Translation Exposure

1
Translation Exposure

• Chapter Eight
• 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

• 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
Current / non-current

• balance sheet items - stock statement
• current assets liabilities - current
  rate
• non-current assets liabilities - historical
  rate
• income statement items - flow statement
• most items - average rate
• except cashflows associated with non-current
  assets or liabilities translated - historical
  rate
• depreciation

12
Current / non-current

• Assets
• Cash
• marketable securities
• accounts receivable
• inventories
• fixed assets

• Liabilities
• accounts payable
• notes payable
• accruals
• long-term liabilities
• equity

13
Current / non-current

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

14
Monetary / non-monetary

• balance sheet items - stock statement
• monetary assets (claims) - current rate
• non-monetary (physical) assets - historical rate
• income statement items - flow statement
• most items - average rate
• except cashflows associated with non-current
  assets or liabilities translated - historical
  rate
• depreciation, cost of goods sold

15
Monetary / non-monetary

• Assets
• Cash
• marketable securities
• accounts receivable
• inventories
• fixed assets

• Liabilities
• accounts payable
• notes payable
• accruals
• long-term liabilities
• equity

16
Monetary / non-monetary

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

17
Temporal method

• balance sheet items - stock statement
• monetary assets (claims) - current rate
• inventories current rate / historical rate
• non-monetary (physical) assets - historical rate
• income statement items - flow statement
• most items - average rate
• except cashflows associated with non-current
  assets or liabilities translated - historical
  rate
• depreciation, cost of goods sold, amortization

18
Temporal

• Assets
• Cash
• marketable securities
• accounts receivable
• inventories
• (market value)
• inventories
• (book value)
• fixed assets

• Liabilities
• accounts payable
• notes payable
• accruals
• long-term liabilities
• equity

19
Temporal

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

20
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