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Performance Pillar

P3 – Performance Strategy

Instructions to candidates You are allowed three hours to answer this question paper. You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to begin using your computer to produce your answer or to use your calculator during the reading time. You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is all parts and/or subquestions). ALL answers must be submitted electronically, using the single Word and Excel files provided. Answers written on the question paper and note paper will not be submitted for marking. You should show all workings as marks are available for the method you use. The pre-seen case study material is included in this question paper on pages 2 to 7. The unseen case study material, specific to this examination, is provided on page 8 and 9. Answer the compulsory question in Section A on page 11. This page is detachable for ease of reference Answer TWO of the three questions in Section B on pages 14 to 19. Maths tables and formulae are provided on pages 21 to 24. The list of verbs as published in the syllabus is given for reference on page 27. Your computer will contain two blank files – a Word and an Excel file. Please ensure that you check that the file names for these two documents correspond with your candidate number.

P3 – Performance Strategy

Thursday 3 March 2011

TURN OVER

 The Chartered Institute of Management Accountants 2011


DEF Airport Pre-seen case study Overview DEF Airport is situated in country D within Europe but which is outside the Eurozone. The local currency is D$. It is located near to the town of DEF. It began life in the 1930s as a flying club and was extended in 1947, providing scheduled services within central Europe. A group of four local state governments, which are all in easy reach of the airport (hereafter referred to as the LSGs), took over the running of the airport in 1961. The four LSGs are named North (NLSG), South (SLSG), East (ELSG) and West (WLSG). These names place their geographical location in relation to the airport. In the early 1970s flights from the airport to European holiday destinations commenced with charter flights operated by holiday companies. In 1986, the first transatlantic flight was established and the airport terminal building was extended in 1987. By 1989 the airport was handling 500,000 passengers per year which is forecast to increase to 3.5 million for both incoming and outgoing passengers in the current financial year to 30 June 2011. The airport mainly serves holidaymakers flying to destinations within Europe and only 5% of the passengers who use the airport are business travellers. DEF Airport was converted into a company in 1990 and the four LSGs became the shareholders, each with an equal share. The company is not listed on a stock exchange. The airport has undertaken extensive development since 2000, with improvements to its single terminal building. The improvements have mainly been to improve the airport’s catering facilities and to increase the number of check-in desks. There has also been investment in the aircraft maintenance facilities offered to the airlines operating out of the airport. Governance The Board of Directors has four Executive directors: the Chief Executive, the Director of Facilities Management, the Finance Director and the Commercial Director. In addition there is a Company Secretary and a Non-Executive Chairman. In accordance with DEF Airport’s Articles of Association, the Non-Executive Chairman is drawn from one of the four LSGs. The Non-Executive Chairman is the sole representative of all four LSGs. The Chairmanship changes every two years with each of the four LSGs taking turns to nominate the Chair. The four LSGs have indicated that they may wish to sell their shareholdings in the airport in the near future. If any LSG wishes to sell its shares in the airport it must first offer them to the other three LSGs. Any shares that are not purchased by the other LSGs may then be sold on the open market. A local investment bank (IVB) has written to the Chairman expressing an interest in investing in the airport in return for a shareholding together with a seat on the Board. Mission statement The Board of Directors drew up a mission statement in 2008. It states “At DEF Airport we aim to outperform all other regional airports in Europe by ensuring that we offer our customers a range of services that are of the highest quality, provided by the best people and conform to the highest ethical standards. We aim to be a good corporate citizen in everything we do.”

DEF Airport development plan The Board of Directors produced a development plan in 2009. The Board of Directors consulted with businesses in the area and followed central government airport planning guidelines. It was assumed that the views of other local stakeholders would be represented by the four LSGs which would feed comments to the Board through the Chairman. The plan relates to the development of DEF Airport and its forecast passenger growth for the next two decades. The Board proposed that future development of the airport will be phased and gradual in order to avoid unexpected consequences for the local communities and industry. March 2011

