Use The Following Information In Answering Problems 1 And 2a

Use The Following Information In Answering Problems 1 And 2avanti

Use the following information in answering problems 1 and 2. AvantiMedia is the wholly owned Italian affiliate of ABC, a U.S. based multinational firm. AvantiMedia produces Projector in Italy from Italian materials and labor. Forty percent of production is sold within Italy and sixty percent is exported to London. All export sales are invoiced in foreign currencies and export prices are fixed in the currency of the importing country.

The corporate income tax rate in Italy is 35%. The current exchange rates are as follows: ₣.58/$; €0.82/$. The December 31, 2011, balance sheet is as follows:

AvantiMedia, Balance Sheet, December 31, 2011

  • Cash: €1,500,000
  • Accounts receivable: €3,100,000
  • Inventory: €2,500,000
  • Net plant and equipment: €5,800,000
  • Common stock: €1,100,000
  • Retained earnings: €7,200,000
  • Total Assets: €12,900,000
  • Accounts payable: €900,000
  • Note payable: €1,800,000
  • Long-term debt: €1,900,000
  • Loan from U.S. Bank (interest 10%): $150,000
  • Loan from London Bank (interest 8%): ₣350,000
  • Total Liabilities: €12,900,000

Expected income and cash flow statement (no devaluation), December:

  • Domestic sales (450,000 units @ €11.8/unit): €5,310,000
  • Export sales (650,000 units @ €11.8/unit): €7,670,000
  • Direct costs (1,000,000 units @ €5.4/€): €5,400,000
  • Cash operating expenses (fixed): €1,250,000
  • Depreciation: €340,000
  • Profit before interest and tax: €5,990,000
  • Interest: €177,360
  • Pre-tax profit: €5,812,640
  • Income tax expense (35%): €2,034,424
  • Profit after tax: €3,778,216
  • Add back depreciation: €340,000
  • Cash flow from operations in Italy: €4,118,000

AvantiMedia's accounting exposure: Assume that on June 21, 2012, the Euro unexpectedly depreciated by 10% to all foreign currencies. Translate the balance sheet into dollars, using the current rate method and the monetary-non-monetary method, assuming that plant and equipment, long-term debt, and common stock were entered on books when the exchange rate was €1.10/$.

Inventory was purchased or manufactured during the prior quarter when the average exchange rate was €0.88/$.

2- AvantiMedia's Economic Exposure: Assume that on June 21, 2012, before any commercial activity begins, the Euro unexpectedly drops 10% to all foreign currencies. To illustrate the effect of post-devaluation, consider the following scenario:

  • a. Export volume increased by 10% because Italian projectors are now cheaper in countries whose currencies have not weakened, and sales volume within Italy remains unchanged.
  • b. The Euro sales price is raised by 10%, and foreign sales prices remain unchanged.
  • c. Direct costs increased by 10%.

Calculate the net change in present value under this scenario, assuming a discount rate of 15% over a two-year horizon for any change in cash flow induced by the Euro/dollar exchange rate.

3- ABC Paris Bid: You are asked by ABC to help determine a bid for installing a large projector production facility in Paris, in Euros. The bid, which includes all costs and profit, must be specified entirely in Euros and submitted on June 20, 2012. The client will announce the decision on July 20, and the Euro payment will be received in 90 days (October 20).

Expected costs and pricing: $1,000,000 in the U.S., ₣100,000 for importing material from the U.K., and €250,000 in Paris. Payments are due on October 20. ABC will charge a 10% profit margin on all costs. The following information is available:

  • U.S. 90-120 days borrowing rate: 8%
  • U.S. 90-120 days deposit rate: 7%
  • Euro 90-120 days borrowing rate: 6.5%
  • Euro 90-120 days deposit rate: 5.5%
  • Pound spot quote: £0.58/$
  • Pound 3-4 month forward quote: $1.50/£
  • Euro spot quote: €0.82/$
  • Euro 3-4 month forward quote: $1.10/€
  • Options strike prices:
  • Call: $1.05/€ at €0.015/€
  • Put: $1.45/€ at €0.025/£

Construct appropriate hedges to guarantee a 25% profit margin and answer:

  1. How much of the revenue is exposed?
  2. What bid amount using borrowing and lending?
  3. What bid amount using forward contracts?

Extra credit: What is the bid amount using options contracts? Describe outcomes under all contingencies.

