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Part 3 Examination Paper 3.3 Performance Management 1 (a) Profit and Loss Accounts for the year ended 31 May 2007 HLP Budget 000 Revenue: Annual fee customers: Property Commercial Consultations: Property Commercial Litigation Total revenue Cost of sales: Salaries Indemnity insurance Subcontract costs: Commercial Litigation Other operating expenses Total costs Net profit Net profit/sales (%) (b) (i) Actual 000 MAS Actual 000

June 2007 Answers

900 1,200 1,281 1,800 480 5,661 1,300 250

900 1,200 1,515 2,028 750 6,393 1,400 250 144 300 2,600 4,694 1,699 266

1,080 1,500 750 1,533 429 5,292 1,560 100 7 7 2,032 3,706 1,586 300

3,000 4,550 1,111 196

Overall client consultation revenues are higher than budget in all three activities undertaken by the business as shown in the following table: HLP Revenue Consultation type: Property Commercial Litigation (budget) 000 2181 3,000 480 HLP Revenue (actual) 000 2,415 3,228 750 MAS Revenue (actual) 000 1,830 3,033 429 HLP Fee per consultation () (budget) 75 150 250 HLP Fee per consultation () (actual) 75 150 250 MAS Fee per consultation () (actual) 60 150 200

HLP revenues from consultations relating to property, commercial and litigation work were 107%, 76% and 566% above budget, respectively. HLP charges 25% more than MAS for property and litigation consultations. HLP and MAS charge the same fee (150) in respect of each commercial consultation. The figures in (a) show that HLP has obtained a budgeted net profit: sales percentage of 196%. Its actual net profit/sales percentage is 266% which is 34% below the net profit/sales percentage (%) achieved by its competitor MAS. HLP has improved its revenue position via a number of factors: (i) Annual fee clients in respect of both Property and Commercial work were as per budget. Property clients were charged 1,200 whilst commercial clients were charged 6,000. Competitor MAS charged fees of 1,200 and 5,000 respectively. The percentage uptake of consultations under the Advisory Protection Scheme had an impact on profit levels for the year ended 31 May 2007. The following table shows the relative figures for HLP and competitor MAS: HLP (budget) Property work: Total consultations per agreement (clients x 20) Actual consultations taken up (per appendix 1.1) Percentage take-up Commercial work: Total consultations per agreement (clients x 40) Actual consultations taken up (per appendix 1.1) Percentage take-up 12,000 9,000 750 % 8,000 4,000 50 % HLP (actual) 12,000 9,900 825 % 8,000 7,200 90 % MAS (actual) 18,000 9,000 500 % 12,000 6,000 50 %

(ii)

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(ii)

As far as annual agreements relating to property work are concerned, HLP had a take up rate of 825% whereas MAS had a take up rate of only 50%. Therefore, HLP has lost out to competitor MAS in relative financial terms as regards the take-up of consultations relating to property work. This is because both HLP and MAS received an annual fee from each property client irrespective of the number of consultations given. MAS should therefore have had a better profit margin from this area of business than HLP. However, the extent to which HLP has lost out cannot be quantified since we would need to know the variable costs per consultation and this detail is not available. What we do know is that HLP earned actual revenue per effective consultation amounting to 9090 whereas the budgeted revenue per consultation amounted to 100. MAS earned 120 per effective consultation. The same picture emerges from annual agreements relating to commercial work. HLP had a budgeted take up rate of 50%, however the actual take up rate during the period was 90%. MAS had an actual take up rate of 50%. The actual revenue per effective consultation earned by HLP amounted to 167 whereas the budgeted revenue per consultation amounted to 300. MAS earned 250 per effective consultation. There could possibly be an upside to this situation for HLP in that it might be the case that the uptake of 90% of consultations without further charge by clients holding annual agreements in respect of commercial work might be indicative of a high level of customer satisfaction. It could on the other hand be indicative of a mindset which says I have already paid for these consultations therefore I am going to request them.

