Foreign Currency Translation - Essay Example

Introduction The past decades have seen an upsurge of International trade, financing and investments, and related cash and credit transactions at an extremely rapid pace. To accommodate the need for foreign-currency denominated transactions, international monetary systems have continued to evolve and in the process have provided opportunities for meeting these growing demands. This has developed into a global sector with international banking market worth 25 trillion US-Dollars of cross-border claims, foreign exchange market with a daily turnover of about 2 trillion US-Dollars, international debt securities of about 18 trillion US-Dollars outstanding, and derivatives market worth 415 trillion US-Dollars in contracts outstanding.1 Financial players in the global market including institutional investors, hedge funds, private equity firms and state owned investment authorities are now involved in cross-border mergers and acquisitions (of about 360 billion US Dollars in 2006) and the increase use of complex financial instruments such as derivatives. All of this has led to increase businesses around the world, be it in same country or in different countries. But what is most important is to be familiar with the business environment in which the business is intended to operate that often may have considerable influences on the business such as the values of society, and the influence of organised groups, such as government departments, consumer groups, environmental groups, animal welfare organisations. But most importantly, businesses are out to generate profits for the investors and to do, serious considerations as to the economic conditions of the host country. A thorough research has to be done to know the company competitors, the market position and their customer’s preferences. Foreign currency translation Statement of Standard Accounting Practice (SSAP) No. 20 (2003) sets out the standard accounting practice for foreign currency translation but does not give any method of calculating such profits and losses that may arise from a company’s dealing and operations due to overseas trading. But at the end of the day, foreign currency translations are required so as to prepare the consolidated financial statements of the foreign enterprise into the currency used in reporting purposes by the main company. Accounting Standards Practice for Enterprises (ASPE) No 19 (2006) provides such monetary amounts to be calculated at the spot exchange rate following the balance sheet date of preparation. Under the Generally Accepted Accounting Principles (GAAP), two methods are provided for calculating foreign currency transactions; the current rate method and temporal rate method. Under the current rate method, all net assets are measured using current rates, which as stated by ASPE No 19, are calculated using the spot exchange rate. Meanwhile under the temporal rate method, only some assets are translated using the spot rate, which often makes the calculations complicated since one will have to calculate the exposed position of the company on the financial market. It is not therefore advised to do such calculations using the temporal method since it gives room for some irregularities especially as not all assets are calculated. Therefore in the case of the company, with a direct sterling/euro exchange rate of 0,7 and an initial investment of 5 million Euros, this means i) if the exchange rate was to remain at 0,7 the parent company will be investing £3,5 million ii) if the exchange rate was to appreciates say to 0,8 as of date of balance sheet, the value of assets will increase to £4 million thereby realizing a profit of £500,000 iii) if the exchange rate was to depreciates to say 0,6 the value of assets will fall and thereby the parent company making a loss of £500,000 In such instances, most foreign entities normally hedge against such risks fluctuations since the value of pounds sterling versus euro could materially affect the amount of these items in the Consolidated Financial Statements, even if their value has not changed in their original currency. For the company to keep proper accounting records, if the company’s transactions are mostly in Euros, the company has to translate these foreign currency dominated cash transactions into pounds. This however has to be done using the exchange rate on the date for which the said transaction was done. This at times may result to charges for the company since the exchange rate may either depreciate or depreciate. Most at times also, the company may incur losses because at the balance sheet date, business transactions settled at a different exchange rate from that of the day which the transaction was done. But if the foreign currency translation is done using the date for which the transaction was done, the company will make a gain especially if a that time, the Euro had depreciated. Estimating spot and forward exchange rates Future expected spot rate is the exchange rate between two currencies that is anticipated to prevail in the spot market on a given future date and which an investor is prepared to pay for a unit of currency on that market. It differs from the current spot rate primarily by the extent to which inflation expectations in the two currencies differ. On the