a. The two methods of reporting in the parent company’s currency are different due to usage of different rates of exchange.
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In our case, using the two methods, we will have significant differences in the reported profits and losses. If we use the spot rate of balance sheet publication, the currency conversion factor will be 12000 pesos per dollar, whereas if we use average rate, the conversion will be done at 10,000 pesos per dollar. There will be a difference of 20 percent in the reporting. On the other hand, if the rate today has been less than the exchange rate at the beginning, the current reported figures would have been lower than those reported under first method.
We should ideally use the method of spot rate at which payments are made. If it is not possible, the average rate would be better and consistent. Average can be taken for monthly figures or weekly rates to make it more accurate and representative of the realistic picture. As the income statement shows, the profits for the year were 25,000 million pesos in the local country. If it is translated to the parent company’s reporting currency using the spot rate of income statement, that is 12,000 pesos = $1, we will have net profits of $2,083,333.
If we use the average rate of the period, that is (8,000+12,000)/2 = 10,000 pesos per $1, we will have net profits of $2,500,000 or $2. 5 million. Under both the methods of reporting the same profits/income of the company to its parent company, the profits are quite different simply due to the currency difference and exchange rate variation over the period. The difference in profits reported is more than $0. 4 million or roughly 20 percent which may change the decisions taken at headquarters.
Taking into consideration the differences in the exchange rates and conversion risk, the company should decide on a measure to select the rate of exchange to use for its reporting during the entire life of the organization. They should consistently use whatever they have decided to use over their entire life. b. Functional currency is the one in which the operational cash is generated and is normally the currency of the country where the operations are going on. If the currency of the operating country is not stable, it can not be considered as functional currency.
The stability of currency means that the rate of inflation over three year period should be less than 100 percent. As in the given case, the rate of inflation is 50 percent, (from 8,000 ps per dollar to 12,000 ps per dollar), the functional currency will be peso as the operational cash flows are generated in pesos and the inflation is within the limits. If the inflation over the past two years reaches 150 %, the functional currency will be changed to the reporting currency of the parent company, which in our case is dollar. . Economic exposure for Avila can be seen by the given conversion rates and their variability over such a short period of time. Economic exposure is the effect of foreign currency rate changes to the cash flows and other measures of operational performance. The exposure for any company is affected by the industry it is operating in and the stability of the currency of its operating country and the parent company. If there is excess demand of pesos, it will push the rates of pesos higher and vice versa.
If the rate gets higher, that is there will be less pesos in a dollar, the performance in the parent company’s report will be better than the situation when the exchange rate gets low. The two reporting methods will lead to significant differences in reported profits and losses to the parent company, from the operations in some other country. 3. Hedging can be a good option to protect the company against any unforeseen changes in the exchange rates. The company can make hedging I a number of ways to make itself protected against foreign exchange risk.
Four positions are possible to provide such a protection using simple forward contracts and options. a. Long forward Under long forward position, the company at the operating country can take a long forward position to fix exchange rate (today) for a future date of transaction. Taking a long position means that the investor is agreeing to buy the underlying asset, at a specified price, agreed by both parties, on some future date. The contract has to be executed irrespective of what the conversion rate will be.
Unlike options, none of the parties has the option to execute the contract or revoke it, but it is mandatory for both of them to carry it out. b. Short forward Short forward position can act equally well at the parent company’s location. The parent company at the parent country can go to short forward position so that it can sell dollars to pesos at a rate specified today. Using both the positions they can hedge the overall loss and can be certain about the expected gains. Options provide a type of insurance against any unforeseen changes in exchange rate.
The buyer of call option and the seller of put option, both have the right to exercise the option or to waste it. The maximum loss in wasting the option is restricted to the price of the option. In this way, the company can set a floor to its loss and can gain as much as it can. c. Long Call Long call allows the parent company to buy a right to buy at a specified rate at some future point in time. If the rate increases, the company will have the option to buy at a lower rate than the market going rate, if it goes down, the loss will be restricted to the price of the option and the gains can be as much as the rate goes down. . Short Put Short Put will allow the company at the operating country to enter into a position to sell a right to sell at a set rate. The working for this will be exactly in the opposite manner as the long call position. 4. Financial architecture affects the overall cost for the company. If the inflation is high and the interest rates are high for a high risk firm, the cost of obtaining financing from banks and other Financial Institutions (FIs) will be high. Equity financing or market financing will require a higher rate of return, but the firm may shift the payments to some future period.
As for bank financing or debt financing, it will have to make payments to the lending institution within the given timeframe. The firms may choose to go for a certain debt to equity ratio to gain advantage of optimal capital structure to optimize their costs of capital or WACC (Weighted Average Cost of Capital). 5. Euro currency is the use of currency in some other country. This in our case refers to storage, saving of pesos in the parent country where the currency in use is dollars. This will provide the company benefits in terms of advantage in domestic interest rate regulations and other barriers to free flow of cash.
Firms participate in the euro currency markets to gain the benefits from exchange rate inefficiencies and under or over valuation of some currencies. If the investments are in the parent company’s currency and the operations are in the local currency of country where operations are being carried out, the exchange rate plays a vital role when calculating returns on investments for the company’s investments and funding by the parent company. If the domestic currency rises in operating country, the rate of return required should be higher than normal to overcome the exchange differences and vice versa.
To overcome this difference and the problems due to fluctuating exchange rates, companies enter euro-currency markets where they can keep their money in parent company’s currency and convert it to functional currency as and when needed. This provides them the opportunity to maintain the required base in terms of parent company’s currency. 6. Other alternatives to run a firm’s fund-flow mechanism are to use various swaps in the form of interest rate swaps or foreign currency swaps. MNCs can go for unbundling of their costs at headquarters to affiliate companies of subsidiaries.
In this way they can divide their costs to subsidiaries. Multinationals can go for transfer pricing mechanisms to avoid taxes on their overall operations. This can be done by pricing their internally traded goods for the purpose of moving profits to low tax nations. This will provide them an overall higher profitability. Companies can also create re-invoicing centers to avoid exchange rate fluctuations. The invoice currency will be the one used rather than the operating currency. This will reduce their exposure to currency and exchange rate risk.
This will increase communication costs and to some extent create an overhead whereby the overall time delays and costs will be increased. MNCs can also transfer funds to their parent companies as dividends if the local conditions and regulatory framework is favorable. The major benefits of using different mechanisms can be obtained because of differences in the tax mechanisms and tax systems in different countries
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