cima t4 paper

8/10/2019 CIMA T4 Paper

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CIMA 2010 Chartered Management Accounting Qualification - Specimen Examination Paper T4 Part BPublished November 2009

The Chartered Institute of Management Accountants 2009

T4TestofPr

ofessionalCom

petence-PartB

CaseStudyExam

T4 Part B Case Study ExaminationSpecimen Examination Paper

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, makeannotations on the question paper. However, you will notbe allowed, underany circumstances, to open the examination answer book and start writingor to use your calculator during the reading time.

This booklet contains the examination question and both the pre-seen andunseen elements of the case material.

Answer the question on page 13, which is detachable for ease of reference.The Case Study Assessment Criteria are also included on page 14.

Maths Tables and Formulae are provided on pages 20 to 23.

Write your full examination number, paper number and the examinationsubject title in the spaces provided on the front of the examination answerbook.

Also write your contact ID and name in the space provided in the right handmargin and seal to close

Contents of this booklet: Page

Pre-seen material Electricity

Generating Corporation

2 - 8

Pre-seen Appendices A D 9 - 12

Question requirement and Assessmentcriteria

13 - 14

Unseen material

Unseen Appendix E

15 - 18

19

Maths Tables and Formulae 20 - 23


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T4 Part B Case Study 2 Specimen Exam Paper

The Electricity Generating Corporation

Introduction

The Electricity Generating Corporation (EGC) is located in a democratic Asian country. EGCwas established as a nationalised industry many years ago. Its home Government at that timehad determined that the provision of the utility services of electricity generation and gasproduction should be managed directly by boards which were accountable directly toGovernment. In theory, nationalised industries should be run efficiently, on behalf of the public,without the need to provide any form of risk-related return to the funding providers. In otherwords, EGC, along with other nationalised industries is a non-profit making organisation. This,the Government claimed at the time, would enable prices charged to the final consumer to bekept low.

Industry structure

EGC operates 12 coal fired power stations across the country and transmits electricity through

an integrated national grid system which it manages and controls. It is organised into threeregions, Northern, Eastern and Western. Each region generates electricity which is sold to 10private sector electricity distribution companies which are EGC's only customers. The 10distribution companies are the suppliers of electricity to final users including households andindustry within the country and are not under the management or control of EGC. They arecompletely independent companies owned by shareholders.

The three EGC regions transmit the electricity they generate into the national grid system. Ashortage of electricity generation in one region can be made up by taking from the national grid.This is particularly important when there is a national emergency, such as exceptional weatherconditions. However, there have been times when EGC has not been able to fully satisfydemand and this has led to power cuts. The charges for electricity generated by EGC areregulated by the Government. EGC sells the electricity it generates to the 10 distribution

companies at a uniform price. The 10 distribution companies then sell the electricity theypurchase from EGC to the final customer. The Government requires EGC to maintain electricitygeneration at all times and has in the past guaranteed that its costs will be met in full by thecentral Government treasury.

The nationalised utility industries were set up in a monopolistic position. As such, no otherproviders of these particular services were permitted to enter the market within the country.Therefore, EGC is the sole generator of electricity in the country. The electricity generatingfacilities, in the form of the 12 coal fired power stations were all built over 15 years ago andsome date back to before EGC came into being. The structure of EGC is that it has aManagement Board headed by a Managing Director who reports to senior civil servants in theGovernments Ministry of Energy.

Financing of EGC

The Government uses its own cash-based accounting system for all the nationalised industries,EGC included. EGC draws funding directly from the Government on a regular basis to cover itscash requirements for its capital needs and any shortfall in its operating costs. The Governmentdoes not operate an accruals-based accounting system for the nationalised industries.

When EGC was formed, a large amount of Government cash funding was required initially togive it financial stability. The model of financing which emerged for EGC was one that resulted inits costs being guaranteed. As EGC is the monopoly generator of electricity in the country itcharges the price approved by the Government to the 10 private sector electricity distributioncompanies. Any overall financial deficit EGC incurs is made up through additional Governmentfunding. In practice, EGC continues to be a large cash consumer of Government funds. While

recognising that it provides funds for capital equipment and renewals, the Governments aim is


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Specimen Exam Paper 3 T4 Part B Case Study

that EGC should at least cover its operating costs from revenue earned from the 10 privatesector electricity distribution companies.

There has been no other source of funding for EGC other than income from the 10 privatesector electricity distribution companies and funds provided directly from the Government. TheGovernment however, has now instituted a loan system to cover expenditure when EGC needs

more cash than it collects in revenue. The argument the Minister of Energy has made is that theGovernment cannot simply provide unlimited funds for EGC. Any further demands for cash byEGC beyond what it collects in revenue can only be met by loans from the Government. Nofunding can be obtained from any other source.

