Movements in Exchange Rate and Impact on Economic Value of Rio Tinto Group - Case Study Example

Impact on economic value from movements in exchange rate [Student Name] [Course Title] [Instructor Name] [Date] Introduction Rio Tinto Group is an international company which operates in multiple markets using different business and operating structures and like any other multinational enterprise the Group’s operations in the international markets are exposed to exchange rate risks. These risks arise from unfavorable changes in the value of currencies of countries where the company has stakes and business against the value of home currency i.e. Australian Dollar. These risks have significant affect the company’s value of assets, liabilities and cash flows. The seriousness of the issue of foreign currency risk facing the companies can be estimated from the data that the RBA has published indicating that during the period from 2010 to 2013 the there has been fluctuation between USD and AUD. This has resulted to negative effect on Rio Tinto Group profits resulting from the unfavorable changes in the cross currency exchange rates. To understand the severity of the impact of currency fluctuations on the company’s business is the case of Rio Tinto Group interests in the international market which are badly affected. Movements in exchange rate of AUD vs USD From the graph below shows exchange rates for the Australian Dollar (AUD) against USD. The movements indicate that the Australian dollar lost ground against the US dollar since the year 2010 to the year 2013. Although there is a fluctuation between the periods but the general trend is the upward trend. In the years 2011/2012, the exchange rate ranged between 1.0308 to1.1052 (Reserve Bank of Australia, 2003). The Effect of changes in the exchange rate on the amount paid between the contract and settlement dates The amount of the contract is USD100,000 on February 1, 2013 and the settlement is on August 1 2013. The exchange rate on February 1, 2013 is AUD 1 = USD 1.0468 and on August 1 2013 AUD1 = USD 0.8969. The exchange rate at on February 1, 2013 is 1.0468 and USD 100,000 will be equivalent to = AUD 99,246.39 The exchange rate at on August 1 2013 is 0.8969 and USD 100,000 will be equivalent to = AUD 111,495.15. The Group will recognize net loss of AUD12, 248.76 in the transaction that is paying AUD12, 248.76 at settlement date as compared to AUD 99,246.39 at contract date due to the negative currency movements. This loss will affect the company’s profitability in 2013 as they have to be realized against next year’s income (Reserve Bank of Australia, 2003). Describe and account for any movements in the exchange rate over the period shown in your graph The exchange rate for the exchange rate for Australian dollar to US dollar moved due to number of factors such as inflation rate and interest rate. For example the upward trend for the exchange rate between march 17 2011 and July 14 2011 can be traced in the interest rates which changed from 4.7 %to 5.04 % in may 4th and continued coming down at the downwards t0 4.82% in July 14th 2011(Reserve Bank of Australia,2003). This movement can destroy the profits of the company like Rio Tinto Group. The depreciation of the Australian dollar against the American dollar appears to have an upward trend which is not appealing. The government will have a difficult time in keeping capital flight. By august 2011, the Australian dollar started gaining against the USD. This can also be observed in the movement of the interest rate The economic impact of changes in the exchange rate over the period After entering in the contract the rate changed requiring the company to pay more dollars which is not a viable option for the company. If the company sells this item it may not be able to compete with other companies those have a recent contract. In order to safe guard from the exchange rate fluctuations, companies hedge their position while entering in a contract (Karim and Priyo, 2009). This means that continues fluctuation of exchange rate has effects on the Rio Tinto group economic value for instance a fall in the exchange rate –that is, depreciation of the AUD. A depreciation of the Australian dollar will immediately affect the relative prices of traded goods: the US dollar price of exports made by Rio Tinto group will fall and the price of imports will rise. These price changes will in turn cause a rise in the demand for Rio Tinto exports and a fall in the demand for imports –so long as these demand changes can be realised, they will affect the payments of the company to imports. The price effects of depreciation, however do not tell the complete story because it is likely that national income will also be affected: changes in income will cause changes in the demand for imports and this will exert a further influence on the imports by Rio Tinto group. If the import’s price elasticity is very large so that increases in demand can easily be met, the depreciation of the AUD will have minimum effects as they will increase mark-up. Otherwise an increase will represent movement from a loss towards a profit and so can be regarded as an improvement. The greater the elasticity of demand for imports, the bigger will be the increase in the total value of value following the depreciation. Only if the demand for imports is perfectly inelastic will the total value remain unchanged (Rehman and Rehman, 2009). The effect of depreciation on the total value of imports is less certain because these time the AUD price is raised directly by the depreciation and a