CIMAPRO19-P03-1 Practice Questions

According to the TARA (Transfer, Avoid, Reduce, Accept) risk management framework, risks are managed based on their position on a likelihood/impact map. Risks with a high impact but a medium (or low) likelihood are typically managed through transference. The financial consequence of such a risk is too severe for the organization to bear (or 'accept'), but the event is not frequent enough to warrant ceasing the activity ('avoid') or investing in potentially prohibitive costs to 'reduce' it to a negligible level. Therefore, transferring the financial impact to a third party, such as through insurance, is the most appropriate and economically viable strategy for an oil refinery facing such a risk profile.

A. Accept: This response is suitable only for risks with both low impact and low likelihood, where the cost of mitigation would exceed the potential loss.

B. Reduce: While reduction measures are always prudent, for a high-impact risk, the residual impact may remain catastrophically high, making transfer a necessary strategy.

D. Avoid: This is the most extreme response, reserved for risks with both high impact and high likelihood, where the risk cannot be effectively managed otherwise.

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1. CIMA Global. (2019). CIMA Professional Qualification Syllabus: P3 Risk Management. The syllabus under Section C: Managing Risk, covers the evaluation and selection of appropriate risk responses, including the TARA framework (Transfer, Avoid, Reduce, Accept), which is a foundational concept for this question. The framework explicitly links risk profiles to response strategies.

2. Committee of Sponsoring Organizations of the Treadway Commission (COSO). (2017). Enterprise Risk Management—Integrating with Strategy and Performance. This framework, which heavily influences the CIMA syllabus, discusses risk responses in the "Performance" component (Principles 13-15). It defines "Sharing" (equivalent to Transfer) as action taken to reduce the severity of risk by transferring a portion to another party, a common response for high-severity events.

3. Hopkin, P. (2018). Fundamentals of Risk Management: Understanding, Evaluating and Implementing Effective Risk Management (5th ed.). Kogan Page. Chapter 12, "Risk Treatment," provides detailed illustrations of risk maps and the TARA framework. It consistently maps the "Transfer" strategy to risks characterized by high impact and low-to-medium likelihood, as the cost of bearing the risk is too high, but its probability does not justify avoidance.

4. Chapman, R. J. (2019). The Rules of Project Risk Management: Implementation Guidelines for Major Projects. Routledge. Chapter 5, "Risk Response Planning," discusses the application of risk response strategies. It clarifies that risk transfer is a primary tool for managing high-impact financial risks that cannot be eliminated, which directly applies to the scenario of an oil refinery. (DOI: https://doi.org/10.4324/9780429467972)

The fundamental financial objective for managers, as agents for shareholders, is to maximize shareholder wealth. The Net Present Value (NPV) rule is the most reliable investment appraisal technique for achieving this goal. A project with a positive NPV is expected to generate returns that exceed its cost of capital. This surplus value directly contributes to the overall value of the firm, which in turn increases the market value of its shares and thus, the wealth of its shareholders. Accepting projects with a positive NPV is therefore directly aligned with the objective of shareholder wealth maximization.

A. The payback period is a measure of liquidity and risk, not value creation; it ignores cash flows after the payback point and the time value of money.

C. High risk does not guarantee high returns; it can lead to significant value destruction if the project fails. Wealth is created by managing the risk-return trade-off, not by maximizing risk.

D. Retaining dividends for reinvestment only increases wealth if the chosen projects have a positive NPV. The act of retention itself is not a direct cause of wealth increase.

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1. Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education. In Chapter 5, "Net Present Value and Other Investment Criteria," the authors state, "The net present value (NPV) rule... is the financial manager’s main tool for evaluating investment proposals... When we calculate a project’s NPV, we are asking whether the project is worth more than it costs. If the NPV is positive, the project is worth more than it costs and it makes a net contribution to value and to the wealth of the firm’s shareholders." (Section 5-1, "A Review of the Basics").

2. CIMA. (2019). CIMA Professional Qualification Syllabus, P3 Risk Management. Chartered Institute of Management Accountants. Syllabus Section B2(b), "Evaluate project proposals using the appropriate investment appraisal techniques," establishes the core competency of using methods like NPV to make capital investment decisions that align with strategic objectives, primarily shareholder value creation.

3. Arnold, G. (2013). Corporate Financial Management (5th ed.). Pearson Education. In Chapter 4, "Investment appraisal methods," it is explicitly stated that "The NPV rule leads to decisions which maximise shareholder wealth... A positive NPV signifies that the ordinary shareholders of the company will be made wealthier by the company undertaking the investment." (p. 98).

4. Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset (3rd ed.). John Wiley & Sons. Chapter 5, "The Basics of Risk," and subsequent chapters on investment analysis reinforce that value is created only when a firm undertakes projects that earn a return greater than the minimum acceptable hurdle rate (cost of capital), a principle that is the foundation of the NPV rule.

Effective risk management within the Systems Development Lifecycle (SDLC) involves implementing specific controls at each phase.

(A) A formal business case during the planning phase is a critical control. It ensures the project is aligned with strategic objectives, has defined scope, and is financially viable, mitigating the risk of investing in a system that provides no business value.

(D) During the analysis phase, meticulously defining data specifications and user requirements is essential. This control mitigates the risk of developing a system that fails to meet business needs or produces inaccurate output.

(C) In the development phase, enforcing programming standards and conducting component testing are key controls to manage technical risk, ensuring the system is reliable, maintainable, and free from critical defects.

B. The objective of a new system is often to improve processes, not merely replicate old functionalities, which may be inefficient or obsolete. This approach introduces the risk of failing to innovate.

E. Parallel running is only one implementation strategy and is not always feasible. Furthermore, a new system's output may be intentionally different (and more accurate) than the old one.

F. A Post-Completion Review is most valuable after the system has been operational for a period (e.g., 3-6 months), allowing for a realistic assessment of benefits and operational issues.

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1. Hoffer, J. A., Ramesh, V., & Topi, H. (2019). Modern Systems Analysis and Design (9th ed.). Pearson.

Page 10, Figure 1-4: This figure outlines the SDLC phases. The text emphasizes that the first phase, Planning, involves a formal request and an assessment of feasibility, which is encapsulated in a business case (supports A).

Page 11, "Analysis" section: This section describes the determination of requirements, stating, "the analyst studies the requirements and structures them according to their interrelationships," which directly supports the detailed specification mentioned in option D.

Page 12, "Implementation" section: This section details coding, testing, and installation. It notes that testing is a vital activity to find and fix errors, and programming standards are a prerequisite for quality code (supports C).

2. Laudon, K. C., & Laudon, J. P. (2020). Management Information Systems: Managing the Digital Firm (16th ed.). Pearson.

Chapter 13, Section 13-2, "Establishing the Business Value of Information Systems": This section explains that a strong business case is required to justify the investment in a new system, detailing its costs, benefits, and alignment with the firm's strategy (supports A).

Chapter 13, Section 13-3, "Testing": This section highlights the importance of unit (component) testing, system testing, and acceptance testing to ensure the system is free of errors and performs as specified (supports C).

3. CIMA (2019). CIMA Professional Qualification Syllabus, P3 Risk Management. Chartered Institute of Management Accountants.

Section C: Information Systems, Topic: Systems development and implementation (Weighting 15%): The syllabus explicitly requires candidates to evaluate the controls at each stage of the SDLC. It specifies the need for "a feasibility study and a business case" (supports A), "specification of user requirements" (supports D), and "testing" (supports C). It also discusses post-implementation reviews as a control to assess if benefits were achieved, which implies a time lag after implementation (refutes F).

The decision to continue or abandon a project must be based on relevant, future-oriented cash flows, ignoring any sunk costs. The $1,500,000 (25% of $6m) already spent is a sunk cost.

The re-evaluated Net Present Value (NPV) is the primary decision tool. The original PV of inflows was $7,200,000 ($6m outflow + $1.2m NPV). The remaining relevant outflows are the uncommitted $4,500,000 plus the new $1,300,000, totaling $5,800,000. The new NPV from this point forward is $1,400,000 ($7.2m - $5.8m). This positive NPV is a defining factor supporting continuation.

Additionally, the decision is a choice between continuing and abandoning. The costs associated with abandonment, such as site restoration, are relevant cash flows that must be considered, making the abandonment option less financially attractive.

B. The re-evaluated NPV is positive ($1,400,000), not negative, as the $1,500,000 sunk cost is correctly excluded from the forward-looking analysis.

C. While shareholder confidence is a valid consideration, the primary defining factor in capital budgeting decisions, according to established theory, is the quantitative financial appraisal (NPV).

E. The potential for other unexpected costs represents project risk, which should be assessed, but it is not a defined factor in the current NPV calculation itself.

1. Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education. In Chapter 6, Section 6-2, the text emphasizes the principle of incremental analysis: "The key is to trace all incremental cash flows from the project... Forget sunk costs." This supports ignoring the $1.5m already spent.

