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OUTLINE FOR CHAPTER 13

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  1. OUTLINE FOR CHAPTER 13 • Understand Translation Exposure • How does translation exposure arise? • Definition • How do the Current and Temporal Methods work? • What are the U.S. rules? • Calculation of exchange gains/losses

  2. Chapter 13 - Translation Exposure • Arises because financial statements of foreign affiliates which are typically stated in foreign currencies need to be restated (translated) in terms of the currency of the parent • Main purpose of translation - preparation of consolidated financial statements

  3. Translation Exposure • Definition - Potential for an increase or decrease on the parent’s net worth and reported net income caused by a change in the exchange rate • Operating exposure is more important (for financial managers) but in the real world translation exposure is quite important

  4. Translation Methods • Methods we will discuss in class: Current Rate - most prevalent in the world Temporal Method

  5. Current Rate Method • Assets and liabilities use current rate • Income statement - use actual exchange rate for the day when revenues, expenses, etc. were incurred or use an appropriate weighted average exchange rate • Dividends - use exchange rate in effect on date of payment

  6. Current Rate Method - Continued • Equity - common stock and paid-in capital accounts use an appropriate historical rate • In the U.S., translation gains / losses are put in a special account (Cumulative Translation Adjustment - CTA). When foreign affiliate is sold or liquidated gains or losses become realized

  7. Temporal Method (similar to the Monetary/Nonmonetary Method) • Monetary assets (cash, marketable securities, accounts receivable, etc.) and monetary liabilities (current liabilities and long-term debt) use current exchange rate • Nonmonetary assets (inventory, fixed assets, etc.) use appropriate historical rate • Dividends - use exchange rate in effect on date of payment

  8. Temporal Method - Continued • Income statement - In general use average exchange rate for period. For depreciation and cost of goods sold use appropriate historical rate • Common stock and paid-in capital accounts use appropriate historical rate • Gains / losses from translation go to current consolidated income

  9. U.S. Rules • For each affiliate must figure out the functional currency • Functional currency - currency of the primary economic environment in which the affiliate operates and generates cash flows • See page 338 for more information in deciding what is the functional currency of the subsidiary.

  10. U.S. Rules - Continued • From page 340 of Multinational Business Finance • If the financial statements of the foreign affiliate are in U.S. dollars no translation is required • If the financial statements of the foreign affiliate are in the local currency and the local currency is the functional currency use the current rate method

  11. U.S. Rules - Continued • If the financial statements of the foreign affiliate are in the local currency and the dollar is the functional currency use (remeasured by) temporal method • If the financial statements of the foreign affiliate are in the local currency and neither the local currency nor the dollar is the functional currency, then financial statements are first remeasured into the functional currency by the temporal method and then translated by the current rate method

  12. U.S. Rules - Continued • If a country has cumulative inflation of approximately 100 % over a 3 year period must use the temporal method

  13. Examples of Translation Methods • Exchange rates: • Plant and equipment, common stock, long-term debt, and inventory were acquired when the exchange rate was $ .06 / peso • Right before devaluation the exchange rate was $ .05 / peso (at end of period) • At start of the new period the rate is $ .04 / peso

  14. Current Rate Method Example

  15. Example Continued

  16. Notes to Previous Example • Dollar retained earnings are the sum of additions to retained earnings each year • Assume a prior CTA account of (240) • The additional loss of $ 420 = cash (-$ 60) + a.r. (-$ 120) + inv (-$ 120) + net plant (-$ 240) + c. liab. (+$ 30) + l.t. debt (+$ 90)

  17. Exchange Gain or Loss • Formula for exchange gain or loss: • ($ exposed assets - $ exposed liabilities) x (percentage change in the exchange rate) • ($ 2700 - $ 600) (-.2) = - $ 420 • where exposed means that the $ value changes when the exchange rate changes

  18. Temporal Method Example

  19. Example - Continued

  20. Notes to the Example • The translation gain or loss would not be shown as a separate item. Retained earnings would be $ 2040. • Translation loss = ( $ 900 - $ 600) (-.2) = - $ 60

  21. Comparison of Temporal and Current Rate Methods • Note in this example the two methods give very different magnitudes of losses • Can also have the situation where there are accounting losses (gains) but operating gains (losses)

  22. Managing Translation Exposure • Balance Sheet Hedge - make $ exposed assets = $ exposed liabilities ( no matter what the exchange rate does there will be no accounting losses or gains) • Creating a balance sheet hedge may and probably will reduce operating efficiency (may for example have too much inventory)

  23. Managing - Continued • Under the temporal method in this example could borrow 6000 pesos and convert to dollars or buy inventory or plant and equipment • Under the current rate method could borrow 42000 pesos and convert to dollars