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Strategic objectives The following strategic objectives have been established in the development plan: 1. Create a planning framework which enables DEF Airport to meet the demands of the forecast passenger numbers; 2. Reduce to a minimum the visual and audible impacts of the operation of the airport on the local environment; 3. Ensure that the airport is financially secure; 4. Improve land based access to the airport; 5. Minimise the pollution effects of the operation of the airport. 6. Maintain / increase employment opportunities for people living close to the airport. By the year ending 30 June 2015, DEF Airport is expected to support about 3,000 local jobs and have a throughput of 5 million passengers per year, an increase of 1.5 million from the 3.5 million passengers forecast for the current financial year ending 30 June 2011. In order to accommodate the forecast increased number of passengers and attain the development objectives, it will be necessary for the airport to extend its operational area to the east of the land it currently occupies. Financial objectives Extracts from DEF Airport’s forecast income statement for the year ending 30 June 2011 and forecast statement of financial position as at that date are presented in the Appendix. The four LSGs have made it clear to the Board of Directors that the airport must at least achieve financial self-sufficiency. The financial objectives of the airport are to ensure that: 1. The airport does not run at a loss; 2. All creditors are paid on time; 3. Gearing levels must not exceed 20% (where gearing is defined as debt to debt plus equity) and any long-term borrowings are financed from sources approved by the four LSGs. Corporate Social Responsibility A key feature of DEF Airport’s development plan is to develop “Sustainable Aviation” initiatives in order to reduce the effects of flying on the environment. One effect on the environment is that the airport is subject to specific planning restrictions affecting flights between the hours of 11 p.m. (2300 hours) and 7 a.m. (0700 hours) to reduce aircraft noise. Flights are permitted between these times, but must be specially authorised. Typically, flights between these times would be as a result of an emergency landing request. A leading international consultancy, QEG, which specialises in auditing the corporate social responsibility (CSR) issues of commercial enterprises, has offered to provide a CSR audit to DEF Airport free of charge. QEG is based in the USA and hopes to expand by offering its services to European enterprises. DEF Airport’s competitors TUV Airport is located about 100 kilometres away from DEF Airport and serves a highly populated industrial city. The Board of Directors of DEF Airport considers TUV Airport to be its main competitor. There are another three competing airports within 80 kilometres of DEF Airport. TUV Airport purchased one of these three competitor airports and subsequently reduced services from it in order to reduce the competitive threat to itself. Airlines Airlines are keen to negotiate the most cost effective deal they can with airports. DEF Airport applies a set of standard charges to airlines but is aware that some of its competitor airports have offered inducements to airlines in order to attract DEF’s business. Airlines across the world are facing rising fuel and staff costs as well as strong competition from within the industry. There has been an overall increase in customer demand for air travel in recent years and low-priced airlines have emerged and are threatening the wellPerformance Strategy

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established, traditional airlines. Consequently, the traditional airlines have begun to cut the number of destinations to which they fly. There are several low-priced airlines that serve DEF Airport’s competitors, but only one, S, also operates out of DEF Airport. S is exploring ways in which it might increase its flights to and from DEF Airport. DEF’s Board of Directors has been approached by a North American airline that wishes to operate services from DEF Airport. This airline specialises in flights for business and first class passengers. However, this airline insists that it would pay DEF Airport in US$. This is contrary to the airport’s policy of accepting payment only in D$, which is the local currency. Analysis of revenue by business segment The forecast split of total revenue of D$23.4 million by business segment for the current financial year ending 30 June 2011 is: % Aviation income 48 Retail concessions at the airport 20 Car Parking 15 Other income 17 (Other income includes income from property rentals, and other fees and charges.) DEF Airport offers discounts for prompt payment. Aviation income In addition to the standard charges, which are set out below, there is a range of surcharges which are levied on airlines for such items as “noisy aircraft” (charged when aircraft exceed the Government limits for acceptable noise levels), recovery of costs and expenses arising from cleaning or making safe any spillages from aircraft and extraordinary policing of flights (for example, arrests made as a result of anti-social behaviour on aircraft). Standard charges made by DEF Airport to the airlines: Charges per aircraft Landing charges – large aircraft: Landing charges – medium aircraft:

D$300 D$170

Parking charges for the first two hours are included in the landing charge. Thereafter, a charge of D$200 per hour is imposed for each large aircraft and D$250 per hour for each medium aircraft. The parking charge is lower for large aircraft because they take at least two hours to clean and refuel, so they almost always have to pay for an hour’s parking, and also because there is less demand for the parking areas used for large aircraft. Medium aircraft tend to take off again within one hour of landing. Approximately 10% of medium sized aircraft landings result in the airline incurring parking charges for one hour. This is normally either because their scheduled departure time requires them to park or because of delays imposed by air traffic restrictions, technical malfunctions or problems with passengers. Charges per passenger Passenger Load: Flights to European destinations: Flights outside Europe:

D$1.60 per departing passenger D$4.00 per departing passenger

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D$1.20 per passenger arriving or departing

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Retail concessions DEF Airport provides the facilities for a range of shops, bureau de change (dealing in foreign exchange currency transactions for passengers), bars and cafes for the budget conscious passenger. DEF Airport has a monopoly in the provision of retail concessions and therefore faces no competition. Car parking Car parking is an important source of DEF Airport’s revenue. The airport has extended its own car parking facilities for customers over recent years. Car parks occupy a large area of what was green belt land (that is land which was not previously built on) around its perimeter. The land was acquired by the airport specifically for the purpose of car parking. A free passenger bus service is provided to take passengers to and from the car parks into the airport terminal building. Competitors have established alternative car parking facilities off-site and provide bus services to and from the airport’s terminal. The parking charges made by the competitors are lower than those levied by the airport. Competitor car park operators offer additional services to passengers, such as car maintenance and valeting, which are undertaken while the car is left in their care. DEF Airport does not have a hotel on its premises. There is a hotel within walking distance of the airport which offers special rates for passengers to stay the night before their flight and then to park their cars at the hotel for the duration of their trip. Other income This heading contains a mixture of revenue streams. The Commercial Director reported that some have good growth prospects. Property rental income is likely to decline though as there has been much building development around the airport perimeter. DEF Airport security Passengers and their baggage are required to go through rigorous security checks. There is a fast track service provided which can be accessed by all passengers at an extra charge. This is intended to speed up the security process. However, on some occasions this leads to passengers on the normal route becoming frustrated because they are required to wait in lengthy queues to pass through the security checks. Airport security staff are required by law to search all departing passengers and their baggage for suspicious or dangerous items. On the very rare occasions that they discover anything they report their concerns to the police. There are always several police officers on patrol at the airport at any given time and so the police can respond to any report very quickly. In addition to passenger and baggage screening, DEF Airport security staff are responsible for the security of parked aircraft and airport property. They do this primarily by monitoring all arriving and departing vehicles and their drivers and by monitoring the many closed circuit television cameras that cover the airport. The airport has had a good record with regard to the prevention of theft from passenger baggage. This is frequently a serious matter at other airports, but DEF Airport has received very few complaints that baggage has been tampered with. DEF Airport’s Head of Security regards the security of baggage as very low risk because of this low level of complaints. The Head of Security at DEF Airport was appointed to his current role in 1990, when the airport was very much smaller than it is today. He was a police sergeant before he joined the airport staff. Immediately before his appointment he was responsible for the front desk of DEF town’s main police station, a job that involved managing the day-to-day activities of the other police officers on duty. He was happy to accept the post of Head of Security because the police service was starting to make far greater use of computers. He had always relied on a comprehensive paper-based system for documenting and filing reports.

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The Head of Security is directly responsible for all security matters at DEF Airport. In practice, he has to delegate most of the actual supervision of staff to shift managers and team leaders because he cannot be expected to be on duty for 24 hours per day or to manage the security arrangements in great detail while administering the security department. The overall responsibilities of the Head of Security have not been reviewed since his appointment. Strategic options The Board of Directors is now actively considering its strategic options which could be implemented in the future in order to meet the strategic objectives which were set out in the airport’s development plan.

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APPENDIX 1 Extracts of DEF Airport’s forecast income statement and statement of financial position for the year ending 30 June 2011 Forecast income statement for the year ending 30 June 2011 Note Revenue Operating costs Net operating loss Interest income Finance costs Corporate income tax expense LOSS FOR THE YEAR

1

D$000 23,400 (25,450) (2,050) 70 (1,590) (130) (3,700)

Forecast statement of financial position as at 30 June 2011 D$000 ASSETS Non-current assets Current assets Inventories Trade and other receivables Cash and cash equivalents Total current assets Total assets

150,000 400 9,250 3,030 12,680 162,680

EQUITY AND LIABILITIES Equity Share capital Share premium Revaluation reserve Retained earnings Total equity Non-current liabilities Long term borrowings Current liabilities Trade and other payables Total liabilities Total equity and liabilities

2

17,700 530 89,100 23,200 130,530

3

22,700 9,450 32,150 162,680

Notes: 1. Operating costs include depreciation of D$5.0 million. 2. There are 17.7 million ordinary shares of D$1 each in issue. 3. The long-term borrowings comprise a D$6.3 million loan for capital expenditure which is repayable on 1 July 2015 and D$16.4 million owed to the 4 LSGs. This has no fixed repayment schedule and is not expected to be repaid in the next year.