2. Drury, C. (2018). Management and Cost Accounting (10th ed.). Cengage Learning. Chapter 10, "Measuring relevant costs and revenues for decision-making," explains that for project abandonment decisions, the analysis should compare the net future cash flows from continuing with the net cash flows from abandonment (including any abandonment costs).

3. MIT OpenCourseWare. (2008). 15.401 Finance Theory I, Fall 2008. Massachusetts Institute of Technology. Lecture Notes, "Lecture 3: The Net Present Value Rule: The First Principle of Investment Decision Making," pp. 10-11. The notes explicitly state the "Sunk Cost Fallacy" and instruct that "Sunk costs are not incremental cash flows" and should be ignored in NPV analysis.

The beta factor (β) is a core component of the Capital Asset Pricing Model (CAPM) and measures a security's systematic risk relative to the overall market. Systematic risk, also known as market risk, is non-diversifiable and affects the entire market. The market itself is defined as having a beta of 1.0. A beta of 1.15 signifies that the shares are 15% more volatile than the market. Therefore, the shares possess a higher level of systematic risk than the market average. Beta does not provide information about unsystematic (specific) risk, which can be eliminated through diversification, nor does it allow for a definitive conclusion about total risk (systematic + unsystematic).

A. Beta is a measure of systematic risk, not unsystematic risk. No conclusion about the level of unsystematic risk can be drawn from this value.

C. Total risk is the sum of systematic and unsystematic risk. Since beta only measures the systematic component, we cannot determine the total risk.

D. Beta provides no information regarding the level of unsystematic risk, so it is impossible to conclude that it is lower than the market average.

1. Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education. In Chapter 8, Section 8.3, "Measuring Market Risk," it is explicitly stated: "The beta of a stock... measures its contribution to the risk of a well-diversified portfolio. This contribution is its systematic risk." A beta greater than 1.0 indicates higher-than-average market risk.

2. CIMA (2019). CIMA P3 Risk Management Study Text. Kaplan Publishing. Chapter 5, Section 3.2, "The Capital Asset Pricing Model (CAPM)," explains that beta measures the systematic risk of an investment. A beta above 1 indicates that the investment is more sensitive to market movements and thus has higher systematic risk than the market portfolio.

3. Sharpe, W. F. (1964). Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. The Journal of Finance, 19(3), 425–442. This foundational paper introduces the CAPM. On pages 438-440, the model establishes that the relevant risk of an individual asset is its covariance with the market portfolio, which is precisely what beta measures (systematic risk). https://doi.org/10.1111/j.1540-6261.1964.tb02865.x

The planning stage of an internal audit is foundational and involves establishing the scope, objectives, and approach. A critical first step is to learn all about the systems and controls in the department being audited (D) to understand the operating environment and identify potential risks. Auditors must also review previous audit findings (F) to identify recurring issues, assess the implementation of past recommendations, and inform the current risk assessment. Based on this preliminary understanding and risk analysis, the auditor then develops a detailed audit program, which includes deciding how the controls will be tested (C) during the fieldwork phase. These activities are essential for a focused and efficient audit.

A. Prepare the report: This is a final activity performed during the reporting stage, after all fieldwork and analysis are complete.

B. Establish whether the controls are adequate or not: This is the conclusion of the audit, determined during the evaluation and reporting stages after testing is complete.

E. Carefully consider any control weaknesses that are reported: This occurs during the evaluation phase of the audit, after testing has identified potential weaknesses.

1. The Institute of Internal Auditors (IIA), International Professional Practices Framework (IPPF), 2017.

Standard 2201 – Planning Considerations: "In planning the engagement, internal auditors must consider... The results of prior engagements." (Supports option F).

Standard 2201.A1: "When planning an engagement for parties outside the organization, internal auditors must establish a written understanding with them about objectives, scope, respective responsibilities, and other expectations... This understanding must include the engagement client’s governance, risk management, and control processes." (Supports the principle of understanding the systems and controls, option D).

Standard 2240 – Engagement Work Program: "Internal auditors must develop and document a work program that achieves the engagement objectives. The work program must include the procedures for identifying, analyzing, evaluating, and documenting information during the engagement." (Directly supports deciding how controls will be tested, option C).

2. Arens, A. A., Elder, R. J., & Beasley, M. S. (2017). Auditing and Assurance Services (16th ed.). Pearson Education.

Chapter 8, "Audit Planning and Analytical Procedures," pp. 220-224: This chapter details the initial planning phase, which includes obtaining an understanding of the client's business and industry (supporting D), assessing client business risk, and reviewing prior period information (supporting F). The chapter further explains that this understanding is used to develop the overall audit strategy and audit program, which outlines the nature, timing, and extent of audit tests (supporting C).