(iii) Budgeted and actual salaries in HLP were 50,000 per annum, per advisor. Two additional advisors were employed during the year in order to provide consultations in respect of commercial work. MAS paid a salary of 60,000 to each advisor which is 20% higher than the salary of 50,000 paid to each advisor by HLP. Perhaps this is indicative that the advisors employed by MAS are more experienced and/or better qualified than those employed by HLP. HLP paid indemnity insurance of 250,000 which is 150,000 (150%) more than the amount of 100,000 paid by MAS. This excess cost may well have arisen as a consequence of successful claims against HLP for negligence in undertaking commercial work. It would be interesting to know whether HLP had been the subject of any successful claims for negligent work during recent years as premiums invariably reflect the claims history of a business. Rather worrying is the fact that HLP was subject to three such claims during the year ended 31 May 2007. Significant subcontract costs were incurred by HLP during the year probably in an attempt to satisfy demand and retain the goodwill of its clients. HLP incurred subcontract costs in respect of commercial properties which totalled 144,000. These consultations earned revenue amounting to (320 x 150) = 48,000, hence a loss of 96,000 was incurred in this area of the business. HLP also paid 300,000 for 600 subcontract consultations in respect of litigation work. These consultations earned revenue amounting to (600 x 250) = 150,000, hence a loss of 150,000 was incurred in this area of the business. In contrast, MAS paid 7,000 for 20 subcontract consultations in respect of commercial work and an identical amount for 20 subcontract consultations in respect of litigation work. These consultations earned revenue amounting to 20 x (150 + 200) =7,000. Therefore, a loss of only 7,000 was incurred in respect of subcontract consultations by MAS. Other operating expenses were budgeted at 530% of sales revenue. The actual level incurred was 407% of sales revenue. The fixed/variable split of such costs is not given but it may well be the case that the fall in this percentage is due to good cost control by HLP. However, it might simply be the case that the original budget was flawed. Competitor MAS would appear to have a slightly superior cost structure to that of HLP since its other operating expenses amounted to 384% of sales revenue. Further information is required in order to draw firmer conclusions regarding cost control within both businesses. (c) (i) Competitiveness may be measured in terms of market share or sales growth. HLP has shown growth in all areas of its business as shown in the following table: Consultation type: HLP HLP Number of Number of consultations consultations (budget) (actual) 26,080 30,100 16,000 20,720 1,920 3,000 Gain over budget 4,020 4,720 1,080 Gain over budget (%) 154 295 563

Property Commercial Litigation

The figures in the above table might well be indicative of increased market share. However, competitiveness may also be measured in terms of relative success/failure in obtaining new business. The split between existing and new business can be calculated from the information contained in appendix 1.1. HLP budgeted to convert (11,000/22,000) = 50% of its enquiries from new clients into chargeable consultations. However, HLP actually converted (10,000/25,000) = 40% of new clients enquiries into chargeable consultations. MAS performed better than HLP with (18,200/28,000) = 65% of enquiries from new clients being converted into chargeable consultations. (ii) Quality of service is the totality of features and characteristics of the service package that bear upon its ability to satisfy client needs. To some extent the number of complaints and the need to provide non-chargeable consultations associated with the remedying of those complaints is indicative of a service quality problem that must be addressed. Hence this problem needs to be investigated at the earliest opportunity. Assuming consultants could have otherwise undertaken

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chargeable work, the revenue foregone as a consequence of the remedial consultations relating to commercial work amounted to (180 x 1500) = 27,000. Client complaints received by HLP during the year amounted to 124% of consultations undertaken by commercial advisors whereas none were budgeted. In contrast, competitor MAS received 135 complaints which coincided with the number of non-chargeable consultations undertaken by them. This may indicate that MAS operate a policy of a remedial consultation in respect of all complaints received from clients. With regard to the number of on-time consultations, HLP only achieved an on-time consultation percentage of 944% which is far inferior to that of 99% achieved by competitor MAS. Also, HLP re-scheduled the appointment times of 1,620 (3%) of its total consultations whereas competitor MAS only re-scheduled 05% of its consultation times. The percentage number of successful consultations provided by HLP and MAS was 85% and 95% respectively which indicates that competitor MAS possesses a superior skills-base to that of HLP. The most alarming statistic lies in the fact that HLP was subject to three successful legal actions for negligence. This may not only account for the 150% increase in the cost of professional indemnity insurance premiums but may also result in a loss of client confidence and precipitate a considerable fall in future levels of business should the claims become much publicised. (iii) Flexibility may relate to the company being able to cope with flexibility of volume, delivery speed or job specification. In this particular context, flexibility appears to have been problematic for HLP as evidenced by the fact that 320 consultations relating to commercial were subcontracted during the year. This could be due to the lack of the ability of HLP advisors to be able to provide consultations to a potentially wide-range of commercial clients, i.e. the variability in the job specification requires greater flexibility than HLP can deliver. Furthermore, a total of 600 consultations relating to litigation work were also subcontracted throughout the year. These subcontract consultations might be due to the inability of HLP to deal with fluctuations in demand. (d) In one respect the managing partner is quite correct since turnover and net profit have reached levels of 6,393,000 and 1,699,000 respectively in just six years. However, there are visible signs that all is not well. All businesses have limited resources and in this respect it is visible that the advisors are stretched, as evidenced by the following statistics regarding resource utilisation. Resource utilisation measures the ratio of output achieved from those resources input. In this scenario the mean number of consultations per advisor may be used as a guide. Average consultations per advisor: Budget Actual Property 2,173 2,508 Commercial 1,600 2,058 Litigation 480 400 Increase/(decrease) 335 458 (80) Increase/(decrease) % 154 286 (167)