End of Pre-seen Material

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SECTION A – 50 MARKS [You are advised to spend no longer than 90 minutes on this question.]

ANSWER THIS QUESTION. THE QUESTION REQUIREMENTS ARE ON PAGE 11, WHICH IS DETACHABLE FOR EASE OF REFERENCE

Question One Unseen case material Potential buyer DEF Airport’s chairman met with Max, a senior partner in a major firm of consultants. Max represents a client whose identity must remain confidential at this stage. Max’s instructions are to investigate the airport’s business affairs in some detail and then to assist the client in the purchase of a controlling interest. Max’s client is indifferent to the proportion of shares obtained from each of the four local state governments (LSGs). It may be that two of the LSGs will sell their entire holdings so that only a small number of shares will be required from a third or perhaps all four LSGs will sell a proportion of their stake. The client will expect to appoint an executive director immediately and will also wish to appoint a new non-executive chairman who will not have any direct relationship with any of the LSGs. DEF’s chairman was concerned about the nature of Max’s questions during the meeting. Max was not particularly interested in the commercial activities of the airport itself. He was, however, keen to know exactly what land the airport owned, how many employees the company had and their length of service, their entitlement to pensions and so on. Max was also keen to know which of the LSGs had jurisdiction over the airport for the purposes of authorising development on the site. DEF’s chairman feels that Max’s client has no particular interest in the airport business itself. He suspects that the plan is to buy control and then to close down the airport and use the site for some other purpose. Max’s questions tended to indicate that he was trying to estimate the costs associated with making the airport’s staff redundant and to determine how difficult it would be to obtain permission to use the site to build a retail development or houses for sale. The chairman called a meeting of DEF’s Board. At the meeting he suggested that the Board should actively resist any attempt by Max to facilitate the purchase of shares until the identity of the third party client is known and the Board is satisfied that there are no plans to fundamentally alter the airport’s mission, as expressed in its mission statement and financial objectives. He also suggested that the Board should not communicate Max’s interest in buying shares to the LSGs themselves. Bureau de change DEF operates a bureau de change in the airport, which exchanges currencies. Most passengers fly within Europe, but approximately 1,000 passengers fly to the USA every day and many exchange D$ for US Dollars (US$) at the airport. DEF exchanges D$ for US$ on a daily basis at its local bank. DEF sets its exchange rate so that it makes a small profit on every US$ exchanged. For example, today’s US$ were purchased from the bank at D$/US$1.227 (that is, D$1 = 1.227 US$) and DEF sold them to customers at D$/$US1.150. The Chief Executive has suggested that the bureau de change may provide a means of resolving the dilemma created by the North American airline who wishes to start a new service to DEF. The airline has made it clear that it will only use DEF if the airport agrees to invoice in US$, but airport policy is to accept payment in D$ only. The Chief Executive proposes that DEF agrees to invoice the North American airline in US$ and also to offer the other airlines the same opportunity. It is anticipated that total US$ March 2011

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receipts from aviation income, rental of property to US airlines and cargo handling will total approximately 60% of DEF’s US$ requirements for the bureau de change. This sum will be paid into a US$ bank account, and that will be used to fund the daily US$ requirements whenever there is sufficient US$ in the account. If the balance in the US$ bank account is insufficient then DEF will exchange currency with its local bank as at present. Retail activities DEF rents out spaces in the shopping area to a number of independent cafes and shops. These make most of their profit from large volumes of small sales, such as snacks, cups of coffee, newspapers and magazines. Many passengers are in transit and are on journeys that commenced outside of Europe. They often have only foreign currency. The shops and cafes will accept any major currencies, but the exchange rates offered are always very poor from the passengers’ perspective. The passengers are prepared to accept these rates in return for the convenience of being able to shop without having any D$. Every point of sale has a list of currencies that will be accepted along with the rates on offer. Any change is given in D$ notes and coins. The foreign currencies have to be counted and banked separately, but these are often quite profitable sales because of the high margins on the goods being sold and the poor exchange rates offered to the customers. All shops and cafes bank all of their receipts on a daily basis.

