Business Assignment 4 Suggested Answers

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1 Business 4079 Assignment 4 Suggested Answers 1. Operating Exposure This exercise follows from the example seen in class and uses the same assumptions. Find, in each of the following cases, the change in the present value of the firm s cash flows over the next five years after an appreciation of the euro from $1.2000/E to $1.2500/E. (a) (5 points) Carlton Germany leaves its domestic price at E12.80 and reduces its export price such that its U.S. dollar price remains unchanged. Sales levels in both markets remain unchanged. Answer: The initial price in $ is = $ If the export price in $ remains constant, this means that the new export price in euros is 15.36/1.25 = E This represents a reduction of = E0.51 for one half of the annual production, i.e. 500,000 units. There is no change in costs and thus the change in cash flow from operations (CFO) is CFO = (1.34) ( 0.51) 500, 000 = E168, 960 from the base case. Since sales in euros decrease by , 000 = E256, 000, the change in accounts receivable is A/R =.25 ( 256, 000) = E64, 000. The change in the present value of the firm s cash flows over the next five years is then PV = 168, ( 1 1 ) ( 1 ( 64, 000).20 (1.20) ) (1.20) 5 = E477,

2 Hence the present value of the firm s cash flows over the next five at the new exchange rate is 5, 169, , 681 = E4, 691, 892 = $5, 864, 864, where E5,169,572 is the present value of the firm s cash flows in the base case. The dollar change in the present value of the firm s cash flows is 5, 864, 864 6, 203, 487 = $338, 622. (b) (5 points) Carlton Germany leaves its domestic and export prices unchanged at euros but exports decrease by 10%. Domestic sales volume does not change. Answer: The change in CFO in this case is CFO = (1.34)( ) (.10) 500, 000 = E105, 600 and investment in NWC is (A/R + Inv.) = ( ) (.10) 500, 000 = E280, 000. The change in the present value of the firm s cash flows over the next five years is then PV = ( 105, 600) 1 ( 1 1 ) ( 1 ( 280, 000).20 (1.20) ) (1.20) 5 = E195, 001. Hence the present value of the firm s cash flows over the next five at the new exchange rate is 5, 169, , 001 = E4, 974, 571 = $6, 218, 214. The dollar change in the present value of the firm cash flows is 6, 218, 214 6, 203, 487 = $14, 727. (c) (10 points) Redo (a) and (b) assuming that 40% of Carlton Germany s variable costs have to be paid in U.S. dollars and the rest in euros. Answer: Please see the Spreadsheet. 2

3 (d) (10 points) Redo (a) and (b) assuming that 60% of Carlton Germany s variable costs have to be paid in U.S. dollars and the rest in euros. Answer: Please see the Spreadsheet. 2. Translation Exposure MasterToy has a foreign subsidiary, Nippon MT, that makes and sells toys in Japan. All of Nippon MT s operations and sales take place in Japan, transactions are denominated in Japanese yen, and the books and records are maintained in yen. The functional currency is the yen. MasterToy, the parent company, reports its earnings in U.S. dollars. Nippon MT s financial statements for 2000, 2001 and 2002 are depicted in Table 2. The subsidiary has been acquired on December 31, 2000, and relevant exchange rates are shown in Table 1. (a) (5 points) Identify the method that MasterToy should use to translate the Japanese yen results of Nippon MT into U.S. dollars. Answer: The functional currency being the yen, the current-rate method should be used to translate the financial statements. (b) (15 points) Convert the 2000, 2001 and 2002 balance sheets and income statements into U.S. dollars using the method mentioned in (a). Answer: The translated statements can be seen in Table 3. All assets and liabilities have been translated using the exchange rate on the balance sheet date, all income statement items have been translated using the average exchange rate for the year of the statement. There being no stock issue in 2001 and 2002, common stock is translated using the exchange rate prevailing at the acquisition date, i.e. 120/$. Retained earnings increase by each year s net income and the cumulative translation account (CTA) is used as the plug variable. Note that CTA goes up when the yen appreciates and it goes down when the yen depreciates. (c) (15 points) Convert the 2000, 2001 and 2002 balance sheets and income statements into U.S. dollars using the other method. Answer: The financial statements remeasured using the temporal method can be seen 3