other hand, the forward exchange rate is normally a fixed rate at may be today for exchanging currency at some future date.2 The forward exchange rate F, observed at time t for an exchange rate at t + 1 is the market determined certainty equivalent of the future spot exchange rate St+ l.3 The forward rate is calculated using the following formula: Forward rate = spot rate x (1 + variable currency rate x days/B) (1 + base currency deposit rate x days/B) Where B is the year-day count of either 365 or 360 days. Following the expectations hypothesis, the forward rate was suppose to be a good prediction of the spot rates, but this has never been the case as early tests have been rejected leaving us with varying degrees of weaker forms of the expectation hypothesis. Hedging techniques Exchange-rate volatility can be considered as a two-edged sword. Prime reason for investing internationally as considered by some experts is to take advantage of currencies that are appreciating against the U.S. dollar or, the dollar depreciating against such currencies, such as the Euro Hedging is said to be the technique whereby one invests in an assets to reduce the overall risk on the other.4 Firms have a wide variety of hedging techniques to hedge against foreign exchange risk exposures. In a Survey conducted by Jesswein et al (1995) using some 500 USA firms, to find out what hedging methods they used, it was realized that 93% reported used forward contracts, swaps, and options. They are various types of hedging techniques. Some investors use foreign currency futures that are offered by the International Monetary Market (IMM) of the Chicago Mercantile Exchange, Japanese yen, Swiss francs, British pounds, and Canadian and Australian dollars. Hedging can also be achieved using options in both the cash market and the futures market. These markets involve two option styles: the European style, which can be exercised only on the last day of the option period, and the American-style, which can be exercised at any time before expiration.5 It is most common to use forward contracts as an external measure to hedge against foreign currency exposures. A forward contract is when two traders agree on the price of an asset today for delivery tomorrow and in this case no money exchanges hands until the delivery date. The firm with headquarters in UK and investment in mainland Europe is particularly vulnerable to exchange rate risks since there is that uncertainty in sterling/euro fluctuation. Let’s take a simple example. Should in case the pound sterling depreciates say by 10% relative to the Euro, this means that the firm has to increase the pound price of her goods by same 10% to be able to maintain the equilibrium. Increasing their prices may not be best solution since it is likely facing competition from similar firms from Far East Asia. This foreign exchange exposure can be offset if the firm using the forward contract since operations from depreciation of the pound sterling will be offset by gains and losses on its financial transactions. Using a numerical example, suppose the futures rate is currently 0,70 per Euro for say an assets due delivery in five months. If in the five months, the futures rate falls to 0,60 per Euro, then the profit on the transaction will be 0,70 – 0,60 = 0,10, which is a profit to the short position. The reverse will also hold true if the five months futures rate appreciates above the agreed upon price of today, which will mean losses to the firm. Internal means of hedging widely used by firms is options. It is worth differentiating between the two types of options used here – the call and put options. The call option allows the holder the right to purchase an asset for a specified price (exercise or strike price) on or before a specified expiration date. The put option on the other hand allows the holder the right to sell the underlying asset for a specified price on or before the expiration date. In this case of the European options, the holder can only exercise the option only on the expiration date. Options are widely used as motivation to executives to entice them to produce results, since the price of their option depends on their performance. Another internal way of hedging is diversification of portfolio. This means, the UK based company can invest in shares of other companies in mainland Europe, since their gains will be offset by any losses they may incur in operations of the subsidiary in mainland Europe. Project appraisal using the NPV method Net Present Value (NPV) analysis is a sensitivity analysis to give the reliability of future cash inflows that an investment or project will yield in the future. It is a useful too to calculate the profitability of a project by calculating the difference between the present value of cash inflows and the present value of cash outflows. Summarily, Traditionally, they exists other methods for project appraisal, such as the payback period, and the internal rate of return, but their disadvantages outweigh their advantages, giving the NPV the most reliable. The advantage of the NPV over the other methods is its ability to compare dollar value today to that value of the same dollar in the future, taking inflation and returns into account. The NPV is therefore that value that expresses how much value an investment