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Required: (a) (i)

Evaluate the present structure of DEF’s board, as described in the Governance section (page 2) of the pre-seen. Your evaluation should reflect all relevant facts provided about DEF. (9 marks)

(ii)

Evaluate the Chairman’s arguments that the board should not cooperate with Max unless it can be determined that the client whom he represents will not change the airport in any fundamental way. (8 marks)

(iii)

Discuss the risks associated with pursuing the airport’s mission statement (as provided in page 2 of the preseen) as a basis for the board’s strategic management of DEF. (8 marks)

(b) (i)

Discuss the risks and benefits to DEF of the Chief Executive’s proposal to accept payments in US$ which would then meet part of the airport’s US$ outgoings. (8 marks)

(ii)

Explain the benefits of internal hedging methods for managing foreign currency risk over external methods involving financial instruments. (8 marks)

(c)

Evaluate the risks to the retailers of accepting foreign currency payments at their shops and cafes. (9 marks)

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

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SECTION B – 50 MARKS [You are advised to spend no longer than 45 minutes on each question in this section.]

ANSWER TWO OF THE THREE QUESTIONS Question Two Grove Council is the local government authority responsible for the running of public services in a district of approximately 200 square miles and with a population of over 300,000. The Grove district comprises a mixture of towns, villages and rural areas. The Council employs approximately 13,000 staff in a wide variety of occupations. The Council is responsible for the maintenance of the entire public infrastructure in its area of responsibility, including the roads and sewerage systems. The Council also manages education and care for vulnerable residents such as the elderly and infirm. The Council has a divisional structure, with divisions taking responsibility for specific matters such as education, roads and so on throughout the Grove district. Injury statistics Employment law requires that every employer, including Grove Council, must maintain a register of all workplace injuries sustained by employees. There is no precise definition of a reportable injury, but Council guidelines indicate that anything that requires a dressing, such as a bandage or sticking plaster, must be reported as minor injuries. Injuries are classified as “serious” if they require the victim to be absent from work for more than three days and “severe” if they require admission to hospital or involve a fatality. The latest injury statistics show that there were 150 injuries during the year ended 31 December 2010, of which 20 were serious injuries and 3 were severe. The Council’s Director of Operations is satisfied with these figures because the number of injuries is no worse than in previous years. He holds the view that such figures are to be expected given the diverse range of jobs, many of which are risky, throughout the Council. The Chief Executive of the Council does not share these views: he thinks that the Council should try to prevent all injuries by eliminating accidents in the workplace. Internal audit of injury reporting procedures The Chief Executive asked Grove Council’s internal audit department to review the systems for reporting injuries. As part of the response to that request a CIMA qualified member of internal audit was sent to investigate the repair depot that maintains the Council’s fleet of vehicles. The depot employs a team of over 40 mechanics and is equipped with a full range of welding and lifting equipment. The depot’s injury register had only two entries for the year prior to the internal audit visit. Both injuries were severe and each involved an injury that required an ambulance to be called and an employee to be admitted to hospital. On enquiry, several of the mechanics explained that the small number of reports is due to the depot manager refusing to record injuries unless they are either serious or severe. Several of the depot mechanics are trained in first aid and no records are kept of any injuries that they treat. All of the mechanics refused to put these allegations in writing for the internal auditor. The internal auditor asked the Head of Internal Audit to send an urgent report to the Chief Executive, but the Head of Internal Audit refused to do so on the grounds that there was insufficient evidence of manipulation. The Head of Internal Audit threatened to suspend the internal auditor if she repeated these allegations to anyone else either inside or outside of the Council. The internal auditor is dissatisfied with the Head of Internal Audit’s response and is considering whether to take the matter further.

