment.
Technology A2Z has a strong reputation for its customer service Business continuity plans
failure and speed of response, particularly with regard to including back-ups and
the Data Analytics division. disaster recovery plans
should be introduced to
However, this is reliant upon the cloud-based
sustain service in times of
technology functioning correctly, with no
interruptions of service or failures. systems failure or
disruption.
Reliance on The Data Analytics division generated 64% and Increase investment in
one division 68% of total revenues in 2020 and 2019 the Digital Solutions
respectively. However, looking at forecast growth division, to attract and
for the two divisions it can be seen that the Digital retain new business.
Solutions division's growth outstrips Data Analytics
at 36% compared to 17% for Data Analytics. This
gives the Data Analytics division less scope to Consider expansion into
expand and there is a risk that this market, upon new industries and
which A2Z currently relies, will start to decline. geographies.
Competitio The market is highly competitive and customers Increase customer

n risk regularly switch providers. For example, in the Data loyalty by understanding
Analytics division, there was a 24% increase in new and responding to
customers between 2019 and 2020 but, during customer needs.
2020, A2Zs lost 15% of customers registered at the
Anticipate and adapt to
end of 2019.
changes in technology
The data reveals a similar picture for the Digital and markets to provide
Solutions division with a 50% increase in customers the most up-to-date
between 2019 and 2020 but a loss of 38% of the technology and solutions.
customers on A2Z's books at the end of 2019. This
Seek out new customers
high turnover of customers will disrupt business through marketing.
operations and is likely to be one driver of the recent
fall in operating margins, since business disruption Perform competitor
is likely to increase cost. analysis.
Reliance on Both divisions appear to be over reliant on one Identify and attract new
a single customer. The Data Analytics division obtained customers.
customer 55% and 61% of revenue from one customer for the
years of 2019 and 2020 respectively.
394
Answer Bank
It is a similar position in the Digital Solutions Work closely with

division with the largest customer delivering 37% current customers to
(2019) and 30% (2020) of revenue. Since customers understand their needs
regularly move to alternative suppliers, this and build loyalty.
increases the volatility of A2Z's revenues. Develop a contingency
plan in the event of a key
customer leaving.

It is simple requirement; however, it is highly time pressured. Efficient planning to
fetch required financial information is key to adequately address the requirement within
time.
Valuation of ordinary share capital
Valuation summary
Equity
value
Valuation method Rs. in '000
(1) Asset-based (W-1) 73,400
(2) P/E based – 2020 earnings [18.7(W-2) × 53,875] 1,007,459
P/E based – 2021 forecast earnings [18.7 × 74,829(W-3)] 1,399,306
Commentary
Asset-based valuation
The asset-based valuation provides a minimum value for Logical to be used in

negotiations. However, this method of valuation is not likely to be relevant for a
service-based company as it fails to include intangible assets such as goodwill. As a
technology business, Logical's value is more likely to be derived from the quality of the
service it provides and the skills/experience of employees rather than from its assets. It
is a useful starting point as the seller would not accept less than the assets-based value,
but it is nothing more than that in this case.
P/E based
This approach requires adjustments to a proxy P/E ratio because Logical is not a quoted
company. The adjustments may be relatively arbitrary in size. In addition, the proxy
company (A2Z) may not be comparable to the target company (Logical) due to
difference in services, structure and size. For this reason, this is an indicative value only
but will represent the highest value that A2Z is willing to pay to acquire Logical.
Workings
Market value at 31
W-1: Asset-based value Dec 2020
Rs. in '000
Total assets 150,197
Total liabilities 76,797
Net asset valuation [150,197 – 76,797] 73,400
395
W-2: Price to earnings ratio-based valuation
A2Z P/E ratio:
Earnings Rs. 66 million
Shares in issue 50 million
EPS 66/50 = Rs. 1.32
Price per share Rs. 37
P/E ratio Price per share/EPS =37/1.32 = 28
Adjusted for lack of marketability 2/3  28 = 18.7
W-3: Earnings
Forecast statement of profit and loss