The loan facilities have been established to emphasise the principle that any additional fundingfrom the Government is a liability to EGC and that it must pay interest on the loan and eventuallypay back the capital sum. This principle was established by the Government in a drive tointroduce a more commercial basis to EGCs financing. Government loans have no fixedrepayment dates and are made to EGC at a preferential rate of interest, fixed at 2% below theGovernment-set bank rate.

Recently, the Minister of Energy has stated that productivity, return on assets and good

stewardship of public funds are of high importance in managing all the nationalised industries.This is a particular challenge for EGC as it is subject to inflationary pressure which hasincreased in the country over the last year, and its Government-approved prices are set for aperiod on the basis of a low, rather than a commercial, price. The response of EGC's ManagingDirector has been that the role of the Management Board is to maintain the provision ofelectricity generation at any cost rather than maximising investment returns or providing valuefor money.

Introduction of commercial accounting practices at EGC

At the request of the Minister of Energy, a pro forma set of accounts incorporating an incomestatement, balance sheet, cash flow statement and a statement of the changes in equity havebeen produced for 2007/8 and 2008/9. This is the first time EGC has prepared accounts using

commercial accounting principles. The purpose of these accounts is to illustrate how EGC'sfinancial position would appear in a commercial environment. Extracts from this set of pro formaaccounts are shown atAppendices A and B.Within these pro forma accounts some of EGC'sloans have been "notionally" converted by the Government into ordinary shares in a furtherattempt to illustrate how EGC's financial reports would appear using the accepted format ofcommercial accounting principles. Financing costs are only payable on the Government loansas shown in the balance sheet.

The pro forma accounts show a loss for the year ended 31 March 2009. Being a nationalisedindustry and effectively the first set of "commercially based" accounts, there are no retainedearnings brought forward into 2007/8. The "Other reserves" is a sum which was vested in EGCwhen it was first nationalised. This represents the initial capital stock valued on a historical costbasis from the former electricity generating organisations which became EGC when it was

nationalised.

Capital market

EGC exists in a country which has a well developed capital market relating both to equity andloan stock funding. There are well established international institutions, which are able toprovide funds and corporate entities are free to issue their own loan stock in accordance withinternationally recognised principles.


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Energy consumpt ion within the country

Energy consumption has doubled in the country over the last 10 years. EGC continues to usecoal fired power stations and now consumes most of the coal mined within the country.

Governance of EGC

The Managing Director of the Management Board of EGC reports to senior civil servants in theMinistry of Energy. There are no shareholders and ownership of the Corporation rests entirelywith the Government. There is a formal annual meeting with senior Government officials atwhich the financial accounts of EGC are approved. Beyond this there are occasional informalmeetings between members of the Management Board and Government officials, particularlywhen the Minister of Energy is required to present information relating to electricity generation tothe countrys Parliament.

Structure of EGC

All the staff employed by EGC are Government employees. The structure of EGC comprises ahierarchy of many levels of management authority. EGC is managed by the Management Boardwhich comprises the Managing Director, the Directors of each of the Northern, Eastern andWestern regions, a Technical Director, the Corporation Secretary and the Finance Director. Withthe exception of the Corporation Secretary and Finance Director, all the Management Boardmembers are qualified electrical engineers.

Within the structure of EGCs headquarters, there are four support functions; engineering,finance, human resource management (HRM) and administration, each with its own chiefofficers, apart from HRM. The Senior HRM Officers and Chief Administrative Officer report to theCorporation Secretary. The Chief Accountant reports to the Finance Director and the ChiefEngineer to the Technical Director. These functions are replicated in each region, each with itsown regional officers and support staff. In the three regions, the Regional Accountants and theirstaff focus mainly on producing management accounting rather than financial accountinginformation. A structure chart and organisational staffing information is given atAppendices Cand Dfor headquarters and a sample region which shows the engineering function under theheading of Technical Staff and Engineering Staff, the finance function under the heading ofFinance Staff and Accountancy Staff, and HRM and administrative functions under theheading of Secretariat Staff.

The number of professional engineering and operational staff has increased over the last 10years in a period when demand for electricity has been increasing. The increase in operationalemployees has led to an increase in managerial and administrative staff at EGC. At EGCheadquarters the management and administrative staff head count has increased to three timesits level of a decade ago. In total, the number of staff employed by EGC at 31 March 2009 was11,608 full time equivalent staff.

Management o f EGCThe Managing Director and Regional Directors all studied in the field of electrical engineering atthe country's leading university and have worked together for a long time. Although they did notall attend the university at the same time, they have a strong belief in the quality of theireducation. After graduation from university, each of the Regional Directors and the ManagingDirector started work at EGC in a junior capacity and then subsequently gained professionalelectrical engineering qualifications. They believe that the experience of working up through theranks of EGC has enabled them to have a clear understanding of EGCs culture and thetechnical aspects of the industry as a whole.