3. Chambers, A., & Odar, M. (2015). A new vision for internal audit. Managerial Auditing Journal, 30(1), pp. 34-55. https://doi.org/10.1108/MAJ-07-2014-1060

Section: "The Internal Audit Process," p. 38: The article describes the typical internal audit process, starting with planning. It states, "The planning phase includes understanding the auditee, identifying risks and controls, and preparing the audit program." This statement directly corroborates the necessity of understanding the systems (D), and preparing the audit program which includes test design (C). Reviewing past work (F) is an implicit part of understanding the auditee and identifying risks.

The Net Present Value (NPV) is calculated by converting the expected future cash flows into the home currency (GB£) and subtracting the initial investment.

1. Expected Annual Cash Flow (US$):

(US$400,000 × 0.40) + (US$700,000 × 0.60) = US$580,000

2. Forecast Exchange Rates (using PPP): S1 = S0 × (1 + iforeign) / (1 + ihome)

Year 1: 1.30 × (1.04 / 1.02) = US$1.3255/GB£

Year 2: 1.3255 × (1.04 / 1.02) = US$1.3512/GB£

Year 3: 1.3512 × (1.04 / 1.02) = US$1.3772/GB£

3. Convert Cash Flows to GB£:

Year 1: US$580,000 / 1.3255 = GB£437,571

Year 2: US$580,000 / 1.3512 = GB£429,248

Year 3: US$580,000 / 1.3772 = GB£421,144

Total Inflows: GB£1,287,963

4. Calculate NPV:

The question's structure implies a 0% discount rate, as no cost of capital is provided.

NPV = Total GB£ Inflows - Initial Investment

NPV = GB£1,287,963 - GB£1,000,000 = GB£287,963. This is closest to option A.

B. GB£391,640: This result may arise from incorrectly applying the Purchasing Power Parity formula, for instance, by inverting the inflation rates, leading to an overstatement of the GB£ cash flows.

C. GB£(111,973): A negative NPV would likely result from using a high, unstated discount rate or a significant error in the exchange rate forecasting that undervalues the future dollar cash flows.

D. GB£554,047: This figure likely results from converting all future US$ cash flows at the current spot rate (US$1.30/GB£), ignoring the effect of inflation differentials as predicted by PPP.

1. Shapiro, A. C. (2019). Multinational Financial Management (11th ed.). John Wiley & Sons. Chapter 16, "International Capital Budgeting," details the methodology of using Purchasing Power Parity to forecast exchange rates for converting foreign cash flows in project appraisal. The home currency approach is explained in section 16.3.

2. Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2016). Multinational Business Finance (14th ed.). Pearson. Chapter 18, "International Capital Budgeting," covers the two main methods for evaluating foreign projects: the home currency approach and the foreign currency approach. The use of parity conditions like PPP to derive forecast inputs is a central theme (pp. 510-514).

3. Damodaran, A. (n.d.). Country Risk and Company Exposure. NYU Stern School of Business, Course materials for Corporate Finance. In his discussion of international project appraisal, Damodaran explains the necessity of maintaining consistency: discount foreign cash flows at a foreign currency discount rate, or convert foreign cash flows to domestic currency (using expected exchange rates derived from PPP) and discount at a domestic rate. (See section on "Valuing Foreign Companies/Projects").

This question assesses the interpretation of statistical measures—expected value (mean) and standard deviation—in a risk management context.

(A) Risk is quantified by the variability of outcomes, for which standard deviation is a primary measure. Policy 2 has a standard deviation of $150,000, which is significantly higher than Policy 1's $80,000. Therefore, Policy 2's outcomes are more dispersed and less predictable, making it the riskier option.

(C) Assuming a normal distribution for the simulated outcomes, we can use Z-scores to compare probabilities. For Policy 2, the $500,000 cost is only 1.0 standard deviation above its mean ($150k/$150k). For Policy 1, it is 1.25 standard deviations above its mean ($100k/$80k). A lower Z-score corresponds to a higher probability of exceeding that value, making Policy 2 more likely to surpass $500,000.

(D) "Upside risk" in a cost scenario refers to the potential for costs to be significantly lower than expected. Policy 2's larger standard deviation means its outcomes are more widely spread on both sides of the mean. This creates a greater potential for very low costs (upside) as well as very high costs (downside) compared to the less volatile Policy 1.