2021
Rs. in '000
Revenue [335,2001.14] 382,128
Cost of sales [117,320/335,200]382,128 (133,745)
Gross profit 248,383
Operating expenses 120,000+(23012)+1309] (120,990)
Profit before tax 105,393
Tax [22,005/75,880]105,393 (30,564)
Profit for the year 74,829
Strong subject matter knowledge is required to address the requirement of this question.
The requirement is high time pressured so students may present their answers in bullets
to save time.
Causes of cyber security incident and recommended actions
Malware
Malware is malicious software and was implicated in the cyber security breaches across
the supermarket industry. Once the software is loaded, it enables the hacker to access
the immediate systems as well as connected systems.
Action:
Staff at A2Z should be encouraged to avoid opening emails from unknown sources as
well as avoiding websites that look unusual or suspicious. If such an email or website
is opened in error, staff should inform A2Z's IT team immediately so that preventative
action can be taken.
Too many permissions
All A2Z's customers have access to the cloud-based storage to upload data for analysis.
This provides a hacker with many potential points of entry to the system.
396
Answer Bank
Action:
A2Z should keep a tight control on who has access to the systems. The permissions
should be updated regularly so that customers who have now left A2Z can no longer
access the system.
Software and application vulnerabilities
All software has technical vulnerabilities that can be exploited by those wishing to
perpetrate a cybercrime. A2Z should ensure that they and their clients are aware of any
identified software problems so that fixes can be applied as soon as possible.
Action:
Systems should be tested regularly and updates (patches) should be applied whenever
they are released by the software provider. A2Z uses their own in-house software so
regular reviews of security and stability of the software should be undertaken.
Human error
A2Z staff run the risk of exposing the business to cyber security risk without intending
to. At the end of December 2020, A2Z was working with 158 customers with
32 customers having been lost since the end of December 2019. It is therefore possible
that access profiles and permissions are not always updated giving hackers the chance
to access A2Z's customer data. Employees may also include the wrong names in
confidential emails or attach the wrong documents.
Action:
Staff training is important to alert employees to potential risks. Also, regular scanning
of the systems will help to identify which customers are and should still be active.
Consequences
Loss of reputation
A data breach at A2Z, even if it was caused by a breach of customer systems, has the
potential to damage A2Z's reputation and may result in a loss of customers, particularly
in such a competitive environment.
Loss of investor confidence
A2Z's business is built around using data, so any breaches are likely to result in a drop
in investor confidence and a fall in the share price. This will make it harder for A2Z to
expand the business through the acquisition of Logical.
Fines/legal action
The Data Protection Laws and Regulations lay out the fines payable in the event of a
customer data breach. A2Z may also be the subject of legal action if customers decide
to sue them for a breach of confidential and sensitive data.
397
Question No 36 - Jazeera Machinery Ltd (June 18)
(a) Valuation of Teela's business assets
Appropriate discussion of each asset
 Note on uncertainty associated with forecast 1
 Property, plant and equipment 3
 Inventory 3
 Receivables 2
 Brand 3
Recommendation 2
(b) Importance of JML's proposed strategy for Teela
 Significance of future use of assets within JML group 2
 Appropriate use of the information from Exhibit 1 2
regarding JML' s intended strategy, and Exhibit 2, to
construct a discounted cash flow
valuation
 Suitable commentary on the valuation that is 3
indicated, in the context of the intended strategy
Key risks associated with this acquisition
 Risk associated with overpaying for Teela 2
 Dependent on establishing a suitable new franchise 1
 Potential obligations arising from closure of sites 2
 Impact on the brand of the recent accident 1
 High level of inventory 1
(c) Impact of income tax
 Income tax payable in 2019 (profit) per ITO 2001 1
 Income tax payable in 2018 (loss) per ITO 2001 s.113 2
 Losses carried forward 1
 Conclusion: impact on NPV 2
398
Answer Bank
(a) Valuation of assets