will result in through the measurement of all cash flows over time back to the current point to the present day in time. If the NPV value got from the calculation results in a positive amount, this means the project is feasible and should be undertaken. But however, any rational investor often make an investment decision based on the after tax returns. Therefore, in the investment project, i) Euro real rate and real cash flow (1 + m) = (1 + r)(1 + i), where; m be the money rate of return r be the real rate of return i be the rate of inflation But we know that, 1,000,000 invested at the beginning of the year should yield 1000000x(1+10%) = 1000000x1.1 = 1,100,000 Euros If we now account for inflation in Euro land at 1.5%, therefore, this amount (1,100,000Euros) will be worth; 1,100,000 / (1+1.5%) = 1,100,000 /(1.015) = 1,083,743.8 Euros, giving a gain of 83,744 or a real rate of return of 8.37% Year Cash flow Deflator (1+i)-n Present value 0 (5,000,000) 1 (5,000,000) 1 1,000,000 0,9524 952,380.95 2 1,500,000 0,9070 1,360,544.22 3 5,000,000 0,8638 4,319,187.99 4 5,000,000 0,8227 4,113,512.37 Discounting the figures at the real rate gives; Year Cash flow Discount rate (1+r)-n Present Value 0 (5,000,000) 1 (5,000,000) 1 952,380.95 0,9225 878,580.21 2 1,360,544.22 0,8510 1,157,854.79 3 4,319,187.99 0,7851 3,390,894.36 4 4,113,512.37 0,7242 2,979,172.70 Total PV 8,406,502.055 NPV €(3,406,502.055) With the project giving a NPV of -3.406.502.055, this means that the project is not a good one to be undertaken by the company and should be therefore rejected. This means that the project has resulted to losses for the company. ii) Real sterling discounted cash flow We know that we have €1 million, convert it to sterling at the current rate of 0,70 to give 1,000,000 x 0,70 = £700,000 If we invest this amount at the beginning of the year at the present rate of 10%, end of year we get (700000 x (1+10%)) = £770,000 Accounting for inflation in the UK at the rate of 2,5%, this amount will become; 770000/(1+2,5%) = £751,219.51 making a profit of £51,219.51 or 5,1% Year Cash flow (€) Cash flow (£) at 0,70 Deflator (1+i)-n Present value (£) 0 (5,000,000) (3,500,000) 1 (3,500,000) 1 1,000,000 700,000 0,9756 682,926.83 2 1,500,000 1,050,000 0,9518 999,405.12 3 5,000,000 3,500,000 0,9286 3,250,097.94 4 5,000,000 3,500,000 0,906 3,170,827.26 Discounting the figures at the real rate gives Year Cash flow (£) Discount rate (1+r)-n Present Value 0 (3,500,000) 1 (3,500,000) 1 682,926.83 0,9515 649,188.23 2 999,405.12 0,9053 904,765.72 3 3,250,097.94 0,8638 2,807,556.8 4 3,170,827.26 0,8196 2,598,733.35 PV 6,960,244.1 NPV £(3,460,244.1) Using the pound sterling, it can be realized that the project has given a negative NPV meaning that the project is not profitable for the company and should be rejected. iii) Using Euro dominated money cash flow discounted at money rate. (1 + m) = (1 + r)(1 + i), where; m be the money rate of return r be the real rate of return i be the rate of inflation (1+m) = (1+8,04%)(1+1,5%) 1+m = 1,10026 m = 1,10026 – 1 = 10026 or 10% Year Cash flow (€) Discount factor (1+r)-n Present value 0 (5,000,000) 1 (5,000,000) 1 1,000,000 0,9091 909,090.91 2 1,500,000 0,8264 1,239,669.42 3 5,000,000 0,7513 3,756,574.0 4 5,000,000 0,683 3,415,067.28 NPV (€) (4,320,401.61) iv) Using Sterling discounted cash flows discounted at sterling money rate. Year Cash flow (£) Discount rate (1+r)-n Present Value 0 (3,500,000) 1 (3,500,000) 1 700,000 0,9091 636,363.64 2 1,050,000 0,8264 867,720 3 3,500,000 0,7513 2,629,550 4 3,500,000 0,683 2,390,500 NPV £(3,024,133.64) In conclusion therefore, this project is not a good project for the company to invest, since NPV of the whole project is negative cash flow. So project is rejected as a bad investment. It should be noted here that even though the NPV measurement appears to have a dominant advantage over the other project appraisal methods used for making investment decisions, it has a disadvantage in that, the NPV does not account for flexibility and uncertainty after the project decision has been taken. So care should be taken when deciding on project investment. However, foreign investment in countries like USA, Japan and the EU are all affected by two factors, the pull and push factors, especially if the company is investing out of her main land. The push factor reflects the opportunity cost of capital in the source country in combination with interest rates, cost of assessing capital and speculative activities in international capital markets. On the other hand, the pull factor gives us an idea on how the host country can influence the amount of Foreign Direct Investment (FDI) it will be ready to receive. Favorable macroeconomic factors will increase the return on capital invested and thus influences positively the amount of FDI it receives. References Dr. Josef Ackermann (June 27, 2007): Effective regulation of international financial markets – priorities for action, Keynote Address IIF Open Programme, Commerzbank Tower, Frankfurt Eugene F. FAMA (1984): Forward and Spot Exchange Rates Journal of Monetary Economics Vol. 14 pages 319 - 338. North-Holland Zvi Bodie, et al (2007). Investment. McGraw Hill. 5th Edition Websites consulted http://en.mimi.hu/business/spot_rate.html http://www.investopedia.com/terms/n/npv.asp Read More