Question

Identify whether the following create substantial transaction, operating, and/or translationexposure (or no exposure at all) for a U.S. company, and how the company will be affected if theforeign currency depreciates. The examples will typically create more than one type of exposure.

D) Widgets International (WI) purchases a British factory, financed by issuing dollar debt and swapping for pound-denominated debt. WI is expecting a steady stream of pound revenues from the factory. FASB 8 is in effect.

Answer 1

Solution:-

If Widgets international purchases a British factory using USD debt swapped for pound denominated debt, it will expose the company to the following foreign currency exposures:

• This directly results in translation expsoures as the company would be conducting operations in foreign currency, earnings revenues from the new factory and incurring expenses as well. These operations will have to be consolidated in the company's accounts in USD and thus will directly expose the company's operating profits, assets and liabilities to the changes in USD pound exchange rate
• The company has swapped its USD loan against the pound denominated loan, which exposes itself to transaction exposure due to adverse movement in USD pound exchange rate as the company will have to repay its loan in pounds
• Since the company has invested in a British factory and has operations in Britain, it exposes the firm to operating exposure as well because the movement in exchange rates can impact the company's long-term business performance and can impact its stock price

If the British pound depreciates against the USD, the company would be impacted as follows:

• It will directly impact the operating margins of the firm as the declined exchange rate would be detrimental for the USD value of pound revenues and expenses to be consolidated in the company's accounts. This will result in a decline in compan's profit margins and overall performance
• It could result in a gain at the time of repayment of the pound denominated loan that the company swapped against the USD loan
• The loan liability and fixed assets of the factory have to be consolidated to teh company's financial statements periodically. Any depreciation in the exchange rate of pound will result in translation profit and loss for the company as the value of both assets and loan liability will go down