The valuation of the business assets is uncertain, given the information available
(the figures for 2018 are an 'unaudited forecast' for six months into the future) but
the following factors should be considered.
Property, plant and equipment
The fair value of the property (asserted to be Rs 2,300 million) should be capable
of being independently ascertained from market data or consulting with
appropriate property experts.
The remaining PPE should be itemised, because some of it may be specialised
equipment, in which case the replacement cost may be higher than the realisable
value.
A market should exist in the agricultural equipment trade for other more general
equipment, in which case the replacement cost may approximate to the realisable
value.
Analysis on an asset-by-asset basis is needed. Selling costs should be deducted,
giving an approximate net realisable value of Rs 3,400 million – Rs 75 million
= Rs 3,325 million.
Inventories
The full retail values quoted by the administrator are an inappropriate basis on
which to value inventories, as these are their selling prices.
More accurate figures are needed concerning the current trade values of the
agricultural equipment, but the cost of acquiring it could be used as an initial
measure. The actual value is, however, likely to be lower than cost, particularly
as there are forecast to be around seven months' sales of vehicles and equipment
held in inventory at the end of 2018 (1,685/3,060 x 12 = 6.6) so it is debatable
whether all of this will still be realisable.
It is unlikely that JML would want to acquire the existing inventory of tractors,
given their poor sales history and apparent problems, and the fact that JML's plan
is to operate a franchise from an alternative manufacturer. They are valued at Rs
615 million and should therefore be deducted from the Rs 1,685 million carrying
value, giving a maximum value for the inventory of Rs 1,070 million.
Receivables
Although the administrator has expressed 'some confidence' that the debt of Rs
15 million will be paid, the fact that it has been outstanding for more than a year
is a cause for concern, and so this amount should prudently be deducted from the
receivables balance.
Assuming that the remainder of receivables are fully recoverable, they can
initially be valued at Rs 75 million – 15 million = Rs 60 million, but the actual
receivables existing at the date of acquisition will still need to be determined.
Brand
An offer was made to acquire the brand in 2016 for Rs 300 million. The offer may
have approximated to the market value at that time, but there must be doubt as to
whether the Teela brand has a comparable value at this time.
399
The company's reputation will have been damaged by selling the unsuccessful
tractors and entering liquidation, along with the fact that it is loss-making.
Taking these factors into consideration a nil value for the brand is prudently
assumed at this stage.
Recommendation
From the above analysis, a total (maximum estimated) value of Teela's assets of
Rs 4,455 million is suggested, based upon values at the forecast date of 31
December 2018. As noted before, caution should be exercised around the
reliability of these figures, given that they are based on an unaudited forecast.
In a discussion of the components of assets in the valuation question it is vital that
students demonstrate judgment by questioning the quality and age of information
provided and explain why some of the assumptions made by directors may not be
valid. Students should also plan to provide a likely valuation for each component and
recommend an overall valuation with caveats on its reliability to achieve a high mark.
(b) Importance of JML's intended strategy
The value to JML of the business assets of Teela may be greater than their break-
up value, reflecting the earnings which can accrue from their future use as part of
the larger Jazeera Machinery group. It may be necessary to bid above the break-
up asset value in order to acquire them, especially if another agricultural
machinery dealer is also interested in purchasing the Teela assets.
It is possible that with different management (i.e. under the ownership of Jazeera)
Teela's performance may improve, but it seems certain that any proposed strategy
for Teela should not include continuing with its current tractor franchise.
Jazeera already has contracts with other manufacturers, including tractor
manufacturers, and may be able to extend these to Teela.
Although this is currently an uncertainty, if the assumption proves correct that
Teela's sales will increase by 100% with new management and a new franchise
arrangement (Exhibit 1), then the value of the business assets could be obtained
from discounting its future cash flows as follows:
2019
Rs'm
Sales (3,519 x 2) 7,038
Cost of sales variable (90% x 3,060 x 2) (5,508)
Cost of sales fixed (10% x 3,060) (306)
Gross profit 1,224
Depreciation (2,815 – 2,480) (335)
Administrative expenses (93 – 20) (73)
Operating profit 816
Add:
Depreciation 335
Operating cash flow 1,151
Less:
Capital expenditure (75)
Annual cash flow 1,076
400
Answer Bank
Present value at 10% in perpetuity of the annual cash flow is: Rs 1,076 million/0.1
= Rs 10,760 million
This value is more than double the maximum break-up value of the assets already