It is interesting to note that property and commercial advisors are being utilised above budgeted levels. There are potential problems if the quality of the service provision is falling. The number of commercial consultations was 295% higher than budget. It may be the case that the advisors are stretched to the point where service quality is being adversely affected. The managing partners statement illustrates tunnel vision on his/her part in that an undue focus is being placed on achieving growth to the detriment of other areas. Matters such as the amount of time spent travelling to/from clients premises, updating client records, together with the time spent updating ones knowledge in light of new or forthcoming legislative changes will render a target of 95% unachievable in such businesses as that of HLP.

(a)

Calculation of expected net present value (000) Sales volume = 3,200 units. Sales revenue per unit Variable costs per unit Contribution per unit 2,500 1,640 860

Total contribution = (3,200 x 860) = 2,752,000 fixed overheads 900,000 = 1,852,000 less taxation (at 30%) 555,600 = 1,296,400. Net present value at a discount rate of 11% per annum = (1,296,400 x 4231) (5,000,000 x 50%) = 2,985,068. The project should be undertaken by the directors of ITL. Notes: (i) Variable cost per unit = 1,490 + Royalty 150 = 1,640. (ii) 200,000 already spent on market research is a sunk cost and therefore not included in the calculation of the expected net present value of the Snowballer proposal. (iii) A real discount rate of 11% has been used. It has been calculated as follows: ((1 + nominal cost of capital)/(1 + rate of inflation)) 1 = 11544/(1 + 004) = 111 1 = 011 or 11%.

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(b)

(i)

The NPV of the proposal is 2,985,068. The initial outlay(net) could be varied by the NPV of 2,985,068 to be 5,485,068 giving a total outlay of 10,970,136 before the NPV would become negative. This is due to the 50% government grant that is available on the initial investment. This represents a percentage increase of 1194% (10,970,136 5,000,000). 5,000,000 The level of annual contribution at which NPV will be equal to zero can be calculated using the formula (1 t) 4231 x initial investment fixed overheads (1 t) = 0, where t is the rate of corporation tax and x = annual contribution. This gives: (1 0.30) 4231x 2,500,000 (900,000 (1 030) 4231) = 0 29617 x = 2,500,000 + 2,665,530 x = 1,744,110. This shows that annual contribution can decline from the existing level of 2,752,000 to 1,744,110. This represents a percentage decrease of 3662% (1,007,890/2,752,000) x 100%. The 4231 in the above formula represents the cumulative discount factor for six years at a rate of 11% per annum. 2,500,000 represents the investment outlay net of the government grant.

