A. Companies Are International in Nature

Mergers-Notes – 4/09/03 1 A. Companies are international in nature 1. Required to report in U.S. currency a. May buy and sell products priced in foreign currencies b. May pay employees in foreign currencies c. May build and maintain assets priced in foreign currencies 2. Things to remember a. Some activities stay abroad despite US currency reporting b. Some activities can be controlled by the firm – timing of cash flows in and out of U.S. c. Some issues cannot be controlled by the firm – exchange rates of foreign currency (relative prices of foreign currency) 3. To meet US GAAP reporting requirements a. Probably keeps local books for each foreign subsidiary i)In currency used by the subsidiary ii) Using accounting standards of the country of the sub b. First, must restate books to US GAAP c. Then, convert any foreign currency to U.S. currency for reporting d. May have to convert to a second foreign currency before translating to US currency e. Proceed wth consolidation B. Several issues 1. Is there an appropriate way to measure the foreign currency? a. Rates change regularly & throughout the year i)Should original rate be used – Value could be outdated ii) Should foreign activities and assets be translated to US currency at the current rate iii) Value could show gains & losses b. Some assets and some events are economically always foreign i)Income and cash obtained abroad stays abroad ii) Any conversion is strictly for accounting purposes c. Company has i)Permanent activities in some countries and currencies ii) Temporary activities in other locations iii) Should they be treated the same way or differently? d. Must imaginie converting foreign assets and liabilities to dollars e. Translating foreign currencies to dollars a necessary fantasy C. A relatively new problem 1. Desire for stable monetary system after World War II a. Bretton Woods international monetary agreement i)Called adjustable peg system ii) Fixed exchange rates based on gold standard b. Assets and events occurring in foreign countries always occurred at about the same foreign exchange rate c. Foreign exchange bound within small ranges d. Countries supported currencies to stay in range Mergers-Notes – 4/09/03 2 i)Support by reserves of hard currencies and gold ii) Range was 1% in either direction iii) If exchange rate falls country buys currency to prop it up iv) If exchange climbs country sold currency to weaken it e. Little price risk on day-to-day transactions i)Foreign activities could easily be converted to U.S. currency ii) Foreign activities relatively minor iii) Small foreign currency markets f. System had some flexibility i)Could change exchange rate by up to 10% without approval ii) Reductions in value of currencies are devaluations iii) Increases in value of currencies are revaluations iv) Changes were abrupt & sources of losses or gains 2. If country devalues its currency a. Worth less in terms of other currencies b. Prices for country’s products stay the same in its currency i)It would cost less for foreigners to buy ii) Encourage exports c. Prices for other countries’ products remain the same in the foreign currencies i)It would cost more for locals to buy ii) Decrease imports d. Overall, encourage local production at expense of other countries’ production i)Like upward revaluations of all other currencies ii) Might encourage competitive devaluations 3. Development of problem a. Direct problem i)Countries continued to develop at different rates ii) Put extreme pressures on countries to maintain currencies D. Flexible exchange rates 1. Bretton Woods fell apart 2. Current situation a. Currencies move against each other with relative freedom b. Still some government support to create orderly markets E. Issues with flexible exchange rates 1. Creates uncertainty in value of foreign sales and assets from period to period 2. Increased size and frequency of foreign currency trading a. When and how to protect value of sales and assets b. What impact is there on corporate value? 3. Companies are active participants a. Deal in several currencies Mergers-Notes – 4/09/03 3 b. Protect day to day business from market fluctuaitons F. Currency markets - introductory information 1. Spot market – currencies traded for immediate delivery 2. Futures market a. Formal market b. Standardized contracts c. Currencies traded for future delivery d. Owe foreign currency in future e. Do not want to suffer risk of currency movement f. Buy contract for delivery of currency to you in future so you can pay in that currency g. Buy contract selling currency in future so you can recive payment in that currency 3. Forward market a. Informal market b. Does same thing c. Contracts by agreement – not standard 4. Market rates a. Spot rate reported in market b. Forward rate reported in market c. Two ways to report i)Dollars per unit of foreign currency (1) $/foreign currency ($/fc) (a) Increase in $/foreign currency ratio > weaker dollar (b) Decrease in $/foreign currency ratio > stronger dollar ii) Units of foreign currency per dollars (1) foreign currency/$ (fc/$) (2) Indirect form G. How should the impact of foreign currencies be reported? 1. Need to recognize that shareholder’s position depends on foreign operations and assets 2. Need to acknowledge that foreign currency fluctuations not controlled by management 3. Companies operate in foreign countries directly or through subsidiaries a. Sale of products b. Purchase of products c. Transfer of intermediate products d. Additional complications 4. Types of currency conversion issues a. Translations i)Necessary to report in dollars ii) Some cash is never returned to US iii) Foreign assets may never be sold for dollars Mergers-Notes – 4/09/03 4 iv) Result pretend that a conversion to dollars has occurred v) No real gains or losses in pretend conversion b. Transactions i)Real events ii) Movement of company currencies into other currencies iii) Costs and risks involved