The Management Board meets formally on a monthly basis but the Regional Directors and theManaging Director regularly meet together on a social level, outside the Management Board

meetings at least once a month. One Regional Director was overheard to remark to his RegionalEngineer that the only function of the Management Board meetings was to formally agree thedecisions made by the Regional Directors and the Managing Director on the golf course.


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The Technical Director is also a qualified electrical engineer but is not a graduate of the sameuniversity as the Managing Director and Regional Directors. She obtained a first class honoursdegree in Engineering with Business. After qualifying as an electrical engineer she took an MBAdegree at a prestigious European university and is currently studying for a PhD in electricalengineering on a part-time basis. The Technical Director and the Finance Director tend to work

closely together in attempting to introduce improvements in financial control within EGC.

The Corporation Secretary has held his post for 22 years and expects to retire in two yearstime. He too has risen through the ranks of EGC, having first started working as a junior clerk ina regional office nearly 40 years ago. He studied hard and obtained a recognised qualificationas a corporate secretary by undertaking correspondence courses. In his period of tenure he hasbeen proud to provide the statutory returns as required by different Government ministries. Hehas always carried out the instructions of the Managing Directors of EGC without question as hehas a strong sense of duty. Similarly, he expects total loyalty from the EGC headquarters staffwho report to him.

The Finance Director is a graduate and a Fellow of CIMA. He has worked in several privateenterprise organisations, engaged both in the retail and manufacturing sectors. Since he joined

EGC in April 2009, he has been trying to introduce a system of budgetary control as herecognises that the Government is aiming to improve economy and efficiency while, at the sametime, maintaining effectiveness in the nationalised industries as a whole. This initiative has beenhampered by the fact that all the staff in the regions, including the finance staff, report to therelevant Regional Director and not the functional staff at headquarters.

At a recent Management Board meeting, the Managing Director made it clear to the FinanceDirector that, in his view, the main purpose of EGC is to maintain electricity generation whateverthe financial implications. The Regional Directors and the Managing Director all agree that theGovernment will not reduce its commitment to funding EGC as this would threaten electricitygeneration. The Finance Director responded by reminding the members of the ManagementBoard that now the Government is making loans not financial grants to EGC and that there is anobligation on EGC to repay these loans at some point in the future.

The Managing Director replied that:Irrespective of whether it is a loan or a gifted payment, the money is still found byGovernment and our job is to maintain electricity generation. It is not the role of theManagement Board to worry about where the money comes from or in what form it arrives.We can leave that to the country's treasury."

The Managing Director then added to the Finance Director:"Do you realistically expect the Government to demand repayment? I don't."

Decision making at EGC

Decision making within EGC is centralised. All decisions on capital expenditure are made by theManagement Board and the Regional Directors are able to strongly influence these decisions.Operational decisions are made in each region. Any decision which requires non recurring

expenditure over $5,000 must be made by the Regional Management Board. If the sum requiredis over $1 million, the decision is referred to the EGC Management Board. At EGCheadquarters, decisions on expenditure relating to headquarters operations are delegated to therelevant EGC Management Board member but any non recurring expenditure over $5,000 mustbe referred to the Managing Director for approval. There is a strong culture throughout EGC ofcommittee structures and of documentation being required to support almost any action oractivity.

Power generation

EGC operates 12 coal fired power stations across the country. There is a well developed coalmining industry in the country but extraction is becoming more expensive. There is no other formof electricity generation in the country except for some wind turbine power experiments whichonly produce a small fraction of the countrys electricity needs.


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The Minister of Energy has stated that the country should progress towards more efficient andalso renewable forms of power generation methods. This followed an announcement by thePrime Minister that the country needed to review how it could provide secure energy suppliesand also reduce its impact on global warming.

Researchers in the country have cited France as an example of a country with a nationalised

electricity industry which now generates most of its electricity from nuclear power. The country inwhich EGC is situated has no nuclear power stations.

Some members of the scientific community have concluded that the country will not be able toreduce its harmful emissions without developing a nuclear power generation programme. (Theterm harmful emissions in this context, refers to pollution coming out of electricity generatingpower stations which damage the environment.) The country's leading researcher into energydevelopment has warned that without nuclear power generation, there will be increased usageof coal. This will generate ever more harmful emissions which will lead to an increase, not adecrease, in global warming. This will attract major criticism from other countries.

The researcher added that reliance on wave and solar power was not realistic as theirdevelopment was not going to be speedy enough to replace existing power generation methods

and meet the ever increasing demands for electricity. He did however acknowledge the potentialbenefit of using wind turbines as a means of environmentally friendly power generation. Anotherresearcher has encouraged the Minister of Energy to clearly set out for the public how nuclearpower can contribute to reducing harmful emissions.

In the past, EGC tended to over estimate demand and so over-capacity was built into thesystem, which led to higher costs. That position has now changed and there have been powercuts due to EGC sometimes being unable to fully satisfy demand. No new power stations havebeen built in the last 15 years.