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Required (a) (i)

Discuss the Director of Operations’ view that it is impossible to prevent all workplace injuries. (5 marks)

(ii)

Discuss the Chief Executive’s view that it is unacceptable for Grove Council to tolerate any workplace injuries. (5 marks)

(b) (i)

Analyse the ethical dilemma faced by the internal auditor. (8 marks)

(ii)

Recommend the course of action that the internal auditor should take if she is unable to persuade the Head of Internal Audit to draw these allegations of underreporting of injuries to the attention of the senior management of Grove Council. (7 marks) (Total for Question Two = 25 marks)

Section B continues on the next page

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Question Three T is a retail organisation that owns six large shops that are located in different areas of a major city. Each shop has approximately 50 sales staff. T also has a central head office, located in that city, which houses all of the accounting and administrative departments. These departments include a Purchasing Department and an Accounts Payable Department. There is also an Internal Audit Department which has five staff. T has recently upgraded its accounting and inventory management systems. Old system In the old system the electronic tills in the shops transmitted details of sales transactions to a central computer at head office. That computer recorded details of all payments received, both in terms of cash and those made by debit or credit card. It also held details of inventory movements and was used to identify when orders were needed to replenish inventory. The accounting staff at head office used a different computer to maintain the nominal ledger. Sales information had to be entered manually into this computer. The Purchasing Department placed orders using pre-numbered order forms which were mailed to suppliers and copies were sent to the shops and to the Accounts Payable Department. Goods are delivered directly to shops. The shops sent “goods received notes” to head office when the inventory arrived. Those documents were used to validate suppliers’ invoices before they were recorded in the payables files in the bookkeeping system. The information from the goods received notes was also used to update the inventory records. The old accounting system generated sales reports at the end of every month. These showed details of the sales made by each shop and the types and volumes of products sold. If additional reports were required by T’s senior management, special programmes had to be written at considerable expense. New system T’s new system integrates all record keeping into a single software package that is run on a central system. Data from the tills is recorded directly into the system. The Purchasing Department places orders electronically with suppliers. Shop staff input details of the goods received into the system directly from the new networked PCs that have been installed in all of the shops. Suppliers’ invoices are input directly into the system by the Accounts Payable staff and the software checks that the related inventory was ordered and received before it allows invoices to be paid. The new system generates the same routine reports as were produced by the old system, but it can be interrogated quickly and easily to produce other reports that T’s management might need. The software that forms the basis of the new system was purchased from a recognised vendor. It is a standard package that required very little adaptation to meet T’s requirements. The software vendor has agreed to provide a telephone helpdesk function for the first three months of the system’s operation. Implementation issues The new system has only been live for just over a week. It was not run in parallel with the old system because T’s finance director deemed that a parallel run would have been too expensive and disruptive to T’s operations. The head of T’s internal audit department offered to conduct a post-implementation review of the system to confirm that user needs are being satisfied, but T’s finance director declined this offer. She argued that any problems with the new system will quickly become apparent after it goes live.

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Required: (a)

Evaluate the argument put forward by T’s finance director for refusing to have a post-implementation review. (10 marks)

(b)

Evaluate the suitability of the internal audit department to conduct T’s post-implementation review in the event that such a review is conducted. (5 marks)

(c)

Discuss the problems that might arise if an entity does not conduct a parallel run when implementing a new system. (10 marks) (Total for Question Three = 25 marks)

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Question Four W Bank is a small bank which offers a range of banking and credit facilities to both individual and business customers. W Bank generates most of its funds for lending by taking deposits from customers who are paid a variable rate of interest in line with market conditions. W Bank generates revenue from acting as an intermediary for interest rate swaps. In order to give itself maximum flexibility, W does not necessarily identify two clients who have matching requirements. Instead, the bank will act as a counterparty to any entity who meets its credit criteria. Ideally, the bank’s portfolio of swaps will tend to balance one another in terms of the mix of fixed and floating positions and the maturity of the arrangements. W Bank has been approached by P, a major quoted company with a sound credit rating. P has a £50m loan outstanding on which it is paying a variable rate of interest of LIBOR + 0.8% per annum. This loan has four years remaining and P’s directors are concerned that interest rates may rise. P’s directors have asked W Bank to arrange a swap that would give P a fixed rate of interest. W Bank has offered P a swap arrangement whereby W bank will borrow £50m from P at LIBOR + 0.8% per annum and will lend £50m to P at a fixed rate of 5.0% per annum. The two parties will pay the net sum due to one another at the end of each of the next four years. W Bank will charge P an annual commission of 0.2% on the £50m loan at the end of each year. The present LIBOR is 4.1% per annum. The swaps department of W Bank is conducting some scenario planning in order to determine W Bank’s exposure arising from this arrangement. The swaps department envisages three likely scenarios: • • •

