Question 1
How should appreciation of a company's home currency affect its cash inflows? How should depreciation of a company's home currency affect its cash inflows?
Exchange gains or losses for a company with subsidiaries resulting from translation of currency are non-cash flow items since they only involve changing one currency to another without movement of cash. Therefore, exchange losses and gains of companies with subsidiaries do not affect the cash inflow since they are non-cash items. However, an appreciation or depreciation of a home currency affects company cash inflows from foreign operations are conducted by branches abroad which are mere extensions of the home company. This is because branches are expected to remit all their earning to the home company.
In case of a company with branches, an appreciation of the home currency will result in a decrease in the cash inflows of the home company. An appreciation of the domestic currency results in weakening of foreign currencies of countries in which the home company has branches in. A stronger dollar relative to foreign currencies in which a home company has branches implies that a unit of a foreign currency will translate into fewer units of the domestic currency. Remittances from the branches will translate into fewer dollars. Therefore, the cash inflow of the home company will reduce.
A depreciation of the home currency will result in an increase in the cash flow of the home company. A depreciation of the domestic currency results in strengthening of foreign currencies countries in which the home company has branches in. A weaker dollar relative to foreign currencies in which a home company has branches implies that a unit of a foreign currency will translate into more units of the domestic currency. Remittances from the branches will translate into more dollars. Therefore, the cash inflow of the home company will increase.
Question 2
Explain why borrowings in US dollars and forward sales of US dollar revenues by Australian mining companies in the 1980 had backfired.
Most Australian companies engaged in the mining business export their products to the USA. They are priced in United States dollars as opposed to Australian dollars. These, mining companies therefore face a significant reduction in revenues denominated in US dollars when translated into Australian dollars with an appreciation of the Australian dollar. With such an exposure, inning companies borrowed in US dollars to hedge against foreign exchange risk when the Australian dollar was appreciating in the late 1970s and 1980s.Borrowing in dollars would result in lower cost of services debt if the appreciation of the Australian dollar could be sustained. Other firms engaged in mineral sales forward contracts to hedge against the exposure to currency risk. Australians firms were confident of the continued appreciation of the Australian dollar against the US dollar that they often engaged in 100 per cent forward sales for forecasted periods of over ten years.
In early 2000, the Australian dollar began to weaken against the United States dollar. Depreciation of the Australian dollar increased the cost of servicing foreign debt denominated in US dollar. Australian companies would pay more for outstanding debt because of the stronger US dollar. On the other hand, Australian companies that sold forwards faced significant reductions in revenues denominated in US dollars when translated into Australian dollars due foreign exchange losses as the contracts matured. These negative impacts of a stronger US dollar were further worsened by a sustained slump in the prices of minerals. In early 2000 prices of major mineral commodities such aluminum, copper, nickel, gold and uranium were declining due to decreased demand. Many of the Australian companies went into financial distress while some were declared bankrupt.
Question 3
The United States dollars paid when hedging = $1.40*100,000 = $140,000.
The United States dollars that would be paid if unhedged = $1.44*100,000 = $144,000.
The real cost of hedging payables = $144,000 – $140,000 = –$4,000.
Question 4
How will the weakened US dollar affect the reported earnings of a US company with subsidiaries all over the world?
The reported earnings will increase. A weakened United States dollar implies that the local currencies in which subsidiaries of the US company are located have become stronger hence higher reported earnings.
Multi-National Companies (MNCs) normally consolidate the financial statements showing the performance of the separate entities and present them as if they are the financial statements of a single entity in accordance with FASB 8 and FASB 52. Financial statement are normally translated into a single currency, usually the currency of the home country in which the MNC is based. This is to make it simpler for investors, creditors and other stakeholders to understand the financial position and performance of the company. When financial statements are converted to a single currency using the prevailing interest rate, a firm may incur exchange gains or exchange losses. When assets denominated in foreign currencies are translated, they are termed to be exposed. In instances where exposed assets are more than exposed liabilities, an appreciation of foreign currencies results in exchange gains. Similarly, foreign currency appreciation result into exchange gains and hence higher reported profits.
In this case, the US Company, will report its consolidated earnings comprising of the earning of all its’ subsidiaries all over the world in US dollars. It will translate the earnings of its subsidiaries abroad into US dollars before consolidating them. A weakened US dollar results in appreciation of foreign currencies. A weakened US dollar also, means that a unit of a foreign currency will translate into more US dollars. This would result in exchange gains by the US Company. Therefore, weakening of the US dollar would result in higher reported profits for a US company with subsidiaries.
References
Kim, S. H., & Kim, S. H. (2006). Global corporate finance: text and cases (6, illustrated ed.). New York: John Wiley & Sons.
Madura, J. (2009). International Financial Management (10, illustrated ed.). London: Cengage Learning.
Vishwanath, S. R. (2007). Corporate Finance: Theory and Practice (2, illustrated ed.). New York: SAGE.
