America one, a US-based company, established a subsidiary in Mexico on January 1 Year 1, by investing 300,000 Mexican pesos (MXN) when the exchange rate was US$0.094 = 1 MXN. The subsidiary's opening balance sheet (in MXN) was as follows:

Cash.................... 300,000 Notes payable..................... 500.000

Fixed assets......... 500,000 Capital stock....................... 300,000

Total assets......... 800,000 Total liab. and equity.......... 800,000

During Year 1, the foreign subsidiary generated sales of MXN1,000,000 and net income of MXN 110,000. Dividends in the amount of MXN 20,000 each were paid to the parent on June 1 and December 1. Inventory was acquired evenly throughout the year, with ending inventory acquired on November 20, Year 1. The subsidiary's MXN financial statements for the year ended December 31, Year 1, are as follows:

Income Statement

For the year ended on 12/31, Year 1_________

____________________________________MXN____

Sales .......................................... 1,000,000

Cost of goods sold...................... (600,000)

Gross Profit................................ 400,000

Depreciation expense................. (50,000)

Other operating expenses.......... (150,000)

Income before tax...................... 200,000

Income taxes.............................. (90.000)

Net income.................... 110,000

Statement of Retained Earnings

For the year ended on 12/31, Year 1________

MXN____

Retained earnings, 1/1/Y1......... 0

Net Income................................ 110,000

Dividends................................... (40,000)

Retained earnings, 12/31/Y1..... 70,000

Balance Sheet

________________________December 31, Year 1______________________________

________________________MXN_____________________________________MXN__

Cash.......................... 80,000 Accounts payable.................. 80,000

Receivables............... 150,000 Notes payable....................... 500,000

Inventory.................. 270,000 Common Stock...................... 300,000

Fixed assets (net)...... 450,000 Retained earnings................. 70,000

Total assets.............. 950,000 Total liab and equity.............. 950,000

Exchange rates (US$per MXN):

January1, Year 1......................... $0.094

June 1, Year 1............................. 0.095

Average for Year 1..................... 0.096

November 20, Year 1................. 0.100

December 1,Year 1.................... 0.105

December 31, Year 1................. 0.110

Required:

The company is able to design its Mexican business such that (1) MXN is designated as its functional currency or (2) US$ is designated as its functional currency.

a. Which one will generate more net income? Why?

a1. By how much? What caused this difference?

b. Which one will generate more assets? Why?

b1. By how much? What caused this difference?

c. What are the amounts of translation adjustments in (1) and (2)?

c1. Describe how you calculated for each.

c2. Why did you calculate this way? (Hint: you need to discuss balance sheet exposure.)