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Translation Exposure

Translation Exposure. Chapter Ten Eitman, Stonehill, and Moffett. 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.

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Translation Exposure

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  1. Translation Exposure Chapter Ten Eitman, Stonehill, and Moffett ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  4. Functional currency • Primary economic environment of the firm ESM Chapter Ten - Translation Exposure

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

  6. Income statement • Revenues • (Costs) • (COGS) • (Operating costs) • (Depreciation) • (Taxes) • Net Income • retained • distributed ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

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

  13. Temporal • revenues • (cost of goods sold) • (operating costs) • (amortization) • (depreciation) • (Taxes) • Net Income ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

  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 ESM Chapter Ten - Translation Exposure

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

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

  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 ESM Chapter Ten - Translation Exposure

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