4 in Table 4. Under this method, cash, accounts receivable, all liabilities and common stock are converted using the same rate as under the current-rate method. The other items are remeasured as follows: Inventory: Note that COGS in each year exceeds the previous year s inventory. Inventory in a given year is therefore entirely acquired in that year and thus a single exchange rate can be used to remeasure it. For 2000, we use the exchange rate on December 31, For 2001 and 2002, we use the respective average exchange rate. This gives: Inventory 2000 = Inventory 2001 = Inventory 2002 = 26, , , = $219 = $284 = $412 COGS: In 2001, COGS corresponds to the 2000 inventory, to be remeasured using the December 31, 2000, exchange rate, plus goods purchased and sold during the year, to be remeasured using the average exchange rate for This gives: COGS 2001 = 26, , , = $644 COGS 2002 = 33, , , = $749 Fixed Assets: These are remeasured using the rate prevailing when acquired. This gives: FA 2000 = 129, = $1, 075 FA 2001 = 1, , , = $1, 592 FA 2002 = 1, , , = $2, 163 4

5 For each year, this corresponds to a rate: 2000 : 2001 : 2002 : 129, 000 1, , 000 1, , 500 2, 163 = /$ = /$ = /$ These rates will be used to remeasure depreciation. Depreciation: The depreciation expense is converted using the same rate as fixed assets. This gives: Depreciation 2001 = Depreciation 2002 = 29, = $248 35, = $299 Accumulated depreciation can be converted the same way or can be found by adding each year s depreciation expense to the previous year s accumulated depreciation. Retained Earnings: This is the plug used to balance the sheets. Foreign Exchange (FX) Gain (Loss): To ensure that each year s net income is consistent with the change in retained earnings, this line is added to the remeasured income statement. Note that since there are fewer monetary assets than monetary liabilities, the firm experiences a loss when the yen appreciates and a gain when the yen depreciates. (d) (10 points) Discuss the financial statement impact of the exchange rate changes under each method. 5

6 Relevant Exchange Rates (in /$) December Average for the year Table 1: Exchange rates for problem 2. 6

7 Balance Sheet as of December 31 (in thousands of yen) Assets Cash 5,100 25,500 49,950 Accounts receivable 45,000 61,500 71,250 Inventory 26,250 33,000 46,500 Current assets 76, , ,700 Fixed assets 129, , ,500 Accumulated depreciation (22,500) (51,900) (86,900) Net fixed assets 106, , ,600 Total assets 182, , ,300 Liabilities and Shareholders Equity Accounts payable 38,250 43,500 36,000 Notes payable 16,500 19,500 27,000 Long-term debt 21,000 69, ,840 Total liabilities 75, , ,840 Common stock 34,500 34,500 34,500 Retained earnings 72,600 90, ,960 Total equity 107, , ,460 Total liabilities and equity 182, , ,300 Income Statements as of December 31 (in thousands of yen) Revenues 180, ,200 Cost of goods sold 75,600 85,540 Depreciation 29,400 35,000 Other expenses 57,960 58,940 Net income 17,640 20,720 Table 2: Financial statements for Problem 2. 7

8 Balance Sheet as of December 31 $000, Current-Rate Translation Assets Cash Accounts receivable Inventory Current assets 636 1,071 1,471 Fixed assets 1,075 1,688 2,224 Accumulated depreciation (188) (463) (762) Net fixed assets 888 1,224 1,461 Total assets 1,524 2,296 2,932 Liabilities and Shareholders Equity Accounts payable Notes payable Long-term debt ,104 Total liabilities 631 1,182 1,656 Common stock Retained earnings Cumulative translation adjustment Total liabilities and equity 1,524 2,296 2,932 Income Statements as of December 31 $000, Current-Rate Tranlsation Revenues 1,557 1,772 Cost of goods sold Depreciation Other expenses Net income Table 3: Current-Rate Translation. 8

9 Balance Sheet as of December 31 $000, Temporal Method Assets Cash Accounts receivable Inventory Current assets 636 1,061 1,475 Fixed assets 1,075 1,592 2,163 Accumulated depreciation (188) (435) (734) Net fixed assets 888 1,157 1,429 Total assets 1,524 2,218 2,904 Liabilities and Shareholders Equity Accounts payable Notes payable Long-term debt ,104 Total liabilities 631 1,182 1,656 Common stock Retained earnings Total liabilities and equity 1,524 2,218 2,904 Income Statements as of December 31 $000, Temporal Method Revenues 1,557 1,772 Cost of goods sold Depreciation Other expenses FX gain (loss) (21) 9 Net income Table 4: Temporal method. 9