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Translation Exposure

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different line items translated at different ... Cash flows denominated in functional currency. Supplier to ... intercompany transactions. large volume - use ... – PowerPoint PPT presentation

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Title: Translation Exposure


1
Translation Exposure
  • Chapter Ten
  • Eitman, Stonehill, and Moffett

2
Translation exposure
  • foreign currency financial statements
  • different line items translated at different
    exchange rates
  • term of different assets liabilities translated
    at
  • historical rates
  • current rates

3
Foreign subsidiaries
  • Integrated foreign entity
  • Extension of parent firm
  • Cash flows denominated in functional currency
  • Supplier to the parent firm
  • Self-sustaining foreign entity
  • Operates independently in foreign environment
  • Cash flows denominated in foreign currency
  • Supplied by local economy
  • Supplies local economy

4
Functional currency
  • Primary economic environment of the firm

5
Balance sheet
  • cash
  • market securities
  • receivables
  • inventories
  • fixed assets
  • payables
  • accruals
  • fixed debt
  • common stock
  • pd in capital
  • acc. Retained earnings

6
Income statement
  • Revenues
  • (Costs)
  • (COGS)
  • (Operating costs)
  • (Depreciation)
  • (Taxes)
  • Net Income
  • retained
  • distributed

7
Types of foreign firms
  • integrated foreign entity
  • one which operates as an extension of the parent
    firm
  • functional currency is that of the parent firm
  • self-sustaining foreign entity
  • one which operates independently of the parent
    firm
  • functional currency is that of the foreign country

8
Determining the functional currency
  • intercompany transactions
  • large volume - use parent currency
  • small volume - use foreign currency
  • large volume determined by a large split between
    revenues and costs
  • sales price responsive more to exchange rate
    changes
  • costs due to importing components from parent
    company
  • interest costs on financing in home currency

9
Current method (Historical)
  • balance sheet items at current rate
  • income statement items
  • exchange rate in effect on dates incurred
  • average exchange rate over the period
  • distributions - rate on date of payment
  • equity
  • equity pd in capital historical rates
  • retained earnings at historical
  • cum translation adj - on consolidated BS

10
Rationale for using current method
  • if relative PPP holds
  • real assets depreciate in foreign currency terms
  • real assets retain constant value in home
    currency terms
  • monetary (financial) assets do not have time to
    depreciate
  • if relative PPP does not hold
  • case is the same as that of a firm in an
    inflationary or deflationary climate

11
Temporal
  • balance sheet items - stock statement
  • monetary assets liabilities - current
    rate
  • non-monetary assets liabilities - historical
    rate
  • inventories may be assigned as current assets
  • income statement items - flow statement
  • most items - average rate
  • except cashflows associated with non-current
    assets or liabilities translated - historical
    rate
  • depreciation

12
Temporal
  • Assets
  • Cash
  • marketable securities
  • accounts receivable
  • inventories
  • fixed assets
  • Liabilities
  • accounts payable
  • notes payable
  • accruals
  • long-term liabilities
  • equity

13
Temporal
  • revenues
  • (cost of goods sold)
  • (operating costs)
  • (amortization)
  • (depreciation)
  • (Taxes)
  • Net Income

14
Rationale for using temporal method
  • This reflects normal evaluation
  • Book values are used
  • monetary (financial) assets do not have time to
    depreciate
  • if relative PPP does not hold
  • case is the same as that of a firm in an
    inflationary or deflationary climate

15
Balance Sheet Hedge
  • Must match foreign denominated liabilities to
    assets
  • Borrow the expected change in equity
  • Based on an expected future spot
  • Convert to home currency now
  • Sell assets equivalent to change in equity
  • Convert to home currency now

16
Current
  • cash
  • market securities
  • receivables
  • inventories
  • fixed assets
  • payables
  • accruals
  • fixed debt
  • common stock
  • pd in capital
  • acc. Retained earnings

17
Temporal
  • Assets
  • Cash
  • marketable securities
  • accounts receivable
  • inventories
  • fixed assets
  • Liabilities
  • accounts payable
  • notes payable
  • accruals
  • long-term liabilities
  • equity

18
Justifying a Balance Sheet Hedge
  • Liquidation of current foreign operations in the
    short to medium term
  • Maintenance of debt covenants
  • Subsidiary operating under hyperinflation
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