Translation Exposure Chapter Ten Eitman, Stonehill, and Moffett January 17, 20161ESM Chapter Ten - Translation Exposure

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 January 17, 20162ESM Chapter Ten - Translation Exposure

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 January 17, 20163ESM Chapter Ten - Translation Exposure

Functional currency  Primary economic environment of the firm January 17, 20164ESM Chapter Ten - Translation Exposure

Balance sheet  cash  market securities  receivables  inventories  fixed assets  payables  accruals  fixed debt  common stock  pd in capital  acc. Retained earnings January 17, 20165ESM Chapter Ten - Translation Exposure

Income statement  Revenues  (Costs) (COGS) (Operating costs) (Depreciation)  (Taxes)  Net Income retained distributed January 17, 20166ESM Chapter Ten - Translation Exposure

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 January 17, 20167ESM Chapter Ten - Translation Exposure

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 January 17, 20168ESM Chapter Ten - Translation Exposure

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 January 17, 20169ESM Chapter Ten - Translation Exposure

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 January 17, ESM Chapter Ten - Translation Exposure

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 January 17, ESM Chapter Ten - Translation Exposure

Temporal  Assets Cash marketable securities accounts receivable inventories fixed assets  Liabilities accounts payable notes payable accruals long-term liabilities equity January 17, ESM Chapter Ten - Translation Exposure

Temporal  revenues  (cost of goods sold)  (operating costs)  (amortization)  (depreciation)  (Taxes)  Net Income January 17, ESM Chapter Ten - Translation Exposure

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 January 17, ESM Chapter Ten - Translation Exposure

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 January 17, 2016ESM Chapter Ten - Translation Exposure 15

Current  cash  market securities  receivables  inventories  fixed assets  payables  accruals  fixed debt  common stock  pd in capital  acc. Retained earnings January 17, ESM Chapter Ten - Translation Exposure

Temporal  Assets Cash marketable securities accounts receivable inventories fixed assets  Liabilities accounts payable notes payable accruals long-term liabilities equity January 17, ESM Chapter Ten - Translation Exposure

Justifying a Balance Sheet Hedge  Liquidation of current foreign operations in the short to medium term  Maintenance of debt covenants  Subsidiary operating under hyperinflation January 17, 2016ESM Chapter Ten - Translation Exposure 18