  24. Rules in Other Countries • Many countries make a distinction between an integrated foreign entity (foreign affiliate is an extension of the parent and cash flows of affiliate are highly related to cash flows of parent) and a self-sustaining foreign entity (basically cash flows of local affiliate are “independent” of those of the parent)

  25. Rules - Continued • In many countries integrated foreign entities use the temporal method and self-sustaining entities use current rate method

  26. Homework - Chapter 13 • # 8 (do both the current rate method and the temporal method)

  27. OUTLINE FOR CHAPTER 14 • Calculation of WACC • To understand the benefits of gaining access to global capital markets

  28. Chapter 14 - Global Cost and Availability of Capital • When firms get access to global markets costs can be reduced as well as availability of funds increased. • Benefits are potentially the highest for small firms and firms in illiquid or segmented markets.

  29. Review - Weighted Average Cost of Capital (WACC) • Cost of the bundle of funds employed by the firm • Kwacc = Ke (E/V) + Kd (1-T) (D/V) where: Kwacc is the weighted average after tax cost of capital Ke is the risk adjusted cost of equity

  30. WACC - Continued Kd is before tax cost of debt T is the marginal tax rate E is the market value of the firm’s equity D is the market value of the firm’s debt V is the total market value of the firm

  31. Cost of Equity (using Capital Asset Pricing Model) • Ke = krf + βi (km-krf) • Where • Ke = required/expected rate of return on equity • Krf = rate of return on risk-free bonds • Βi = systematic risk of firmi • Km = required/expected rate of return on the market

  32. Beta • B

  33. Review - Marginal Return on Capital Schedule (MRR) • Suppose a firm has three projects with the following returns and initial costs: Project Yield Cost A .14 10 million B .12 6 million C .10 8 million

  34. MRR - Continued 14 Rate of Return 12 10 10 16 24 Budget

  35. Improving Market Liquidity • Market liquidity: if a firm issues a new security will market price suffer and will a change in price of any if its securities elicit a big order flow • It is assumed that a firm can not raise unlimited funds without the cost of those funds increasing even if firm maintains optimal capital structure

  36. Improving Market Liquidity - Continued • Key idea: if a firm is able to get international sources of capital, it should have a lower marginal cost of capital at some point at least in the short-run (see diagram on page 385). • A firm would raise funds both in international markets as well as domestic markets.

  37. Improving Market Liquidity - Continued • As a result, the firm may be able to take on more projects which will add value. • These benefits may be significant for firms residing in countries with illiquid capital markets

  38. Overcoming Market Segmentation • Definition of market segmentation: Return/risk tradeoffs are different in various markets after adjusting for foreign exchange risk and political risk • Likely a firm operating in a segmented market will have a higher marginal cost of capital than if it were in an integrated market

  39. Gains form Overcoming Market Segmentation • See diagram on page 385 for these gains • Markets are becoming more and more integrated so these gains are becoming less and less

  40. What Causes Market Segmentation • (1) Information barriers (language, accounting principles, quality of disclosure) - foreign investors may not have access to good information and therefore may not want to invest in a market full of these barriers • (2) Transaction costs (taxes, commissions, etc.) - if too high investors will go to other markets

  41. Causes - Continued • (3) Foreign exchange risk - if exchange rates are too volatile or if currency depreciates too much, foreigners may not want to invest there • (4) Small-country bias (volume too low for international investors, maybe an illiquid market)

  42. Causes - Continued • (5) Political Risk - fear of government intervention (example - capital controls) • (6) Regulatory barriers (excessive rules) - discourage investors from investing in that market

  43. Comparing Cost of Capital for Multinationals and Domestic Firms • Read pages 393-397.

  44. OUTLINE FOR CHAPTER 15 • Crosslisting • ADRs • Sourcing Equity Abroad

  45. Chapter 15 - Sourcing Equity Globally • Emphasis in this chapter are firms operating in less liquid or segmented markets • Often US and UK firms source overseas to fund large foreign acquisitions and not for their existing domestic or foreign operations

  46. Crosslisting • Listing your company shares on a foreign market

  47. Why Crosslist on Foreign Stock Exchanges • (1) Improve the liquidity for existing shareholders by letting them trade in their home markets and currencies • (2) Possibly have a favorable effect on share price if markets are segmented or illiquid

  48. Why Crosslisting - Continued • (3) If a company wants to issue stock in the future in a particular market may want to crosslist now. • (4) Might help if trying to acquire firms in foreign markets (if pay in stock, not cash)

  49. Why Crosslisting - Continued • (5) Increase firm’s visibility and political acceptance to customers, suppliers, creditors and local governments - if there is local ownership the firm may be more popular • (6) Create a secondary market for shares to reward employees

  50. Barriers to Crosslisting • For non-U.S. firms the disclosure requirements for the SEC are tough and continuous • May also need a continual program of investor relations