Organisation 1 & 2 This question concerns two organisations, one in the private sector and one in the public

sector. Organisation 1: This is a listed company in the electronics industry. Its stated financial objectives are: "To increase earnings per share year-on-year by 10% per annum"; and To achieve a 25% per annum return on capital employed".

This company has an equity market capitalisation of 600 million. It also has a variety of debt instruments trading at a total value of 150 million. Organisation 2: This organisation is a newly-established purchaser and provider of healthcare services in the public sector. The organisation's legal status is a Trust. Its total income for the current year will be almost 100 million. It is considering funding the building of a new healthcare centre via the Private Finance Initiative (PFI). The total debt will be 15 million. Capital and interest will be repaid over 15 years at a variable rate of interest, currently 9% each year. The Trust's sole financial objective states simply "to achieve financial balance during the year". Its other objectives are concerned with qualitative factors such as "providing high quality healthcare". Required: (a) Discuss (i) the reasons for the differences in the financial objectives of the two types of organisation given above; and (ii) the main differences in the business risks involved in the achievement of their financial objectives and how these risks might be managed. Use the scenario details given above to assist your answer wherever possible. (18 marks)

(b) Explain how the financial risks introduced into the public sector organisation by the use of PH might affect the achievement of its objectives and comment on how these risks might be managed. (7 marks) Note: Candidates from outside the UK may use examples of private financing of public sector schemes in their own country in answering part (b) of this question if they wish. (Total 25 marks)

Organisation 1 & 2 (a) Introduction In recent years, the objectives of public and private sector organisations have moved closer together; the public sector recognising the need to be more accountable for taxpayers' money and the private sector recognising there are stakeholders in the company other than the shareholders. However, private sector companies still have their key responsibilities to shareholders and are obliged to maximise their return on investment within the constraints imposed by social, legal and political interests and influences. EPS as an objective There is disagreement about the importance of EPS as a decision criterion but it is an important historic measure within the company. Comparison of EPS with other organisations is not useful although the growth in EPS can be directly compared. This growth is viewed as an important yardstick by which companies' performance is assessed by the market and shareholders. This external scrutiny is largely missing in the public sector where public attention is focused on quality of services rather than financial rewards. Return on capital employed The directors of a private sector company have a fiduciary duty to shareholders as their priority. In the private sector, there is a requirement to offer the prospect of an adequate return on capital employed or investment. It has to produce a return comparable at least with similar risk investments to satisfy this group of stakeholders. In the public sector, it essentially means persuading a higher authority, and ultimately the Treasury, that the proposed activities represent value for taxpayers money. This is often politically driven, rather than being based on an assessment of long-term financial health. The scenario does not give a market-based objective, such as return on equity. Most listed plcs would use DCF and NPV approaches to investment decisions in order to take some account of risk of their investments. The basis might be rule-of-thumb or more formal CAPM-type approaches. Using the time value of money as a decision criterion is not particularly well developed in the public sector. The cost of capital, if used at all, is dictated by the Treasury and is likely to ignore aspects such as risk and realistic expectations of inflation. Tax is ignored, on the grounds that it is an internal transfer. Cash limits A feature of the public sector is the over-riding importance attached to the current fiscal year's cash flows. "Borrowing" is not generally available although short-term deficits can be ''brokered" either centrally or between institutions. Some public sector organisations attempted some years ago to finance using commercially-priced debt instruments (not asset-backed PFI debt) and suffered severe losses. The reason for this might be that public-sector finance managers are not experienced in borrowing commercially. A private sector company can borrow more freely subject to normal considerations of prudence and commercial probity. Management of risk A major difference between the two sectors is clearly one of risk. A public sector organisation, such as a health trust, has a more or less guaranteed number of ''customers'' and associated income from the government. It does not therefore have to compete in the same way as private organisations. There is, however, a key difference between the public and private sectors' definition of customer, which is the redistributive nature of the public sector organisation's operations. There is an economic link between consumption and price, which the private sector can easily accommodate. In the UK public sector many services are free at the point of delivery. If an organisation's income comes from a source other than paying customers, then demand will inevitably exceed supply. This is the risk faced by public sector organisations that they constantly struggle to manage, frequently by ''robbing Peter to pay Paul" or imposing some form of rationing of services. In summary then, the main risk to be faced by a private sector organisation is falling demand. whereas in the public sector it is rising demand and insufficient resources to meet it. The risk to the private sector organisation. failing to obtain the required level of earnings and return on investment, can be managed by normal commercial risk management techniques: undertaking analysis of customers and markets; providing product and service excellence; providing equitable treatment of all stakeholders in the organisation (paying creditors on time, fair remuneration for employees, respect for the environment and local community interests etc); insuring where possible against risks, for example exchange and interest rate risks can be hedged, insurance

can be taken out against loss, theft or damage. The list of stakeholders in a plc - for example creditors, employees - could also apply to the public sector with taxpayers replacing shareholders. However, the main risk faced by this organisation is in many ways more complex. It has to be managed within the political constraints imposed by government as well as cash limits. Management techniques are: constant monitoring of value-for-money, of goods and services from internal and external suppliers; buying services for its clients based on evidence of effectiveness (especially in health services); using private sector funds within allowed limits, for example the PFI to fund major capital projects.

(b) Note: The example used here is that of organisation 2 in the question. There are many variants of the PFI, and some carry more risk than others. The original purpose of the PFl was not to force public sector managers into operating as commercial enterprises but to supplement limited public sector funds. The cost to the borrower of PFI was generally below commercial rates, not necessarily because of the asset backing, which is relevant also to the private sector, but because of the much reduced risk of default. The main risks to the achievement of the trust's financial objective arising from the PFI debt are as follows: Interest rates rise substantially and are not matched by increases in government payments; Income from government falls, for whatever reason, and capital and interest payments still have to be made.

To be fair, the risks in this example are relatively small. Equal annual payments to service the loan would be 15 million / 8.061 = 1,860,811, less than 2% of total income and the UK government has pledged increases in health-care funding considerably higher than inflation for some years to come. Income depends on patients treated and it is highly unlikely that patient numbers or treatment episodes will fall by any significant margin. However, should this unlikely event take place, then the trust could attempt one or more of the following strategies: Negotiate a longer repayment period - PFI for hospitals and health care centres is typically 20-30 years so the 15-year term in the scenario here is much shorter than the norm. Negotiate lower treatment rates with the providers from whom it purchases health-care. This would be difficult if the provider is in the public sector because it also will have similar financing considerations. Providers in the private sector may be willing to be more flexible. Improve their efficiency targets for the treatments they provide- The result of this might be to assist the achievement of the non-financial objectives rather than contributing to the achievement of the financial objective.