calculated at Rs 4,455 million, indicating that Jazeera is adding considerable
value with its preferred strategy for Teela. This strategy is, however, completely
dependent on it being able to turn the company into a profit making venture by
doubling its revenue. The increase of 100% in sales in 2019 seems very
optimistic, and is dependent on a new tractor franchise being established quickly.
While the increase of 100% in sales in 2019 seems optimistic, the assumption of
no growth in profits at all after 2019 appears too pessimistic.
Capital allowances have been ignored in this calculation; their inclusion would
increase the present value. It should also be recognised that the depreciation
charge that has been added back to the cash flows is high. A detailed capital
budget and projections would be needed to enable a more accurate cash flow
forecast to be made.
Finally, the perpetuity assumption may not be valid – more information on the
prospects for the revitalised Teela business and its future strategy would enable a
definite timeframe to be determined, along with a residual value of the business
at that time.
Key risks
The main risk is overpaying for the acquisition of Teela, and that as a result it
may not deliver the strategic and financial benefits expected. This risk is
moderated where JML only pays the asset value because if the benefits of
operating Teela do not fully materialise, then at least some of the assets can
presumably be sold.
Despite this, there remain a number of risks:
 There is a significant risk that JML will be unable to turn around Teela’s
business in the way that it hopes it will be possible. The strategy appears
to depend on being able to establish a suitable new franchise agreement.
It may be necessary to consider a franchise selling equipment that is more
aligned with Teela’s expertise in fertilisers and pest control, rather than to
continue with a strategy of selling tractors that has failed in the past. The
tractor market may be too well established for new entrants.
 Teela’s assets will include loss making locations, as well as profitable
ones. It may be decided to operate the most profitable and strategically
valuable locations, and close others, but this also will incur closure costs.
There may be obligations to Teela employees which will incur costs (such
as redundancy pay) if areas of the business are to be closed.
 The tractor crash may have a longer term impact on Teela’s brand. There
is a risk that its reputation could fall further if, for example, a similar
problem emerges involving a piece of fertiliser equipment.
 The level of inventories appears to be very high, and may indicate further
problems in making sales than is currently fully understood.
401
There are many components to this requirement, so it is essential that students spend
time in analysing the requirement carefully to identify each element. Students are then
advised to plan how to efficiently present the cash flow valuation, discuss each of the
practical challenges to ensure a successful strategic implementation, and allocate
sufficient time to explain each identified risk of acquisition. For the cash flow valuation
it is recommended that students show their workings so method marks can be awarded.
In the discussion of risks, students should consider if there are any ways the company
can mitigate against this risk and include judgements on whether each risk is major or
relatively minor.
(c) The discounted cash flow working in part (b) shows that from the financial year
2019, Teela Ltd would become profitable. As per first schedule part 1 of ITO
2001, the income tax rate for companies is 30% for the tax year 2018 and onwards.
Therefore, Teela would be required to pay tax at the rate of 30% on its operating
profit in 2019.
However, Teela’s forecast for the financial year 2018 shows a net loss of Rs
107 million. Therefore, as per ITO 2001 Section 113, minimum tax at the rate of
1.25% would be required to pay on the turnover. For the purpose of turnover, any
sales tax, federal excise duty, and any trade discounts shown on invoices or
deemed income should be excluded. Further, this minimum tax shall be carried
for adjustment against the tax liability for five tax years immediately succeeding
the tax year for which the amount was paid.
As per ITO 2001 Section 57, as Teela Ltd sustained a loss in a tax year (i.e. 2018),
this loss shall be carried forward to the following tax year and so on, but it cannot
be carried forward more than six tax years immediately succeeding the tax year
for which the loss was first computed (i.e. 2018).
Conclusion:
Based on the above clauses, the NPV would decrease due to the inclusion of a
minimum tax payment in 2018, and normal income tax at the rate of 30% in the
tax year 2019 and onwards.
However, the carried forward minimum tax paid and carried forward tax losses
for the tax year 2018 will have a positive impact on 2019 cash flows.
Tutorial comments
For the discussion of the impact on income tax, students are advised to include a
discussion of the forecast profit and loss, and consider how losses could be utilised if
carried forward under existing tax rules. Students should also consider if the existence
of tax losses and the ability to carry these forward would have a beneficial impact on
the net present value of the strategic proposal.
402