(ii)

(c)

The life cycle of the Snowballer: NPV of year 1 net cash flow = 1,296,400 x 0901 = NPV of year 2 net cash flow = 1,296,400 x 0812 = Total for year 1 and year 2 Investment outlay (net) NPV required in year 3 in order to achieve a zero NPV 1,168,056 1,052,677 2,220,733 2,500,000 279,267

However, if fixed overheads are incurred in year 3 irrespective of the sales life of the Snowballer then discounted fixed costs amounting to 460,530 (900,000 x 07 x 0731) would be incurred. Hence discounted contribution required in order to achieve a zero NPV would amount to 279,267 + 460,530 = 739,797. The total discounted contribution for the whole of year 3 amounts to 2,752,000 x 70% x 0731 = 1,408,198. Hence the reduction in year 3 life allowable in year 3 = (1,408,198 739,797)/1,408,198 = 4746% (say 47% approximately). So the life cycle required during year 3 = 53% or (053 of the year). This means that 2 + 053 = 253 years are required to produce an overall NPV = 0. Hence the fall in the life cycle of the project (for an overall NPV = 0) = 6 253 = 347 years or 347/6 = 578% (which is the sensitivity measure). (d) Factors that should be considered by the directors of ITL include: (i) (ii) The cash flows are estimated. How accurate they are requires detailed consideration. The cost of capital used by the finance director might be inappropriate. For example if the Snowballer proposal is less risky than other projects undertaken by ITL then a lower cost of capital should be used. (iii) The rate of inflation may vary from the anticipated rate of 4% per annum. (iv) How strong is the Olympic brand name? The directors are proposing to pay royalties equivalent to 6% of sales revenue during the six years of the anticipated life of the project. Should they market the Snowballer themselves? (v) Would competitors enter the market and what would be the likely effect on sales volumes and selling prices? N.B: Only three factors were required.

(a)

The primary focus of the research and development director There is a need to measure the ability of CSG to offer up to date services that are sought after by existing and potential customers. In this regard it would be relatively easy to determine the number of new products/services introduced in previous periods. The performance of individual innovations should also be assessed. Also the aggregate expenditure on the development of new services may indicate how CSG has performed with regard to offering up to date, customer focused services. The primary focus of the finance director CSG could use return on capital employed (ROCE), economic value added (EVA) or residual income (RI) as measures of financial performance. EVA and RI are both superior to return on capital employed (ROCE) in that each method is more likely to develop goal congruence in terms of acquisition and disposal decisions. It is vital that any performance measure chosen is consistent with the NPV rule. The use of RI could prove problematic when managers adopt a short term outlook and use short term performance measures as decisions may not be consistent with the NPV rule. EVA attempts to avoid the problems associated with understated asset values that arise in the use of ROCE and RI. Current values should be used as opposed to historical costs.

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The primary focus of the human resources director CSG could use measures such as the rate of staff turnover, the level of absenteeism, training costs per employee and the number of applications received for each job vacancy. These measures may provide an indication of the extent to which CSG can be regarded as a socially responsible employer. These measures should be compared with those of prior periods and targets. Employee attitude surveys may also be undertaken on a systematic basis in order to assess matters such as the degree of satisfaction with the payment systems that are in operation, management style and working conditions. The primary focus of the corporate affairs director CSG could use measures such as the amounts spent on the disposal of waste chemicals, the number of complaints received from clients and members of the public and the total of contributions made to organisations which seek to meet social objectives, e.g. charities, schools and hospitals. (b) Growth may be measured in a number of ways which are as follows: Cash flow This is a very important measure of growth as it ultimately determines the amount of funds available for re-investment by any business. Sales revenue Growth in sales revenues generated is only of real value to investors if it precipitates growth in profits. Profitability There are many measures relating to profit which include sales margin, earnings before interest, taxation, depreciation and amortisation (EBITDA) and earnings per share. More sophisticated measures such as return on capital employed and residual income consider the size of the investment relative to the level of profits earned. In general terms, measures of profitability are only meaningful if they are used as a basis for comparisons over time or in conjunction with other measures of performance. Growth rate in profitability are useful when compared with other companies and also with other industries. Return on investment A growing return upon invested capital suggests that capital is being used more and more productively. Indicators of a growing return would be measured by reference to dividend payment and capital growth. Market share Growth in market share is generally seen as positive as it can generate economies of scale. Number of products/service offerings Growth is only regarded as useful if products and services are profitable. Number of employees Measures of productivity such as value added per employee and profit per employee are often used by shareholders in assessing growth. Very often an increased headcount is a measure of success in circumstances where more people are needed in order to deliver a service to a required standard. However it is incumbent on management to ensure that all employees are utilised in an effective manner. It is a widely held belief that growth requires profits and that growth produces profits. Profits are essential in order to prevent a company which has achieved growth from becoming a target for a take-over or in a worse case scenario goes into liquidation. Hence it is fundamental that a business is profitable throughout its existence. Growth accompanied by growth in profits is also likely to aid the long-term survival of an organisation. CSG operates in Swingland which experiences fluctuations in its economic climate and in this respect the exploitation of profitable growth opportunities will help CSG to survive at the expense of its competitors who do not exploit such opportunities. Note: Alternative relevant discussion and examples would be accepted.