EGC generates electricity using coal fired power stations. The Managing Director and RegionalDirectors of EGC are not very enthusiastic about other methods of electricity generation andhave publicly stated their opposition to nuclear power. Their main concern has been on the

grounds of public safety and the safe disposal of spent nuclear fuel. Quite apart from the verylarge capital investment which would be needed to establish nuclear power stations, they claimthat the case for nuclear fuelled electricity production has not yet been proved. In particular, theyargue that the cost of decommissioning a nuclear power station is very high.

Little research has been undertaken by EGC into alternative methods of power generation or theimpact on the environment of continuing to use coal for fuel. The only research that has beendone in the past was on ways of generating greater power yields from coal fuel sources.Unsurprisingly, much of this research has been funded by the country's coal production industry.

Price charged by EGC for electricity generated and EGCs cost structure

A kilowatt (kW) is a unit of energy, representing the rate at which energy is used or produced.

EGC, in line with most electricity generators and suppliers in other countries, charges itscustomers by the kilowatt hour (kWh). A kWh is a unit of energy and represents one hour ofelectricity consumption at a constant rate of 1 kW. For example an electric fire rated at 1 kWhwill consume 1 kW of electricity in one hour. The Government approved price charged by EGCfor electricity in 2008/9 was $022 per kWh.

In total, in the financial year 2008/9 EGC generated and sold 60,000 million kilowatt hours ofelectricity to the 10 private sector distribution companies (compared with 58,000 million kilowatthours in 2007/8).


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The following costs were incurred by EGC in 2008/9 compared with 2007/8:

2008/9 2007/8 $ million $ millionGenerating costs (including fuel) 10,145 9,874

Regional staff costs and overheads 845 812Headquarters staff costs and overheads 820 780Repairs and maintenance 228 268Research and development 11 8Operating leases 58 49Total generating costs 12,107 11,791Depreciation 799 650Total operating costs incurred 12,906 12,441

Accounting system in operation at EGC

The accounting system that is in operation at EGC provides for a calculation of the total

operating costs incurred in each region which includes the apportionment of headquarters staffcosts and overheads. The cost accounts for EGC as a whole are produced annually. Themethod of apportionment of headquarters costs is simple. All headquarters costs are divided bythree and charged equally to each region. The rationale for this system, which has been inoperation since EGC was first established, is that since headquarters provides a service acrossall three regions, they should bear the actual costs incurred on an equal basis. It has beenargued by the Regional Directors that this may not necessarily reflect the actual serviceprovided to each region by headquarters in any one year. All research and development iscarried out at headquarters and so these costs are charged equally to each region.

The Finance Director has expressed severe concerns about the lack of detailed managementinformation. Consequently, he has asked the Regional Accountants to establish a workinggroup, its task being to develop more detailed management accounting information.

The breakdown of operating costs across each of the three regions for 2008/9 is given below:

Northern Eastern Western Total$ million $ million $ million $ million

Generating costs 5,026 2,618 2,501 10,145Regional staff costs and overheads 385 248 212 845Headquarters staff costs and overheads 274 273 273 820Repairs and maintenance 112 56 60 228Research and development 4 4 3 11Operating leases 0 35 23 58Total generating costs 5,801 3,234 3,072 12,107Depreciation 237 284 278 799Total operating costs incurred 6,038 3,518 3,350 12,906

In addition $1,248 million was spent in 2008/9 on renewals of plant and equipment. Of this,$701 million was spent in the Northern Division, $320 million in the Eastern Division and$227 million in the Western Division. The renewals are necessary to keep the plant andequipment operational. These renewals enable EGC to maintain output at about the same levelalthough there may be some variation in total output and generating capacity between years.


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Electricity generation

The following table shows the generation of electricity by the 12 power stations operated byEGC in 2008/9 compared with the generated output in 2007/8:

2008/9 Utilisation Electricity 2007/8 Utilisation

Output of 100% generation Output of 100%produced capacity at 100%capacity in

2008/9

produced capacity

kWh(million)

% kWh(million)

kWh(million)

%

Northern Region:Station N1 2,644 46 2,950 51Station N2 4,560 57 4,640 58Station N3 7,207 67 6,538 61Station N4 8,513 83 8,018 78

22,924 34,761 22,146Eastern Region:

Station E1 4,306 82 4,218 80Station E2 2,548 71 2,531 71Station E3 6,836 80 6,433 75Station E4 8,194 87 7,909 84

21,884 26,803 21,091Western Region:Station W1 3,931 76 3,796 73Station W2 4,846 74 4,745 72Station W3 4,202 83 4,113 81Station W4 2,213 79 2,109 75

15,192 19,585 14,763

EGC as a whole generated close to the maximum amount of electricity in 2008/9 that they were

capable of producing given the condition of some of the power stations. The total capacity ofEGCs electricity generation if all its power stations operated at 100% efficiency all of the timewith no breakdowns in 2008/9 was 81,149 million kWh.