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Management Professional

Marks Question Answer

18 Techcon Ltd 20 71 268

19 Ashir and Arham 25 76 272

20 Rabia Limited 50 79 277

Section 3: Past Exam Questions

Exhibit 1 – Extracts from report on internal processes

Exhibit 2 – Extracts from VisionPak’s most recent financial statements

Tutorial guidance before you begin

Exhibit 2 – Report from Laila Shah – BMG’s senior environment officer

Exhibit 3 – Extract from a story in the Gwadar Times newspaper

Tutorial guidance before you begin

Tutorial guidance before you begin

Exhibit 1 – Critical news report – Punjab Daily Bugle

Tutorial guidance before you begin

5 Fresh ‘n’ Frozen

Exhibit 1 – Company Delivery Targets

Exhibit 2 – Email from Head of Delivery

Tutorial guidance before you begin

Exhibit 2 – financial data about BiOs

S. No. Taxable income Rate of tax

Exhibit 1 – Email of internal discussion about JV

Year 1 80,000 550

Year 2 125,000 575

Year 3 165,000 600

Exhibit 3 – Questions from the directors of PJ

Exhibit 4 – News report on the Venezuelan Economy

Tutorial guidance before you begin

Tutorial guidance before you begin

Exhibit 1 – Offer from the Board of PCT

Exhibit 2 – Share price and investor ratio details

Tutorial guidance before you begin

Exhibit 1 – Financial information relating to the proposed contract with TSD

Exhibit 2 – Proposed project in Country T

Exhibit 3 – Exchange controls introduced in Country T

Tutorial guidance before you begin

Summary statement of financial position as at 30 June 20X7 Rs'm

Exhibit 4 – Comparable company information

Comparable Effective Market value Asset beta Latest trailing

Datastore 17% 27.3% 1.17 32.0

Perm-a-data 19% 33.6% 1.25 28.6

E-Store 17% 20.1% 1.26 38.3

FilingData 15% 45.6% 1.33 37.4

Exhibit 5 – Risks arising from the acquisition of Y-Tech

Tutorial guidance before you begin

Exhibit 1 – Directors of KMC – views on financing the takeover

Exhibit 2 – Financial statements of KMC and PAMC

Statement of financial position as at 31 March 20X7

Tutorial guidance before you begin

Kamran is currently reviewing how to finance his proposed organic growth. He is

Extract from the statement of profit or loss as at 31 December 20X9

Tutorial guidance before you begin

Exhibit 1 – Net Present Value calculations

15 Khan and Co.

Exhibit 1 – Extracts from the Financial Statements

Exhibit 2 – Current cost/revenue information from the assistant management

Exhibit 3 – Notes taken from meeting with management

16 Lahore World Travel Ltd

APPENDIX 1 – STRATEGY AND ACQUISITION OPPORTUNITY

APPENDIX 1 – 'DAILY NEWS' REPORT

Professional Qualifications and Professional Qualifications and Experience

Experience and duties Experience and duties

Key skills and competencies Key skills and competencies