(a)

Pay-off table Demand Prob Contract A Kilograms Contribution Purchase options Contract B Contract C Expected Contribution Expected Contribution Expected value value value 020 1,008,000 201,600 72,000 14,400 (504,000) (100,800) 040 1,008,000 403,200 2,403,000 961,200 1,827,000 730,800 040 1,008,000 403,200 2,592,000 1,036,800 3,276,000 1,310,400 1,008,000 2,012,400 1,940,400 Contract D Contribution

160,000 234,000 360,000

Expected value (1,656,000) (331,200) 675,000 270,000 4,644,000 1,857,600 1,796,400

On the basis of expected values HFL should select Contract B under which 240,000 kilograms will be supplied during the forthcoming year which would give an annual expected value of 2,012,400.

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Note 1: Example of workings for the Pay-off table in part (a): If we assume that Contract B was selected and subsequent demand was for 160,000 kilograms then the resultant contribution would be calculated as follows: (160,000 x 50) (240,000 x 370) = (8,000) + (80,000 x 025) = 12,000 x 6 =72,000. (b) The minimum contribution for each possible decision is as follows: Contract A B C D Minimum contribution () 1,008,000 72,000 (504,000) (1,656,000)

Applying a Maximin approach to this decision would result in the selection of Contract A under which 160,000 kilograms of organic mushrooms would be supplied to HFL. Applying a minimax regret approach, the regret matrix would appear as follows: Contract type Demand per outlet 160,000 234,000 360,000 Maximum regret A 160,000 0 1,395,000 3,636,000 3,636,000 B 240,000 936,000 0 2,052,000 2,052,000 C 280,000 1,512,000 576,000 1,368,000 1,512,000 D 360,000 2,664,000 1,728,000 0 2,664,000

Therefore in order to minimise the maximum regret, Contract C, under which 280,000 kilograms of organic mushrooms would be supplied to HFL, would be chosen. (c) The directors might select Contract D under which 360,000 kilograms of organic mushrooms would be supplied to HFL for each outlet. This is the entire capacity of HFL which would ensure that competitors would not be able to supply the same product and hence the competitive advantage held by HFL might be preserved.

(a)

To: Board of directors From: Management Accountant Date: 8 June 2007 The potential benefits of the adoption of a balanced scorecard approach to performance measurement within GER are as follows: A broader business perspective Financial measures invariably have an inward-looking perspective. The balanced scorecard is wider in its scope and application. It has an external focus and looks at comparisons with competitors in order to establish what constitutes best practice and ensures that required changes are made in order to achieve it. The use of the balanced scorecard requires a balance of both financial and non-financial measures and goals. A greater strategic focus The use of the balanced scorecard focuses to a much greater extent on the longer term. There is a far greater emphasis on strategic considerations. It attempts to identify the needs and wants of customers and the new products and markets. Hence it requires a balance between short term and long term performance measures. A greater focus on qualitative aspects The use of the balanced scorecard attempts to overcome the over-emphasis of traditional measures on the quantifiable aspects of the internal operations of an organisation expressed in purely financial terms. Its use requires a balance between quantitative and qualitative performance measures. For example, customer satisfaction is a qualitative performance measure which is given prominence under the balanced scorecard approach. A greater focus on longer term performance The use of traditional financial measures is often dominated by financial accounting requirements, for example, the need to show fixed assets at their historic cost. Also, they are primarily focused on short-term profitability and return on capital employed in order to gain stakeholder approval of short term financial reports, the longer term or whole life cycle often being ignored. The limitations of a balanced scorecard approach to performance measurement may be viewed as follows: The balanced scorecard attempts to identify the chain of cause and effect relationships which will provide the stimulus for the future success of an organisation.