B. Policy 1 will always be the more expensive in any given period.

This is incorrect because the expected value is an average, not a guaranteed outcome. The distributions of possible costs overlap, so a low-cost outcome for Policy 1 could be cheaper than a high-cost outcome for Policy 2.

E. Policy 2 is clearly the better policy.

This is incorrect because the choice depends on ERT's risk appetite. A risk-averse entity might prefer the certainty of Policy 1 despite its higher expected cost, while a risk-seeking entity might be attracted by Policy 2's lower expected cost, accepting the higher risk.

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1. For Standard Deviation as a Measure of Risk (A):

Drury, C. (2018). Management and Cost Accounting (10th ed.). Cengage Learning EMEA. In Chapter 19, "Quantitative methods in decision making," the standard deviation is presented as a fundamental measure of the risk or dispersion of possible outcomes around the expected value. (Specifically, see sections on decision making under conditions of risk and uncertainty).

2. For Probability Calculation using Z-scores (C):

Bertsimas, D., & Freund, R. M. (2004). Data, Models, and Decisions: The Fundamentals of Management Science. Dynamic Ideas. Chapter 6, "Simulation," discusses how to analyze the output of simulations, including using the mean and standard deviation to calculate probabilities of specific outcomes, often by assuming a normal distribution and using Z-scores. (See Section 6.5, "Analysis of Simulation Output").

3. For Upside/Downside Risk and Risk Appetite (D & E):

CIMA. (2019). CIMA P3 Risk Management Study Text. Kaplan Publishing. Chapter 3, "Risk Identification and Measurement," explains that standard deviation measures total volatility, encompassing both downside and upside potential. The text also emphasizes throughout that the selection of a course of action depends on balancing risk and return according to the organization's specific risk appetite, meaning no single option is universally "better."

Before committing capital to a specific diversification strategy, it is critical for K Ltd to undertake foundational strategic analysis. This involves two key activities. First, an internal analysis of its current operations and customer base (Option E) is required to understand its existing strengths, customer loyalty, and what its current market values. Second, an external analysis of the broader market (Option F) is necessary to identify emerging trends, potential growth areas, and future customer needs. These analytical steps provide the essential data to make an informed, evidence-based decision on the most appropriate and potentially successful diversification path, mitigating the risks associated with uninformed expansion.

A. Set up a number of activity holidays; adventure, sports and trekking for example. This is a specific diversification strategy (product development) that should only be considered after research confirms its viability and alignment with company capabilities.

B. Bulk book cruise accommodation and create a special package deal for retired couples. This is a specific strategic choice combining product and market development. It is premature to commit to this without prior market and customer analysis.

C. Expand the number of locations it currently serves. This is a market development strategy. It is a potential outcome of strategic analysis, not an immediate first step, as the new locations must be carefully selected.

D. Re-image the locations it currently serves to make them more exotic and family friendly. This is a marketing or repositioning tactic for the existing product portfolio, not a diversification strategy to widen the company's scope of operation.

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1. CIMA Official Study Text, P3 Risk Management. The CIMA P3 syllabus emphasizes that the formulation of strategy begins with strategic analysis before moving to strategic choice and implementation. This involves assessing the external environment (supporting option F) and the internal strategic capability (supporting option E) to understand the organization's strategic position. This analysis forms the basis for evaluating future strategic options. (Reference: CIMA, P3 Risk Management Study Text, Kaplan Publishing, Chapter 2: Strategic Analysis).

2. Johnson, G., Whittington, R., Scholes, K., Angwin, D., & Regnér, P. (2017). Exploring Strategy: Text and Cases (11th ed.). Pearson Education. The widely-used "Exploring Strategy Framework" presents strategic management as a process of understanding the Strategic Position, making Strategic Choices, and managing Strategy in Action. Understanding the strategic position involves analysing the macro-environment, industry, and internal strategic capabilities. Options E and F are direct actions related to understanding this position, which must precede making a strategic choice like A, B, or C. (Reference: Chapter 1, Figure 1.2 The Exploring Strategy Framework, p. 13).

3. MIT OpenCourseWare. (2014). 15.902 Strategic Management I, Fall 2014. Massachusetts Institute of Technology. University courseware on strategic management consistently teaches that effective strategy formulation starts with a rigorous analysis of both the external industry environment and the firm's internal resources and capabilities. This foundational analysis is essential for identifying and evaluating diversification opportunities. (Reference: MIT OCW, 15.902 Strategic Management I, Lecture Notes, Session 2: Industry Analysis & Session 3: Internal Analysis).