LIBOR will remain at 4.1% per annum for the duration of the swap LIBOR will remain at 4.1% per annum for one year and will then fall to 3.9% for the remaining duration of the swap LIBOR will remain at 4.1% per annum for one year and will then rise to 5.6% for the remaining duration of the swap

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Required: (a)

Calculate the net present value (NPV) of the cash flows that W Bank will generate from this swap under each of the three scenarios identified by the swaps department. W Bank discounts cash flows from such projects at 7%. (8 marks)

(b) (i)

Advise W Bank on the risks that will arise from this swap arrangement. (6 marks)

(ii)

Explain how W Bank might mitigate the risks arising from this swap and identify the difficulties in doing so. (6 marks)

(c)

Evaluate the benefits to P of entering into this swap arrangement. (5 marks) (Total for Question Four = 25 marks)

(Total for Section B = 50 marks)

End of question paper Maths tables and formulae are on pages 21 to 24

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PRESENT VALUE TABLE

(

Present value of $1, that is 1+ r payment or receipt.

)竏地 where r = interest rate; n = number of periods until

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820

2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673

3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554

4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456

Interest rates (r) 5% 6% 0.952 0.943 0.907 0.890 0.864 0.840 0.823 0.792 0.784 0.747 0.746 0.705 0.711 0.665 0.677 0.627 0.645 0.592 0.614 0.558 0.585 0.527 0.557 0.497 0.530 0.469 0.505 0.442 0.481 0.417 0.458 0.394 0.436 0.371 0.416 0.350 0.396 0.331 0.377 0.312

7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215

9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149

Periods (n) 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104

13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073

Interest rates (r) 15% 16% 0.870 0.862 0.756 0.743 0.658 0.641 0.572 0.552 0.497 0.476 0.432 0.410 0.376 0.354 0.327 0.305 0.284 0.263 0.247 0.227 0.215 0.195 0.187 0.168 0.163 0.145 0.141 0.125 0.123 0.108 0.107 0.093 0.093 0.080 0.081 0.069 0.070 0.060 0.061 0.051

17% 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043

18% 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037

19% 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.079 0.062 0.052 0.044 0.037 0.031

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

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Performance Strategy


Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years

1− (1+ r ) − n r

Periods (n) 1 2 3 4 5

1% 0.990 1.970 2.941 3.902 4.853

2% 0.980 1.942 2.884 3.808 4.713

3% 0.971 1.913 2.829 3.717 4.580

4% 0.962 1.886 2.775 3.630 4.452

Interest rates (r) 5% 6% 0.952 0.943 1.859 1.833 2.723 2.673 3.546 3.465 4.329 4.212

7% 0.935 1.808 2.624 3.387 4.100

8% 0.926 1.783 2.577 3.312 3.993

9% 0.917 1.759 2.531 3.240 3.890

10% 0.909 1.736 2.487 3.170 3.791

6 7 8 9 10

5.795 6.728 7.652 8.566 9.471

5.601 6.472 7.325 8.162 8.983

5.417 6.230 7.020 7.786 8.530

5.242 6.002 6.733 7.435 8.111

5.076 5.786 6.463 7.108 7.722

4.917 5.582 6.210 6.802 7.360

4.767 5.389 5.971 6.515 7.024

4.623 5.206 5.747 6.247 6.710

4.486 5.033 5.535 5.995 6.418

4.355 4.868 5.335 5.759 6.145

11 12 13 14 15

10.368 11.255 12.134 13.004 13.865

9.787 10.575 11.348 12.106 12.849

9.253 9.954 10.635 11.296 11.938

8.760 9.385 9.986 10.563 11.118

8.306 8.863 9.394 9.899 10.380

7.887 8.384 8.853 9.295 9.712

7.499 7.943 8.358 8.745 9.108

7.139 7.536 7.904 8.244 8.559

6.805 7.161 7.487 7.786 8.061

6.495 6.814 7.103 7.367 7.606

16 17 18 19 20

14.718 15.562 16.398 17.226 18.046

13.578 14.292 14.992 15.679 16.351

12.561 13.166 13.754 14.324 14.878

11.652 12.166 12.659 13.134 13.590

10.838 11.274 11.690 12.085 12.462

10.106 10.477 10.828 11.158 11.470

9.447 9.763 10.059 10.336 10.594

8.851 9.122 9.372 9.604 9.818

8.313 8.544 8.756 8.950 9.129

7.824 8.022 8.201 8.365 8.514

Periods (n) 1 2 3 4 5

11% 0.901 1.713 2.444 3.102 3.696

12% 0.893 1.690 2.402 3.037 3.605

13% 0.885 1.668 2.361 2.974 3.517

14% 0.877 1.647 2.322 2.914 3.433

Interest rates (r) 15% 16% 0.870 0.862 1.626 1.605 2.283 2.246 2.855 2.798 3.352 3.274