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Advocates of a balanced scorecard approach to performance measurement suggest that it can constitute a vital component of the strategic management process. However, Robert Kaplan and David Norton, the authors of the balanced scorecard concept concede that it may not be suitable for all firms. Norton suggests that it is most suitable for firms which have a long lead time between management action and financial benefit and that it will be less suitable for firms with a short-term focus. However, other flaws can be detected in the balanced scorecard. The balanced scorecard promises to outline the theory of the firm by clearly linking the driver/outcome measures in a cause and effect chain, but this will be difficult if not impossible to achieve. The precise cause and effect relationships between measures for each of the perspectives on the balanced scorecard will be complex because the driver and outcome measures for the various perspectives are interlinked. For example, customer satisfaction may be seen to be a function of several drivers, such as employee satisfaction, manufacturing cycle time and quality. However, employee satisfaction may in turn be partially driven by customer satisfaction and employee satisfaction may partially drive manufacturing cycle time. A consequence of this non-linearity of the cause and effect chain (i.e., there is non-linear relationship between an individual driver and a single outcome measure), is that there must be a question mark as to the accuracy of any calculated correlations between driver and outcome measures. Allied to this point, any calculated correlations will be historic. This implies that it will only be possible to determine the accuracy of cause and effect linkages after the event, which could make the use of the balanced scorecard in dynamic industries questionable. If the market is undergoing rapid evolution, for example, how meaningful are current measures of customer satisfaction or market share? These criticisms do not necessarily undermine the usefulness of the balanced scorecard in presenting a more comprehensive picture of organisational performance but they do raise doubts concerning claims that a balanced scorecard can be constructed which will outline a clear cause and effect chain between driver and outcome measures and the firms financial objectives. (b) (i) The statistics in respect of GER are as follows: 2007 Financial perspective Goals: Measures: Success Profit Survival Cash flow Prosperity Return on capital employed Customer perspective Goals: Measures: New products % sales from new routes Competitiveness % ticket sales from enquiries Responsive supply % of on-time stops Internal business perspective Goals: Measures: Service excellence Cost per route (000) Service provision efficiency Cost per passenger mile (excluding depreciation) () New route introduction Introduction schedule, actual v plan Innovation and learning perspective Goals: Measures: Product focus Number of routes producing 80% of sales Employee skill level Training hours per employee W(1) Cash flow (2007) Net profit Depreciation Profit on ordinary activities Adjustments for movements in working capital: Stocks Debtors Creditors Cash generated from operations Acquisition of fixed assets Net cash flow 000 6,600 3,300 9,900 (1,660) 990 660 9,890 (6,960) 2,930 2006

6,600 2,930 (W1) 155%

5,280 unknown 147%

24 80 98

20 80 97

413 035 150%

488 036 66%

20 85

24 80

Note: Alternative relevant discussion and examples would be accepted.

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(ii)

Performance measures that may be used to assess the customer perspective of the balanced scorecard of GER include the following: Lost or damaged luggage per 1,000 passengers Train cancellation rate Denied boarding rate Number of passenger complaints. Note: Only three measures were required.

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Part 3 Examination Paper 3.3 Performance Management

June 2007 Marking Scheme Marks Marks

(a)

Revenue calculations: Advisory Protection Scheme Consultations Costs: Salaries Indemnity insurance Subcontract costs Other operating expenses Presentation Net profit: sales (%) Consultation fees structure Advisory Protection Schemes: Fee structure Utilisation rates Cost structure Competitiveness Service quality Flexibility Statement is wrong Concerns

3 4 1 1 2 2 1 1 1 1 3 4 5 7 3 2 4

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(b)

10

(c)

15

(d)

6 45

(a)

Contribution Fixed overheads Grant receivable Corporation tax NPV Sunk cost (i) (ii) Calculation Calculation

1 05 05 05 15 1 2 2 4 3x1

Maximum 4

(b)

4 4 3 15

(c) (d)

Calculation Factors

(a)

Comments (on merit): Directors statements Comments (on merit): Assessment Advantages/issues

4x3

12

(b)

4 4

8 20

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(a)

Pay-off table Recommendation Maximin number Explanation Minimax regret regret table explanation Comments on merit

Marks 11 1 1 1 3 1 2

Marks 12

(b)

6 2 20

(c)

(a)

Memorandum format Comments (on merit) (i) Goals Cash flow Performance measures Performance measures

1 7 3 4 4 3x1

(b)

Maximum 9 3 20

(ii)

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