Government dr ive for increased efficiency

The Minister of Energy has indicated to the Management Board members of EGC that theGovernment wishes to encourage more efficient methods of energy production. This includesthe need to reduce production costs and reduce harmful emissions. The Government has limitedresources for capital investment in energy production and wishes to be sure that future energyproduction facilities are more efficient and effective than at present.

The Minister of Energy is aware that the acceleration of the decline of the coal industry in

another country resulted in the loss of many jobs in that country. This not only affected the coalindustry itself but also other industries such as equipment suppliers, who were dependent on thesurvival of coal mining.

General election called

In a surprise move, the Prime Minister has called a general election. Among a number of othermajor proposals, the governing political party has proposed that one of its first tasks if re-electedwould be to make the nationalised industries more efficient and accountable. The mainopposition party has included the privatisation of all nationalised industries as a priority if it iselected. There are two main political parties in the country and while other political parties doexist and compete for seats in parliament, they have not been able to form a Government in thepast. The probability that one of the two main political parties will win the election is thereforevery high. A hung parliament, where no one political party has overall control, has a very lowprobability and can be ignored.


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APPENDIX A

EXTRACTS FROM THE PRO FORMA ACCOUNTS OF THE ELECTRICITY GENERATINGCORPORATION

INCOME STATEMENT

Year ended Year ended31 March 31 March

2009 2008$ million $ million

Revenue 13,200 12,760Total operating costs 12,906 12,441Operating profit 294 319Financing costs (430) (319)Loss for the period (136) 0

BALANCE SHEETAt At

31 March 31 March 2009 2008

$ million $ millionNon-current assets (net) 15,837 15,388

Current assetsInventories 1,529 1,514Receivables 2,679 2,491Cash and cash equivalents 133 156

Total current assets 4,341 4,161

Total assets 20,178 19,549

Equity and reservesOrdinary shares 5,525 5,525Losses (136) 0Other reserves 1,367 1,367

Total equity and reserves 6,756 6,892

Long-term liabilities (Government loans) 9,560 8,471Current liabilities

Payables 3,862 4,186Total liabilities 13,422 12,657

Total equity and liabilities 20,178 19,549


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APPENDIX B

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 2009

$ million $ millionCash flows from operating activities:

Loss (136)Adjustments for:

Interest expense 430Depreciation 799(Increase)/decrease in inventories (15)(Increase)/decrease in receivables (188)Increase/(decrease) in payables (324)

702Cash generated from operations 566Financing costs (430)Net cash from operating activities 136

Cash flows from investing activities:

Purchase of non-current assets (1,248) (renewals of plant and equipment)

Cash inflow/(outflow) before financing (1,112)Cash flows from financing activities:

Proceeds from Government loans 1,089

Net decrease in cash and cash equivalents (23)Cash and cash equivalents at 31 March 2007 156Cash and cash equivalents at 31 March 2008 133

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 MARCH 2009

Share Other Retained Totalcapital reserves earnings

$ million $ million $ million $ millionBalance at 1 Apri l 2008 5,525 1,367 0 6,892Loss for the period (136) (136)Balance at 31 March 2009 5,525 1,367 (136) 6,756


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APPENDIX C


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APPENDIX D


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Electricity Generating Corporation Unseen material provided on examination day

Additional (unseen) information relating to the case is given on pages 15 to 19.

Read all of the additional material before you answer the question.

ANSWER THE FOLLOWING QUESTIONS

You are the Divisional Management Accountant in the Northern Division. The NorthernDivision was formerly known as the Northern Region. The post of DivisionalManagement Accountant was formerly known (in the pre-seen material) as theRegional Accountant.

The Northern Division General Manager (NDGM), recently appointed as head of theNorthern Division, has asked you to provide advice and recommendations on theissues which the Northern Division Management Board must address, including howcultural change may be brought about within the Northern Division.

Question 1

Prepare a report that prioritises, analyses and evaluates the issues facing the NorthernDivision of EGC and makes appropriate recommendations.

(Total marks for question 1 = 90 Marks)

Question 2

Prepare two slides for presentation to NDGM which summarise the case from theNorthern Divisions point of view for making the investment proposed for power stationsN1 and N2. Your slides should contain no more than 5 bullet points on each andinclude the financial justification for making the investment.

(Total marks for question 2 = 10 Marks)

Your script will be marked against the TOPCIMA Assessment Criteria shown on thenext page.


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Assessment Cri ter ia

Criterion Maximum marks

availableAnalysis of issues (25 marks)

Technical 5

Application 15

Diversity 5

Strategic choices (35 marks)

Focus 5

Prioritisation 5

Judgement 20

Ethics 5Recommendations (40 marks)

Logic 30

Integration 5

Ethics 5

Total 100


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Electricity Generating Corporation unseen material provided on examination day

Read this information before you answer the question

Structural change at EGC

The governing political party won the general election and immediately set about putting its pre-election proposals into action. One of the first announcements by the Prime Minister was thatthe Electricity Generating Corporation (EGC) must become more efficient and accountable. Itwill remain a single nationalised industry for now and will continue to be solely engaged inelectricity power generation.

