Question

1. How does translation exposure affect a business with a high percentage of business conducted by subsidiaries? What factors come into play?

2. Answer the following questions regarding DFI strategy.
(a) Bronco Corp. has decided to establish a subsidiary in Taiwan that will produce stereos and sell them there. It expects that its cost of producing these stereos will be one third the cost of producing them in the United States. Assuming that its production cost estimates are accurate, is Bronco's strategy sensible? Explain. (10 points)
(b) Once an MNC establishes a subsidiary, DFI remains an ongoing decision. What does this statement mean?

Answer 1

Answer 1:

Translation exposure is the risk of change in value of assets, equities, income or liabilities of a company due to fluctuations in exchange rates. Foreign currency translation is the restatement of accounting data in reporting currency.

In case of Multinational with subsidiary(ies):

• Higher the percentage of business conducted by subsidiary, greater is the translation exposure.
• Higher the fluctuations in relevant foreign currency vis-a-vis the reporting currency of Parent company’s (Head Office) greater are the translation exposure.

The factors that come into play are size of firm/subsidiary, % business conducted in foreign currency, International asset size, fluctuations in foreign currencies relative to reporting currency, competitiveness

Answer 2(a):

If a company decides to expand business in a foreign country, for it to be successful, it is essential that it offers product/services at competitive prices. It is given that cost of producing will be one third the cost of producing them in the United States. To sell stereos in Taiwan, it may be necessary to produce stereos in Taiwan or in other low cost countries to offer stereos at competitive prices in Taiwan. As its local competitors in Taiwan will be selling at prices which are based on cost of production they incur in Taiwan. It will not be viable to produce stereos in USA and sell in Taiwan.

Further, Bronco can sell stereos produced in Taiwan in US as well. This will definitely be an advantage.

As such Bronco's strategy is sensible.

Company's expanding to foreign countries (going multinational) has to evaluate different risk exposures that come with foreign expansion which includes translation exposure. The company has to assess the risk exposures, mitigations strategies and factor the same into its evaluation of feasibilities.

Answer 2(b):

DFI (direct foreign investment) comes into play once an MNC establishes a subsidiary. However it is not one time decision while establishing the subsidiary. Once subsidiary is established, it will have earnings/ surplus cash flows. It will be necessary to decide whether to reinvest surplus cash flows to expand in host country or to remit to parent. As such DFI will remain an ongoing decision.