Page 5 - CIMA OCS Workbook February 2019 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

EXERCISE THREE (RISK)
REPORT

To: Ping Bennett (FD)
Date: Today

Indoor Toys Proposal
1. Introduction
This report analyses the proposed plan to design and sell indoor activity toys by considering risk
and returns and with particular emphasis on how these concepts can be communicated to the
Board.
2. Risk and Return

2.1 Key Concepts to communicate
Many investments and plans are evaluated by reference to risk and return.

‘Return’ considers whether and how we stand to gain (or lose) from the investment. It could be
measured by absolute figures such as profit or cash, or by percentages, such as a return on capital
employed.
‘Risk’ recognises that any return we expect to gain is not certain and that the outcome could be
better (‘upside potential’) or worse (‘downside risk’) than expected.

We consider both because, generally, you have to be willing to accept higher risks in the pursuit of
higher gains. The key question to discuss is whether the risk exposure is acceptable or not.

2.2 Returns
Out of the figures presented, the following could be viewed as possible ‘returns’:
Operating profit based on expected sales volume

This shows the operating profit based on the expected sales demand in each year and measures
return in terms of profit, a concept that is easy to understand. It would therefore show the
expected impact on the financial statements.

However, this would not necessarily equate to the expected cash position. Furthermore, it may
not represent an actual possible outcome, but rather an average, something of questionable
relevance given the project is a one-off.
Profit after tax based on expected sales volume

This has the same pros and cons as the gross profit figure but is perhaps more useful as it takes
into account more implications of the project, such as selling and distribution costs, admin
expenses and taxation.

2.3 Risk
Out of the information presented, the following could be useful to discuss risk:

Best and worst case scenarios
The best and worst case scenarios give you an idea of the spread of likely revenue and hence the
risk.
The figures given suggest that in year 2, for example, revenue could be up to 37.5% higher than
expected or up to 50% lower. As stated before the issue is whether or not a potential fall of 50% is
an acceptable risk.

KAPLAN PUBLISHING 61