FARMINGTON INDUSTRIES INC

9 Pages   |   2,050 Words

FARMINGTON INDUSTRIES INC.

MANAGING CURRENCY EXPOSURE RISK

Table of Contents
 
Executive Summary. 3
Currency Devaluation Analysis. 4
Balance Sheet. 6
Income Statement. 6
References. 9

Executive Summary

The Farmington Industries incurred an exchange loss and gains which were reported in their income statements that were forecasted for the year ended 1994. This result was brought about due to the foreign exchange policy changes that took place in Mexico as of that year. The government decided to devalue their Mexican peso in order to increase the level of exports so as to pay off the huge current deficit that the government had incurred by taking debts and by not paying them back in a timely manner.

This current account deficit necessitated a need for the Mexican peso to depreciate against the dollar in order to increase the level of exports and in so doing the companies in Mexico that were exporting goods started reporting losses because of this policy change. The article thus effectively portrays a situation where Farmington Industries has been taken as a means of portraying how such a policy change could adversely affect the businesses of Mexico and thereby affect the booming economy in a negative manner.
 

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The Farmington Industries parent company was established in the United States of America and a subsidiary in Mexico namely, Farmington de Mexico, incurred a huge currency exchange loss because the company did not have the foresight to adapt to the devaluation of the peso. Due to this weak management, the company was not able to hedge against the currency risk that it could have avoided by using the dollar currency for its trade transactions.
Therefore, the subsidiary company in Mexico had to export goods that were now relatively cheaper whereas other parts of the company located in the United States reported a profit as they benefitted by exporting their goods to Mexico as those goods were now relatively expensive for Mexico hence making the company incur currency exchange gains.

Currency Devaluation Analysis

  1. Farmington de Mexico’s 1994 peso income statement includes an exchange loss, whereas Exportaciones (Farmington) S.A’s peso income statement includes as exchange gain. What accounts for this difference?
Exchange loss and gains are those which arise mainly as a result of transactions involving foreign currency. It is produced when goods and services of a particular company are bought and sold at credit at a price denominated in foreign terms or when loans are lent or borrowed such that their payables and receivables are in terms of foreign currency. The main factor influencing the gains and losses of exchange is the exchange rate of a particular country. In the case of Farmington Industries the income statement of 1994 reports a huge amount as an exchange loss of about 9 million pesos. This is because of the impact and implementation of the announcement made by the government of Mexico. It declares the abolishment of support on the Mexican peso.
 
The outcome of such a statement resulted in a drastic devaluation of the Mexican currency by 13% which later on further fell by 40% against the US dollar. This caused the items of imported goods to be relatively expensive and the exported goods to become relatively cheaper because due to the devaluation of the peso, the value of the currency against the dollar fell and then this resulted in the products that were being sold to become cheaper for the foreign companies through exports. Moreover, through this devaluation, Farmington which was exporting goods would then have to report an exchange loss as the relative prices of the goods would then fall and Exportaciones would report an exchange gain as the prices of the goods would be relatively higher thus enabling more profits through foreign exchange of the imported goods.
  1. What is the effect of the peso devaluation on the operations and financial statements of the company’s maquiladora?
Due to the devaluation the effects of such a policy measure would be observed on the company’s recently established maquiladora facility which basically imports U.S manufactured goods and uses those raw materials to form finished goods in Mexico. Those finished goods are then exported to the United States. Due to the devaluation, this facility would also report an exchange loss as it will be exporting goods to the United States of America at a relatively cheaper price. Hence because of a decrease in the relative price of the good due to the devaluation of the peso we can conclude that in the financial statements of the company’s maquiladora, an exchange loss would be reported.
 
Apart from that the operations of the company would also face a drastic setback as the profits would relatively fall more due to the fact that the goods that the company was purchasing from the United States would now be relatively more expensive. Hence a dual set back for this part of the company would occur resulting in a greater exchange loss because the imported goods would be relatively expensive and the exported goods would be relatively cheaper. Hence the cost of operating would rise and the profits would fall due to the devaluation of the peso.
  1. What is the effect of the peso devaluation on the operations and financial statements of Farmington (Antilles) N.V.?
Farmington (Antilles) N.V. was a corporation established by the company in the United States which basically dealt with exporting those goods that were manufactured in the United States to many countries including Mexico. This part of the Farmington company when dealing with the exporting of goods to Mexico would profit due to the devaluation of the Mexican peso as the goods that this company would be exporting to the Mexican companies would in fact be imports for the Mexican based companies, hence the exported goods of Farmington (Antilles) N.V. would be relatively expensive and would then report higher profits.
 