The previous Managing Director, Regional Directors and Corporation Secretary have all left theorganisation. A new divisionalised structure for EGC was announced by the Minister of Energy.The Governments intention is that the new structure for EGC will provide more autonomy fordecision making at divisional level. EGC now has a new Management Board, headed by anewly appointed Chairman. There is a new Divisional General Manager for each of theNorthern, Eastern and Western divisions. All are members of the Management Board of EGC,as are the Finance Director and Technical Director and the new Corporation Secretary. TheChairman has made it very clear to Management Board members that EGC as a whole mustundergo cultural change to become more efficient and accountable.

The Northern Divisional General Manager (NDGM) has established his divisional structurewhich includes a Divisional Management Accountant. This post was formerly known (in the pre-seen Appendix D) as the Regional Accountant.

Performance within the divisions of EGC

Each of the Northern, Eastern and Western divisions has its own management team, under the

direction of its respective Divisional General Manager. The 10 private sector electricitydistribution companies will continue to purchase their electricity as at present from EGC tosupply the final users. The divisions may now compete on price for the sale of electricity to these10 private sector electricity distribution companies. The Management Board of EGC is requiredby the Government to ensure that the three divisions generate electricity efficiently andeconomically and maintain sufficient volumes to meet demand effectively.

The Chairman has made it clear that in order to compete effectively with each other, thedivisions all need to become more efficient in terms of reducing the cost of electricity generation.This includes a review of their staffing levels. The Chairman stated that strong financial controlneeds to be introduced within the divisions.

The Chairman also said the divisions need to provide management information to assist in the

effective control of their costs. They must also satisfy the demands being made of them by theGovernment to introduce a range of performance measures. In addition, it is necessary for thedivisions to demonstrate that they are meeting targets on reducing harmful emissions into theatmosphere.

Price and supply of generated electrici ty

The objective of the Government is to keep electricity prices as low as possible. Each of thethree divisions of EGC now publishes on a daily basis the quantity of electricity it plans togenerate each day and the price at which it will sell it to the 10 private sector electricitydistribution companies. This means that price and supply from the three divisions may fluctuateon a daily basis and consequently supply may be controlled by the divisions to affect price.


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Research and development

Currently all research and development is centrally controlled by EGC and the costs arecharged equally across the divisions. Following the introduction of the divisional structure it isnow proposed that the Divisional General Manager of the Eastern Division takes control of theentire research function for EGC.

The new Northern Divisional General Manager (NDGM), feels particularly frustrated that he isunable to obtain finance in order to carry out research. He is aware that there is much evidenceshowing how effective wind turbines would be if they were built in the Northern Divisional area.

Government programme for electrici ty generation by using wind power

The Government has now stated clearly that it will not tolerate nuclear power generation ofelectricity. Instead, the Minister of Energy has announced a very large programme for theinstallation of turbines driven by wind power, all of which will be established within the area ofthe Northern Division. These turbines will be phased in over a 4 year period and all will beoperational by November 2013. When compared with existing methods of electricity generation,the new innovative wind turbines are expected to reduce harmful emissions per kilowatt hour

(kWh) of electricity produced. Similarly, the Government expects that the wind turbines willeffectively reduce overall electricity generation costs per kWh compared with the costs incurredat present by EGC.

When they are fully operational, the wind turbines will generate 12,000 million kWh of electricityin total each year in addition to the 60,000 million kWh generated by EGC in 2008/9. Thegeneration of 60,000 million kWh of electricity may be taken as the maximum generatingcapacity in 2008/9 as it was so close to the limit of what EGC is actually capable of generating.The Government has stated that to meet expected demand, the country will only require thegeneration of 64,500 million kWh of electricity by November 2013, a 75% increase over the2008/9 level of electricity generated. The operation of the wind turbines will enable some of themost inefficient coal fired power stations to be scaled down so that they will only be used as areserve power source. This will significantly reduce variable running costs at each scaled down

power station. The erection of the wind turbines will be carried out by a specialist buildingcontractor, which has already been appointed.

The Government will provide funds for the initial capital cost of the wind turbines but has not yetdecided who will operate and manage the programme. The Minister of Energy has stated thatthere will be only one organisation appointed to operate and manage the entire programme. Healso said that he will need assurance that if the Northern Division of EGC is appointed tooperate and manage the wind power generation programme, EGC as a whole must commit toachieving the following two targets:

1. Ensure the overall average cost of electricity generation is no more than $0183 per kWh (at2008/9 price levels) by November 2014. This target average cost applies across all forms ofelectricity generating methods including the use of coal or wind power. (The averageoperating cost per kWh in 2008/9 for EGC as a whole was $02151).