significant decrease in quantity demanded is required for the total value to fall. In order to manage economy related and business related risks Rio Tinto Group should foresee the market conditions and forecast changes in exchange rates which may affect the company’s cash flows in respective markets and overall earnings when profits calculated. Before carrying out any analysis, first is the determination of exposure to currencies other than the home currency (White, 2009). Then the effects of exchange rate changes are determined to gauge the exposure ranges. These effects are the costs of two factors, exposure and rate changes. What is most important, however, is not the precise measurement of the distortions resulting from exchange rate changes, but the recognition that they exist. Once you recognize the issues, you can usually estimate the financial statements to begin with. Even a general understanding of the effects of changing exchange rates should improve investment decisions (Huchet-Bourdon and Korinek, 2011). For Rio Tinto which has AUD as home currency, the exposure will be equals net monetary imports. However in reporting for the profits a cumulative transaction of adjustment on the balance sheet will indicates that the firm is using the temporal method. Balance sheet composition: balance sheet exposure is also affected by the asset/ liability structure of foreign operations. Exposure can be reduced by borrowing in the local currency or through hedging activities (Shapiro, 2006). Once exposure are known or estimated, the exchange effects can be computed. The effects is on the opening balance multiplied by the rate change over the entire period and on the change in balance multiplied by the rate of change from the date of the change to the end of the period. In case there is no well known information, it is assumed that the local currency changes occurred evenly and use the average rate for the period. Income statement- Revenue will be translated at the payment date exchange rate which will affect reported income because the rate is higher than contract date. However, in some cases trade- weighted index will be used to carry out translations. Despite the difficult of the approximations required, some effort must be made to gauge the income statement exposure to rate changes (Brigham and Ehrhardt, 2010). The most pervasive income statement effects of exchange rate changes are the flow effect of rate changes on revenue and expense. This effect must be disaggregated from the effect of operations and exchange rate effect is stimulated by multiplying the income statement component by the change in the average exchange rate. The exchange rate effect is always there, although it is frequently omitted from management comments about operating results(Rehman and Rehman, 2009). Cash flow statement- All cash flows must be translated at the average rate for the period; the choice of functional currency does not matter. Period – to - period changes in average rates directly affects reported cash flows. However, seasonal cash flow patterns or other timing differences can result in cash flow effects that differ from income statement effects, even when the local currency is the functional currency (Besley and Brigham, 2008). For recurring transactions, the exchange rates effects on reported cash flows are quite simple. Cash flows are translated at the average rate for the period, regardless of the choice of functional currency. Almost all operating cash flows and many investing and financing cash flows occur relatively evenly in the year. However such transactions as payments for acquisitions and major debts issuance or retirements are occasions and their time is important (Mankiw, 2008). The index used to measure rate change effects on cash flows should be the same one used to measure the income statement effects. It is important to keep a clear distinction between period-end rates used for balance sheet analysis and period – average rates that affect income and cash flow data. Hence, from this discussion it could be concluded regarding the company’s ‘natural hedging’ strategy that this strategy has been a great success where the company is not only able to cater the expanding demand for its vehicles but also at the same it has been to curb exposure to foreign currency transactions related to its sales and purchase of components (McTaggart, Finlay and Parkin, 2003). References Besley, S., & Brigham, E. (2008). Principles of Finance (4th ed.). Mason: Cengage Learning. Brigham, E., & Ehrhardt, M. (2010). Financial Management Theory and Practice. Mason: Cengage Learning. Huchet-Bourdon, M. & Korinek, J. (2011). To What Extent Do Exchange Rates and their Volatility Affect Trade?- OECD Trade Policy Papers No. 119. Retrieved September 30, 2013, from Karim, A. & Priyo, K. (2009). Impact of the Exchange Rate Regime Change on the Value of Bangladesh Currency. Retrieved September 30, 2013, from Mankiw N.G. ( 2008). Principles of Economics. New Delhi: Thompson South-Western, McTaggart D., Finlay C. & Parkin, M. (2003). Economics. Sydney: Pearson education, Rehman, M. & Rehman, S. (2009). Relationship of Exchange Rate with Various Macro Economic Variables. Retrieved September 30, 2013, from Reserve Bank of Australia (2003). Statistical Tables- Exchange Rates. Retrieved September 30, 2013, from Shapiro, A. C. (2006). Multinational Financial Management. New York: John Wiley & Sons. White, M. (2009). The Impact of Exchange Rates. Retrieved September 30, 2013, from http://ezinearticles.com/?The-Impact-of-Exchange-Rates&id=3978396 Read More