Paper For Above instruction

The financial management of multinational firms entails navigating complex currency and economic exposures that can significantly impact corporate profitability and valuation. The case of AvantiMedia, a wholly owned Italian affiliate of ABC, exemplifies these challenges through its international operations, exposure to currency fluctuations, and strategic cost management. This paper analyzes AvantiMedia's accounting and economic exposures to currency risk, evaluates the implications of currency depreciation, and explores hedging strategies and cross-border bid planning for a major production facility in Paris.

Accounting Exposure of AvantiMedia

Accounting exposure, also known as translation risk, arises from the need to convert financial statements expressed in foreign currencies into the parent company's functional currency, here USD. Using the current rate method, assets and liabilities are translated at current exchange rates, affecting the reported equity and income. Conversely, the monetary-non-monetary method considers historical rates for non-monetary items and current rates for monetary assets and liabilities, offering a different perspective on translation risk.

Applying the current rate method on December 31, 2011, with a euro-dollar rate of €0.82/$, the balance sheet assets and liabilities translate into USD as follows: cash (€1,500,000) becomes approximately $1,829,268; receivables (€3,100,000) become about $3,780,488; inventory (€2,500,000) roughly $3,048,780; and plant and equipment (€5,800,000) approximately $7,073,171. Liabilities, such as accounts payable (€900,000), translate to about $1,097,561. The historical cost for plant and equipment, long-term debt, and stock, entered at €1.10/$, results in a book value close to USD equivalents that remain unaffected by current exchange rate movements, providing a baseline for assessing exchange rate effects.

Impact of Euro Depreciation on Accounting Measures

Suppose the Euro depreciates by 10% to all foreign currencies on June 21, 2012. Under the current rate method, monetary assets (cash, receivables, liabilities) such as €1,500,000 in cash, would depreciate in USD value proportionally, reducing their USD equivalent by approximately $182,927. Non-monetary assets like plant and equipment, entered at historical rates (€1.10/USD), are unaffected, illustrating how depreciation impacts the translation of monetary versus non-monetary items differently. This results in a decrease in reported assets and equity, affecting the company's balance sheet and potentially its perceived financial health.

Using the monetary-non-monetary method, only monetary items are translated at the current rate, implying a decline in USD valuation reflecting the weaker euro—while non-monetary items remain at historical rates. This divergence can lead to different reporting outcomes, influencing managerial decisions, investor perceptions, and tax implications.

Economic Exposure and Post-Devaluation Effects

Economic exposure, or operating exposure, relates to how exchange rate movements influence a firm's future cash flows and market competitiveness. In AvantiMedia’s scenario, a 10% euro depreciation impacts demand and cost structure. The increase in export volume by 10% results from increased price competitiveness in foreign markets, boosting revenues. Raising euro export prices by 10% offsets the volume increase, maintaining revenue per unit but potentially affecting demand. The 10% rise in direct costs raises expenses, offsetting gains from increased export volumes and prices.

Calculating the net present value effect involves estimating incremental cash flows attributable to currency depreciation and discounting them at 15% over two years. The expected cash flow changes—additional revenues from increased volumes and prices, plus higher costs—must be balanced to assess whether the currency move creates value or erodes it, considering both macroeconomic and microeconomic factors.

Cross-border Bid Planning and Hedging Strategies

ABC’s bid for a Projector production facility in Paris necessitates meticulous financial planning, especially given currency volatility. The bid comprises costs in USD, GBP, and Euro, with payments due in 90 days. To hedge against currency risk, ABC can employ forward contracts, options, or borrow/lend strategies, ensuring profit margins are protected. The bid amount must incorporate the costs plus a 10% markup, and hedging can lock in exchange rates to realize predictable cash flows.

Calculations involve converting costs and profit margins into Euro, factoring in forward rates, and evaluating the optimal hedge. For example, forward contracts can lock in costs at specific rates, while options provide flexibility with protections against adverse rate movements.

For the bid, the exposure is primarily the Euro amount of €250,000 plus additional costs in USD and GBP. Using forward contracts with the specified forward rate of $1.10/€ may secure the Euro costs, whereas options could be selected to provide contingent protections based on strike prices. Borrowing and lending strategies, considering interest rate differentials, further reduce exchange rate risk, aiding in a more accurate bid to achieve the desired profit margin.

Conclusion

Managing currency and economic exposures is crucial for multinational corporations like AvantiMedia and ABC. Effective translation risk mitigation via the current rate or monetary-non-monetary methods informs financial reporting, while active hedging of transactional and operational risks safeguards cash flows. Strategic bid planning with hedges for projects accelerates profitability assurance despite volatile currencies. Ultimately, integrating comprehensive risk management approaches enhances the firm's resilience and competitive advantage in international markets.

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