ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Identifying Risk - Past Papers ^{6 / 9}

Bournelorth Co is an IT company which was established by three friends ten years ago. It was listed on a local stock exchange for smaller companies nine months ago.

Bournelorth Co originally provided support to businesses in the financial services sector. It has been able to expand into other sectors over time due to the excellent services it has provided and the high quality staff whom its founders recruited. The founders have been happy with the level of profits which the IT services have generated. Over time they have increasingly left the supervision of the IT services in the hands of experienced managers and focused on developing diagnostic applications (apps). The founders have worked fairly independently of each other on development work. Each has a small team of staff and all three want their teams to work in an informal environment which they believe enhances creativity.

Two apps which Bournelorth Co developed were very successful and generated significant profits. The founders wanted the company to invest much more in developing diagnostic apps. Previously they had preferred to use internal funding, because they were worried that external finance providers would want a lot of information about how Bournelorth Co is performing. However, the amount of finance required meant that funding had to be obtained from external sources and they decided to seek a listing, as two of Bournelorth Co’s principal competitors had recently been successfully listed.

25% of Bournelorth Co’s equity shares were made available on the stock exchange for external investors, which was the minimum allowed by the rules of the exchange. The founders have continued to own the remaining 75% of Bournelorth Co’s equity share capital. Although the listing was fully subscribed, the price which new investors paid was lower than the directors had originally hoped.

The board now consists of the three founders, who are the executive directors, and two independent non-executive directors, who were appointed when the company was listed. The non-executive directors have expressed concerns about the lack of frequency of formal board meetings and the limited time spent by the executive directors overseeing the company’s activities, compared with the time they spend leading development work. The non-executive directors would also like Bournelorth Co’s external auditors to carry out a thorough review of its risk management and control systems.

The funds obtained from the listing have helped Bournelorth Co expand its development activities. Bournelorth Co’s competitors have recently launched some very successful diagnostic apps and its executive directors are now afraid that Bournelorth Co will fall behind its competitors unless there is further investment in development. However, they disagree about how this investment should be funded. One executive director believes that Bournelorth Co should consider selling off its IT support and consultancy services business. The second executive director favours a rights issue and the third executive director would prefer to seek debt finance. At present Bournelorth Co has low gearing and the director who is in favour of debt finance believes that there is too much uncertainty associated with obtaining further equity finance, as investors do not always act rationally.

Required:
(b) (i) Identify the risks associated with investing in the development of apps and describe the controls which Bournelorth Co should have over its investment in development. (6 marks)

Riviere Co is a small company based in the European Union (EU). It produces high quality frozen food which it exports to a small number of supermarket chains located within the EU as well. The EU is a free trade area for trade between its member countries.

Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using internally generated funds for new investment projects. This constraint means that it cannot accept every profitable project and often has to choose between them.

Riviere Co is currently considering investment in one of two mutually exclusive food production projects: Privi and Drugi. Privi will produce and sell a new range of frozen desserts exclusively within the EU. Drugi will produce and sell a new range of frozen desserts and savoury foods to supermarket chains based in countries outside the EU. Each project will last for five years and the following financial information refers to both projects.

Project Drugi, annual after-tax cash flows expected at the end of each year (€000s)

Both projects’ net present value has been calculated based on Riviere Co’s nominal cost of capital of 10%. It can be assumed that both projects’ cash flow returns are normally distributed and the annual standard deviation of project Drugi’s present value of after-tax cash flows is estimated to be €400,000. It can also be assumed that all sales are made in € (Euro) and therefore the company is not exposed to any foreign exchange exposure.

Notwithstanding how profitable project Drugi may appear to be, Riviere Co’s board of directors is concerned about the possible legal risks if it invests in the project because they have never dealt with companies outside the EU before.

Required:
(c) Discuss the possible legal risks of investing in project Drugi which Riviere Co may be concerned about and how these may be mitigated. (7 marks)

Strom Co is a clothing retailer, with stores selling mid-price clothes and clothing accessories throughout Europe. It sells its own-brand items, which are produced by small manufacturers located in Africa, who work solely for Strom Co.

The recent European sovereign debt crisis has affected a number of countries in the European Union (EU). Consequently, Strom Co has found trading conditions to be extremely difficult, putting pressure on profits and sales revenue.

The sovereign debt crisis in Europe resulted in countries finding it increasingly difficult and expensive to issue government bonds to raise funds.

Two main reasons have been put forward to explain why the crisis took place: firstly, a number of countries continued to borrow excessive funds, because their expenditure exceeded taxation revenues; and secondly, a number of countries allocated significant sums of money to support their banks following the ‘credit crunch’ and the banking crisis.

In order to prevent countries defaulting on their debt obligations and being downgraded, the countries in the EU and the International Monetary Fund (IMF) established a fund to provide financial support to member states threatened by the risk of default, credit downgrades and excessive borrowing yields. Strict economic conditions known as austerity measures were imposed on these countries in exchange for receiving financial support.

The austerity measures have affected Strom Co negatively, and the years 2011 and 2012 have been particularly bad, with sales revenue declining by 15% and profits by 25% in 2011, and remaining at 2011 levels in 2012.

On investigation, Strom Co noted that clothing retailers selling clothes at low prices and at high prices were not affected as badly as Strom Co or other mid-price retailers. Indeed, the retailers selling low-priced clothes had increased their profits, and retailers selling luxury, expensive clothes had maintained their profits over the last two to three years.

In order to improve profitability, Strom Co’s board of directors expects to cut costs where possible. A significant fixed cost relates to quality control, which includes monitoring the working conditions of employees of Strom Co’s clothing manufacturers, as part of its ethical commitment.

Required:

Discuss the risks to Strom Co of reducing the costs relating to quality control and how the detrimental impact of such reductions in costs could be decreased. (6 marks)

Kilenc Co, a large listed company based in the UK, produces pharmaceutical products which are exported around the world. It is reviewing a proposal to set up a subsidiary company to manufacture a range of body and facial creams in Lanosia. These products will be sold to local retailers and to retailers in nearby countries.

Lanosia has a small but growing manufacturing industry in pharmaceutical products, although it remains largely reliant on imports. The Lanosian government has been keen to promote the pharmaceutical manufacturing industry through purchasing local pharmaceutical products, providing government grants and reducing the industry’s corporate tax rate. It also imposes large duties on imported pharmaceutical products which compete with the ones produced locally.

Although politically stable, the recent worldwide financial crisis has had a significant negative impact on Lanosia. The country’s national debt has grown substantially following a bailout of its banks and it has had to introduce economic measures which are hampering the country’s ability to recover from a deep recession. Growth in real wages has been negative over the past three years, the economy has shrunk in the past year and inflation has remained higher than normal during this time.

On the other hand, corporate investment in capital assets, research and development, and education and training, has grown recently and interest rates remain low. This has led some economists to suggest that the economy should start to recover soon. Employment levels remain high in spite of low nominal wage growth.

Lanosian corporate governance regulations stipulate that at least 40% of equity share capital must be held by the local population. In addition at least 50% of members on the Board of Directors, including the Chairman, must be from Lanosia. Kilenc Co wants to finance the subsidiary company using a mixture of debt and equity.

It wants to raise additional equity and debt finance in Lanosia in order to minimise exchange rate exposure. The small size of the subsidiary will have minimal impact on Kilenc Co’s capital structure. Kilenc Co intends to raise the 40% equity through an initial public offering (IPO) in Lanosia and provide the remaining 60% of the equity funds from its own cash funds.

Required:

Discuss the key risks and issues that Kilenc Co should consider when setting up a subsidiary company in Lanosia, and suggest how these may be mitigated. (15 marks)