Patterson Distributors, Inc., purchases various electronic components from a variety of manufacturers and then distributes the products to end users. In the past, both domestic and foreign manufacturers of the components shipped the product to Patterson’s two U.S. distribution warehouses. In order to reduce costs and serve its customers on a timelier basis, Patterson is considering opening two international distribution centers. The company will form a 100%-owned foreign subsidiary to own the centers. The foreign subsidiary will need to secure financing and build and furnish a distribution warehouse in each location.
Projections, in the respective country’s foreign currency (FCA), for the first 12 months of operations are as follows:
Company A
(FCA)
Investment of parent company. .. . . . . . .. . . . . .. .. ... . 1,000,000 FCA
Debt financing:
Principal balance at beginning of year . .. .. . . .. . .. . 4,000,000 FCA
Interest rate . . . . . .. .... .. . . . . . .. . . . . .. .... . .. . 6%
Repayment frequency . .. .. . . . . . . . .. . . .. .... ... . Quarterly
Amortization period .. .... .. . . . . . .. . . . . .. .. ... . 20 quarters
Periodic payment... .. .. .. . . . . . . . .. . . .. .... ... . 232,983 FCA
Year-end principal balance. .. . . . . . . . .. . . .. ... ... 3,292,344 FCA
Sales revenue . . .. . .. .. .. .. . . .. . .. . . .. .. .. .. . .. . 2,200,000 FCA
Inventory:
Purchases.. . . .. . .. .. .. .. . . .. . .. . . .. .. .. .. . .. . 1,460,000 FCA
Frequency of purchases.. .. .. . . . . . . . .. . . .. ... ... Equal amounts
at end of each quarter
Ending inventory per LIFO .. .. . . . . . . . .. . . .. ... ... 140,000 FCA
Other expenses (excluding interest
And depreciation) .. .. .. .. . . . . . . . .. . . .. .... ... . 158,068 FCA
Cost of distribution center:
Land. .. .. .. .. .. .. . .. .. .. .. .. .. . .. . . .. . . . . . . . 1,600,000 FCA
Building .... .. .... . .. .... .. .... . .. . . . . .. . . . . . 2,200,000 FCA
Furnishings.. .. .... . . . .. .. .. .... ... .. . . .. . . . . . 720,000 FCA
Useful life based on straight-line depreciation:
Building .... .. .... . .. .... .. .... . .. . . . . .. . . . . . 40 years
Furnishings.. .. .... . . . .. .. .. .... ... .. . . .. . . . . . 12 years
End of year:
Accounts receivable. . . . . . .. .. .. ... .... .. . . .. . .. 210,000 FCA
Accounts payable ... . . . . .. .. .. ... .... .. . . .. . .. 130,000 FCA
Other current assets.. . . .. .... .. .. ... .. . . . . .. . . . 50,000 FCA
Various projected exchange rates throughout the forecast period are as follows:
1 FCA =
At beginning of year .. .. . . . .... .. .. .. . .. . . . . .. . . $1.000
At end of first quarter.. .. . . . .... .. .. .. . .. . . . . .. . . 1.020
At end of second quarter . .. . .... .. .... . .. . . . . .. . . 1.030
At end of third quarter ... .. . .... .. .... . .. . . . . .. . . 1.050
At end of fourth quarter .. .. . .... .. .... . .. . . . . .. . . 1.040
Average for the year .. .. . . . .... .. .. .. . .. . . . . .. . . 1.025
Although Patterson has prepared the projections in the respective foreign currencies, the company has the ability to structure transactions in such a way that either the foreign currency or the U.S. dollar is the functional currency.
Required
1. Construct a year-end trial balance for the foreign subsidiary. Based on the information provided, calculate the translation adjustment and re-measurement gain or loss for the subsidiary assuming that the functional currency is the FCA and the dollar, respectively.
2. Discuss, in retrospect, whether the parent company would want to hedge its investment and, if so, how that might be accomplished.
3. Assume that the parent did hedge its investment in the subsidiary. This was accomplished by borrowing 600,000 FCA at the end of the first quarter. No principal payments were made during the year. How much of the gain or loss on this hedge would have been considered ineffective against the translation adjustment? The re-measurement gain?