Determine whose rate of return (i.e., local or parent currency returns) Wal-Mart should use when evaluating foreign direct investment opportunities and justify the position.
Foreign Direct Investment (FDI) is an international flow of capital that provides a parent company or multinational organization with control over foreign affiliates. The behavior of exchange rates influences FDI activity. Exchange rates are defined as the domestic currency price of a foreign currency. Exchange rates can influence both the total amount of foreign direct investment that takes place and the allocation of this investment spending across a range of countries (Bogoslaw, 2009).
Wal-Mart is among many multinational companies that have expanded production and distribution networks globally to take advantage of opportunities for higher local rates of return, market share, and accessibility to production inputs (Nathan, 2012). This -- along with foreign government import restrictions, opening of new markets and invitation for foreign investments with worthwhile incentives -- lead many multinational firms to prefer FDI over other forms of international business. However, such business is exposed to dangers as well such as economic, currency, and market risk. The potential financial effect of these risks cannot be left unaccounted for in foreign investment decisions and must be analyzed to understand the potential effects on operating profitability.
Wal-Mart's strength is due, in part, to negotiations with suppliers around the world. Suppliers can take advantage of huge sales volumes which are often much more profitable than sales generated from other stores (Huang, et.al., 2012). Wal-Mart's buyers are known for being aggressive negotiators on purchases and for extracting the best terms for the company. This means the company has to deal extensively in different currencies. Small changes in the daily foreign currency market can significantly impact the costs for Wal-Mart and in turn its profitability. Thus, companies like Wal-Mart need capital for purchasing products locally (Nowell, 2008). This can be achieved by paying in local currencies or the U.S. dollar, typically whichever is cheaper and works to the company's advantage. In most cases, local currency rates of return should be considered when considering foreign direct investment opportunities.
To illustrate the impact of foreign currency, consider the currency of China, the renminbi (RMB), and its impact on a global business like Wal-Mart. The Chinese government tries to keep the value of its currency low or cheap to help promote exports. For Wal-Mart, a cheap RMB means that it takes fewer U.S. dollars to buy Chinese products. Wal-Mart can then buy inexpensive Chinese products, add a small profit margin, and then sell the goods in the United States at a price lower than what its competitors can offer (Nathan, 2012). Thus, Wal-Mart would benefit from trading in the local currency to see a higher rate of return. Similarly, if the Chinese RMB increases in value, then Wal-Mart has to spend more U.S. dollars to buy the same products, whether the products are clothing, electronics, or furniture. Any increase in cost for Wal-Mart will mean an increase in cost for their customers in the United States, which could lead to a decrease in sales.
In such cases, Wal-Mart might want to consider dealing in USD if it protects overall costs. The future of the dollar as a medium of international exchange is an "issue" primarily because the U.S. trade deficit is huge, growing, and apparently destined to grow forever. To counter this, Wal-Mart will typically require that the currency exchange rate be fixed in its purchasing contracts with global suppliers (Nowell, 2008). By fixing the currency exchange rate, the company locks in its product costs and therefore its profitability. Fixing the exchange rate means setting the price that one currency will convert into another. This eliminates risk from unexpected drops or increases in the value of local currency and/or the USD. While global companies have to buy and sell in different currencies around the world, their primary goal is to avoid losses and to fix the price of the currency exchange so that they can manage their profitability with surety.
2. Determine the role that accountants play in the managerial planning process for Wal-Mart and how their advice is likely being used.
Wal-Mart's finance and accounting departments impact business and communities in over 27 countries (Wal-Mart, 2012). Accountants, business analysts and treasury managers, work toward a holistic environment that mitigates risk and capitalizes on opportunity. Accountants in particular work with various departments throughout the company to seek pinpoint those processes that are the most efficient and cost-effective. Their feedback helps business units evaluate the company's operating procedures and methods to ensure business improvements and competitive advantage in the marketplace. The Global Internal Audit Services division is spearheaded by accounting and partners with all areas of the company to focus resources on the most significant business risks and drive operational effectiveness (Marshall, 2000).
Management continually reviews the company's accounting policies, how they are applied and how they are reported and disclosed in financial statements (Wal-Mart, 2012) . Ernst & Young (E&Y) serves as the company's independent accountants and audit consolidated financial statements each fiscal year. E&Y and its predecessor, Arthur Young & Company, have been Wal-Mart's independent accountants since prior to the Company's initial offering of securities to the public in 1970.
The role of the accounting firm includes audits to assess the effectiveness of internal control over financial reporting, the review of the company's quarterly reports on 10-Q, statutory audits required internationally, comfort letters, and consents for and review of registration statements and other documents filed with the SEC (Marshall, 2000). Accounting consultations ensure due diligence in generally accepted accounting principles, the application of generally accepted accounting principles to proposed transactions, and audits not statutorily required. Finally, E&Y ensures tax compliance at international locations, offers domestic and international tax advice and planning, offers assistance with tax audits and appeals, and carries out all tax planning related to mergers and acquisitions, employee benefit plans, and IRS ruling requests.
3. Make one solid recommendation for how Wal-Mart can minimize its foreign exchange exposure. Explain the rationale behind your recommendation.
To minimize its foreign exchange exposure today, Wal-Mart will often hold currency swaps to hedge the currency exchange component of net investments in the other countries (Nowell, 2008). A currency swap is a financial instrument that helps parties swap notional principals in different currencies and thus pay interest payments on the received currency. The purpose of currency swaps is to escape risk exposure associated with exchange rate fluctuations, ensure receipt of foreign monies, and to achieve better lending rates. Currency swaps are comprised of two notional principals that are exchanged at the beginning and at the end of the agreement.
Swaps are like packages of forward contracts and can be used to avoid certain credit risks. In broad terms, a currency swap is an agreement by two companies to exchange specified amounts of currency now and to reverse the exchange at some point in the future. The lack of credit risk comes from the nature of a currency swap. Default on a currency swap means that the currencies are not exchanged in the future, while default on a parallel loan means that the loan is not repaid. Unlike a parallel loan, default on a currency swap does not mean loss on an investment or earnings. The only risk in a currency swap is that the companies must exchange the foreign currency in the foreign exchange market at the new exchange rate. Wal-Mart also uses this strategy to hedge the currency exchange rate fluctuation exposure associated with the forecasted payments of principal and interest of non-U.S. denominated debt (Nathan, 2012).
Alternatively, Wal-Mart transaction exposure could be minimized by netting transaction exposure. Netting transaction exposure can be especially beneficial for larger companies that do frequent and sizeable amounts of foreign currency transactions. Unexpected exchange rate charges "net out" over many different transactions. For instance, a receivable of 10 million Deutsche Marks owed to a U.S. company in 45 days is much less risky if the U.S. company must pay a German supplier 5 million Deutsche Marks in 30 days. The risk is even less if the business has only receipts in Deutsche Marks on a continuing basis.
Transaction exposure is further reduced when payments and receipts are in many different currencies. Therefore, an unexpected increase in the value of the French Franc, for example, may improve the profit margin on receipts from France. However, an unexpected decrease in the value of the Canadian Dollar may reduce profits on a receipt from Canada. Although transaction exposure cannot be netted away entirely, it may be small enough that the company is better off accepting the exposure rather than incurring the costs associated with the hedging techniques currently being employed by Wal-Mart.
4. Determine if Wal-Mart would benefit more from a financial futures contract or a forward exchange contract. Explain your rationale.
A forward contract is an agreement between two parties to buy or sell an asset at a pre-agreed future point in time at a pre-agreed…