2. Produce a plan which enables the development of new technology which will provide forimproved electricity generation with less waste, resulting in an overall reduction of harmfulemissions by an average of 2% per year for 10 years commencing on 1 April 2010.

NDGM has made it clear to the Northern Divisions Management Board that when theGovernment implements the wind turbine programme there may be a risk of job cuts if theNorthern Division is not appointed to operate and manage the programme.

NDGM estimates that if the Northern Division were appointed to operate and manage the windturbine power generation programme the total operating costs of the division, includingapportioned headquarters overheads, at the 2008/9 price level, would be reduced. The forecastamount of this reduction in operating costs would be $570 million per year for each powerstation that is scaled down to become a reserve power source. This scaling down will not


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happen until November 2013 when all the wind turbines will be operational. This estimate takesfull account of the total cost of operating the wind turbines and remaining coal fired powerstations, including the savings from scaling down the power stations which are held in reserve.Append ix Eprovides information on output, capacity utilisation and costs relating to each of thepower stations in the Northern Division in 2008/9.

Northern Division investment proposal

Each division is now an investment centre in its own right. The members of the DivisionalManagement Boards now have authority to make investments within prescribed limits normallyup to $100 million. Projects which exceed $100 million must be approved by the EGCManagement Board. EGC uses a cost of capital charge in line with the Government's rate of6%. Capital funding to EGC will continue to be made by loans from the Government. Taxationcan be ignored as EGC does not pay tax.

NDGM has agreed with EGCs Chairman and Finance Director that the total operating costs ofgeneration in the Northern Division in 2008/9 of $6,038 million would be reduced in determiningthe controllable costs of the division. They have agreed that all except the headquarters staffcosts and overheads of $274 million and research and development costs of $4 million, which

were charged by headquarters, will be regarded as the controllable costs within the division.

Other information relating to the 2008/9 accounts:

Northern Division EGC $ million $ millionNon-current assets (net) 5,751 15,837Total revenue 5,043 13,200Total operating costs 6,038 12,906Total controllable costs 5,760 12,906

An investment project which would be operational by 31 March 2010 is being considered by theNorthern Divisions Management Board. NDGM is very keen to improve the division's return on

investment as he recognises that the other two divisions significantly outperform his own. EGCuses two investment criteria, Return on Investment and Residual Income. Return on Investmentis defined as total revenue less total controllable costs expressed as a percentage of net non-current assets (as shown above).

This investment project involves a capital cost of $1,800 million (depreciated at 10% per year ona straight line basis) for equipment which would increase fuel efficiency and be introduced intopower stations N1 and N2. This would reduce the amount of coal used and consequentlysignificantly reduce harmful emissions from N1 and N2. In 2008/9, N1 and N2 accounted for65% of the entire harmful emissions from the power stations in the Northern Division. (TheNorthern Division emitted 42% of the total harmful emissions for EGC as a whole in 2008/9).The project would enable staffing at these power stations to be reduced. It is estimated that thetotal savings generated by the introduction of this equipment, before depreciation, will be $315

million per year at 2008/9 price levels. This will commence immediately following the installationof the equipment.

NDGM is aware that some members of the EGC Management Board are not in favour of thisinvestment project taking place as they expect the Northern Division to be appointed to operateand manage the wind turbine programme and consequently they believe that power stations N1and N2 will be scaled down.

Earth tremor damage to power station N4

A report by geological researchers at the country's leading university has stated that buildings inthe Northern Division are becoming increasingly subject to the threat of earth tremors. Thereport was clear that the area was not subject to serious earthquakes but only to the far lessdamaging earth tremors. There has been an increase in earth tremors within the area of theNorthern Division. These have caused damage to the infrastructure in the area, including to


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power station N4. The Government has now introduced strict construction regulations requiringall new buildings to be able to withstand earth tremors. Any new power stations across thecountry will be subject to these construction regulations.

A structural report on the damage to power station N4 has concluded that it is safe and cancontinue to operate at the moment and should be able to do so for the next five years without

any reduction of its generating capacity, even if earth tremor activity increases as expected.However, in order to guarantee continuity of its generating capacity after this period, repairsshould be carried out within the five-year period. These will cost $1,500 million at the 2008/9price level. As with other buildings whose capital cost was financed by the Government, powerstations do not have any building repair or renewal insurance.

The power station, which produced 8,513 million kWh in 2008/9 or about 37% of the totalelectricity generated in the Northern Division, would have to close down for a period of sixmonths while the repairs are carried out. These repairs would enable the power station to meetthe new Government construction regulations and allow it to maintain its long term electricitygenerating levels at about 83% of capacity. (SeeAppendix E)

Divisional Management Accountant

As Divisional Management Accountant you are required to provide NDGM with immediateadvice and recommendations on the issues which the Northern Divisional Management Boardmust address, including how cultural change may be brought about within the Northern Division.In addition, you are required to prepare two slides for presentation to NDGM, summarising thecase for the investment proposal, including the financial justification, for power stations N1 andN2.


