Translation exposure
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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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Translation exposure

Translation Exposure

Chapter Ten

Eitman, Stonehill, and Moffett

ESM Chapter Ten - Translation Exposure


Translation exposure1

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


Foreign subsidiaries

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


Functional currency

Functional currency

  • Primary economic environment of the firm

ESM 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

Balance sheet

ESM Chapter Ten - Translation Exposure


Income statement

Income statement

  • Revenues

  • (Costs)

    • (COGS)

    • (Operating costs)

    • (Depreciation)

  • (Taxes)

  • Net Income

    • retained

    • distributed

ESM Chapter Ten - Translation Exposure


Types of foreign firms

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


Determining the functional currency

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


Current method historical

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


Rationale for using current method

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


Temporal

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


Temporal1

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


Temporal2

Temporal

  • revenues

  • (cost of goods sold)

  • (operating costs)

  • (amortization)

  • (depreciation)

  • (Taxes)

  • Net Income

ESM Chapter Ten - Translation Exposure


Rationale for using temporal method

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


Balance sheet hedge

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


Current

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


Temporal3

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


Justifying a balance sheet hedge

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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