Due to the devaluation the relative prices of the goods being sold in Mexico would rise as the dollar would be appreciating against the peso. Hence due to the relative increase in the level of prices the relative profit for the company would also incur a rise thus this would then lead to an increase in the operations of the company due to an exchange gain being reported in the financial statements of the company so as to benefit from such foreign currency exchange policies.
  1. Prepare Farmington de Mexico’s 1994 U.S dollar financial statements for inclusion in the parent company’s 1994 consolidated financial statements.
Farmington de Mexico’s Balance Sheet for the year ended 1994 in U.S Dollars is as follows:

Balance Sheet

ASSETS   $ (Million)   LIABILITES $ (Million)
           
Cash   15   Accounts Payable 100
Accounts Receivable   150   Peso debt 225
Inventories   115   U.S Dollar debt 150
Facilities (cost) 400     Miscellaneous 65
(Accumulated depreciation) -105 295     540
Miscellaneous   40   Equity 75
    615     615
           

Income Statement

The income statement for the year ended 1994 in dollars for Farmington de Mexico is as follows:
    $ (Million)
Sales   1800
Cost of goods sold   750
Gross Margin   1050
Depreciation   20
Selling,general and administrative   450
Exchange loss   45
Pretax profit   535
     
 
The exchange rate that was taken for preparing the financial statements for the company was the year end exchange rate of 5 pesos to 1 U.S Dollar.
  1. Describe how Exportaciones (Farmington) S.A.’s 1994 U.S dollar financial statements would differ from those prepared by Farmington de Mexico.
Exportaciones (Farmington) S.A.’s 1994 U.S dollar financial statements would differ from those prepared by Farmington de Mexico because Farmington de Mexico would still be reporting an exchange loss in its income statement and Exportaciones would instead be reporting an exchange gain in its income statement.
 
This exchange gain and loss would arise due to the devaluation of the peso as a result of which Farmington de Mexico would be selling its products relatively cheaper than Exportaciones and the exchange gain that it would report in its income statement would amount to $20 million, whereas the exchange loss for Farmington de Mexico as computed in the above tables would amount to $45 million. The exchange loss would be greater than the gain because the imported raw materials for the company would now be much more relatively expensive ad the exported goods would now be much more relatively cheaper thus inducing such a huge loss.
  1. How well was Farmington Industries prepared for the December 20, 1994 devaluation? Be specific and indicate the consequences.
It seems that Farmington Industries was not well prepared for the December 20, 1994 devaluation because of the huge exchange loss that they incurred as can be observed by the income statements of the company as of that year.
 
Moreover, it seems that such an occurrence had been forecasted to happen before hand and in such an occurrence taking place the company should have stayed ahead by preparing itself for such an eventuality. It was also no well prepared in the sense that the company could have actually benefitted by such a policy procedure by resorting to the Dollar as its currency used for trade purposes. The consequences of such an action was that of the exchange loss that the company had to bear, although Exportaciones did benefit and reported an exchange gain but that was mainly due to the fact that its operations were as such that they dealt with importing U.S goods rather than exporting them from Mexico as was the case for Farmington de Mexico.
  1. Going forward, what actions would you recommend Farmington Industries take to mitigate or take advantage of the peso devaluation?
To hedge against such currency exchange risks, the company should have adopted a policy whereby they would be just dealing in one currency trade transactions which would then help them mitigate the losses they incurred. Moreover, the company should have foreseen the apparent devaluation of the Mexican peso as this was bound to happen due to the fact that Mexican economy was operating in such a way that the government was aggressively limiting inflation by limiting the trade activities of the peso.
 
Furthermore, the country was going further and further into debt and was not making any effort to pay back the accumulated debt and the interest on it. This resulted in an increase in the current account deficit and it was thus anticipated that the government would devalue the Mexican peso in order to increase exports by making the Mexican goods appear cheaper to the rest of the world.
 
This strategy resulted in the companies reporting loss, Farmington industries being one of them. Hence the inevitability of the Mexican peso being devalued was there and the company had as yet not taken action before the policy could be implanted or after which resulted in the poor management of the company’s trade transactions, which further resulted in the exchange loss being incurred. Hence the company was not better prepared for such an eventuality when it could have been and could have turned this loss to a gain by hedging against it through using the dollar for trade purposes.
  1. What is your appraisal of the question-and-answer position of the company’s January 3 conference call? What further action would you recommend the company take to deal with the peso devaluation concerns of its shareholders and the investing community?
The conference call as of January 3 showed that the company even after the devaluation had occurred was not managing this policy change well as it still had not made any plans for adapting to this change which had taken place as of 20 December, 1994. Moreover, the conference call revealed that the company did use the dollar currency for most of its transactions and that the Mexican peso was also used by the company in a few cases for trade purposes.
 
The company could have hedged against the foreign exchange risk by adopting a foreign exchange forward hedging approach whereby the company could have assessed the currency which was stronger relatively to the Mexican peso and could have used that currency for its trade transaction purposes instead of using the Mexican peso which underwent a devaluation. Hence such measures would have mitigated the losses for Farmington industries and other shareholders and the rest of the investing community.

References

Hawkins, David F., and Jacob Cohen. "Farmington Industries, Inc.: Managing Currency Exposure Risk." Harvard Business School 2004.

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