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APPENDIX E

NORTHERN DIVISIONS OUTPUT, CAPACITY UTILISATION, TOTAL AND AVERAGEOPERATING COSTS IN 2008/9 AND COMPARISON OF TOTAL OPERATING COSTSACROSS THE DIVISIONS

2008/9 Utilisation Total operating Average Output of 100% costs operating produced capacity costs per kWh kWh (million) % $ million $Northern Region:Station N1 2,644 46 1,051 0398Station N2 4,560 57 1,478 0324Station N3 7,207 67 1,708 0237Station N4 8,513 83 1,801 0212 22,924 6,038

The total operating costs of the divisions and for EGC as a whole in 2008/9 were as follows:

Northern Eastern Western EGC $ million $ million $ million $ millionTotal operating costs 6,038 3,518 3,350 12,906The Government-approved price charged by EGC for electricity in 2008/9 was $022 per kWh.


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APPLICABLE MATHS TABLES AND FORMULAE

Present value table

Present value of 1.00 unit of currency, that is (1 + r)

-n

where r= interest rate; n= number of periods untilpayment or receipt.

Periods(n)

Interest rates (r)1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.9092 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.8263 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.7514 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.6835 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.6216 0.942 0.888 0.837 0.790 0.746 0705 0.666 0.630 0.596 0.5647 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.5138 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.4679 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424

10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.38611 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350

12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.31913 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.29014 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.26315 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.23916 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.21817 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.19818 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.18019 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.16420 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods(n)

Interest rates (r)11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.8332 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694

3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.5794 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.4825 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.4026 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.3357 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.2798 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.2339 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194

10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.16211 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.13512 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.11213 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.09314 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.07815 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.06516 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.05417 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.04518 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038

19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.03120 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026


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Cumulative present value of 1.00 unit of currency per annum, Receivable or Payable at the end of

each year for nyears

r

r n)(11

Periods(n)

Interest rates (r)1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.9092 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.7363 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.4874 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.1705 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.3557 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.8688 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.3359 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.49512 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.81413 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.10314 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.36715 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.82417 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.02218 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.20119 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.36520 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods(n)

Interest rates (r)11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.8332 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.5283 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.1064 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.5895 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.3267 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605

8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.8379 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.03110 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.32712 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.43913 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.53314 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.61115 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675

16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.73017 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.77518 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.81219 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.84320 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870


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Formulae

Valuation Models

(i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity,where P

0is the ex-div value:

P0=

prefk

d

(ii) Ordinary (Equity) share, paying a constant annual dividend, d, in perpetuity, where P0isthe ex-div value:

P0=ek

d

(iii) Ordinary (Equity) share, paying an annual dividend, d, growing in perpetuity at a constantrate, g, where P0is the ex-div value:

P0=

gk

d

-e

1

or P0=

gk

g

e

0][1d

(iv) Irredeemable (Undated) debt, paying annual after tax interest, i(1-t), in perpetuity, whereP0is the ex-interest value:

P0=

net

][1

dk

ti

or, without tax:

P0=d

k

i

(v) Future value of S, of a sum X, invested for nperiods, compounded at r% interest:

S = X[1 + r]n

(vi) Present value of 1 payable or receivable in nyears, discounted at r% per annum:

PV=n

r][1

1

(vii) Present value of an annuity of 1 per annum, receivable or payable for nyears,

commencing in one year, discounted at r% per annum:

PV=

nrr ][1

11

1

(viii) Present value of 1 per annum, payable or receivable in perpetuity, commencing in oneyear, discounted at r% per annum:

PV=r

1


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(ix) Present value of 1 per annum, receivable or payable, commencing in one year, growingin perpetuity at a constant rate of g% per annum, discounted at r% per annum:

PV=gr

1

Cost of Capital

(i) Cost of irredeemable preference capital, paying an annual dividend, d, in perpetuity, andhaving a current ex-div price P0:

kpref=

0P

d

(ii) Cost of irredeemable debt capital, paying annual net interest, i(1 t), and having acurrent ex-interest price P0:

kdnet=0

][1

P

ti

(iii) Cost of ordinary (equity) share capital, paying an annual dividend, d, in perpetuity, andhaving a current ex-div price P0:

ke=

0P

d

(iv) Cost of ordinary (equity) share capital, having a current ex-div price, P0, having just paid adividend, d0, with the dividend growing in perpetuity by a constant g% per annum:

ke= g

P

d

0

1 or ke= g

P

gd

0

]1[0

(v) Cost of ordinary (equity) share capital, using the CAPM:

ke= Rf+ [Rm Rf]

(vi) Weighted average cost of capital, k0:

k0= ke

DE

D

d

D

E

VV

Vk

V

V

EV


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T4 Part B Case Study Examination

Specimen Paper

Thursday Afternoon Session

cima t4 paper

Documents