17% 0.855 1.585 2.210 2.743 3.199

18% 0.847 1.566 2.174 2.690 3.127

19% 0.840 1.547 2.140 2.639 3.058

20% 0.833 1.528 2.106 2.589 2.991

6 7 8 9 10

4.231 4.712 5.146 5.537 5.889

4.111 4.564 4.968 5.328 5.650

3.998 4.423 4.799 5.132 5.426

3.889 4.288 4.639 4.946 5.216

3.784 4.160 4.487 4.772 5.019

3.685 4.039 4.344 4.607 4.833

3.589 3.922 4.207 4.451 4.659

3.498 3.812 4.078 4.303 4.494

3.410 3.706 3.954 4.163 4.339

3.326 3.605 3.837 4.031 4.192

11 12 13 14 15

6.207 6.492 6.750 6.982 7.191

5.938 6.194 6.424 6.628 6.811

5.687 5.918 6.122 6.302 6.462

5.453 5.660 5.842 6.002 6.142

5.234 5.421 5.583 5.724 5.847

5.029 5.197 5.342 5.468 5.575

4.836 4.988 5.118 5.229 5.324

4.656 7.793 4.910 5.008 5.092

4.486 4.611 4.715 4.802 4.876

4.327 4.439 4.533 4.611 4.675

16 17 18 19 20

7.379 7.549 7.702 7.839 7.963

6.974 7.120 7.250 7.366 7.469

6.604 6.729 6.840 6.938 7.025

6.265 6.373 6.467 6.550 6.623

5.954 6.047 6.128 6.198 6.259

5.668 5.749 5.818 5.877 5.929

5.405 5.475 5.534 5.584 5.628

5.162 5.222 5.273 5.316 5.353

4.938 4.990 5.033 5.070 5.101

4.730 4.775 4.812 4.843 4.870

Performance Strategy

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Formulae Annuity Present value of an annuity of £1 per annum receivable or payable for n years, commencing in one year, discounted at r% per annum:  PV = 1 1 − r 

  [1 + r ]  1

n

Perpetuity Present value of £1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum: PV =

1 r

Growing Perpetuity Present value of £1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum: PV =

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1 r −g

Performance Strategy


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Performance Strategy


LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb. LEARNING OBJECTIVE Level 1 - KNOWLEDGE What you are expected to know.

Level 2 - COMPREHENSION What you are expected to understand.

VERBS USED

DEFINITION

List State Define

Make a list of Express, fully or clearly, the details/facts of Give the exact meaning of

Describe Distinguish Explain

Communicate the key features Highlight the differences between Make clear or intelligible/State the meaning or purpose of Recognise, establish or select after consideration Use an example to describe or explain something

Identify Illustrate Level 3 - APPLICATION How you are expected to apply your knowledge.

Apply Calculate Demonstrate Prepare Reconcile Solve Tabulate

Level 4 - ANALYSIS How are you expected to analyse the detail of what you have learned.

Level 5 - EVALUATION How are you expected to use your learning to evaluate, make decisions or recommendations.

Performance Strategy

Analyse Categorise Compare and contrast

Put to practical use Ascertain or reckon mathematically Prove with certainty or to exhibit by practical means Make or get ready for use Make or prove consistent/compatible Find an answer to Arrange in a table

Construct Discuss Interpret Prioritise Produce

Examine in detail the structure of Place into a defined class or division Show the similarities and/or differences between Build up or compile Examine in detail by argument Translate into intelligible or familiar terms Place in order of priority or sequence for action Create or bring into existence

Advise Evaluate Recommend

Counsel, inform or notify Appraise or assess the value of Advise on a course of action

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March 2011


Performance Pillar

Strategic Level Paper

P3 – Performance Strategy

March 2011

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Performance Strategy


P3 – Performance Strategy Thursday 3 March 2011