Schwesser Level 2 Study Note book 2, Reading 18: Multinational Operations
Concept Checkers, question 14
Can someone please explain the logic behind this to me? I am quite confident when it comes to this reading but at this questions I am totally lost:
Foreign currency fluctuations often drive operational responses that mitigate the simple mechanical translation of earnings. During periods of sustained movements in currency, the marketplace and competition adjust to the changing rates. For example, when pricing offerings in the marketplace, the company may use some of the advantage from a weakening U.S. dollar to improve its position com- petitively, and price more aggressively to win the business, essentially passing on a portion of the currency advantage to its customers. Competition will frequently take the same action. Consequently, the company believes that some of the currency- based changes in cost impact the prices charged to clients. The company also maintains currency hedging programs for cash man- agement purposes which mitigate, but do not eliminate, the volatility of currency impacts on the company’s financial results.
The company translates revenue, cost and expense in its non- U.S. operations at current exchange rates in the reported period. References to “adjusted for currency” or “constant currency” reflect adjustments based upon a simple constant currency mathematical translation of local currency results using the comparable prior period’s currency conversion rate. However, this constant currency methodology that the company utilizes to disclose this information does not incorporate any operational actions that management may take in reaction to fluctuating currency rates. Based on the currency rate movements in 2012, total revenue decreased 2.3 percent as reported and was flat at constant currency versus 2011. On a pre-tax income basis, these translation impacts offset by the net impact of hedging activities resulted in a theoretical maximum (assuming no pricing or sourcing actions) decrease of approximately $100 million in 2012. The same mathematical exercise resulted in an increase of approximately $600 million in 2011. The company views these amounts as a theoretical maximum impact to its as-reported finan- cial results. Considering the operational responses mentioned above, movements of exchange rates, and the nature and timing of hedging instruments, it is difficult to predict future currency impacts on any particular period, but the company believes it could be sub- stantially less than the theoretical maximum given the competitive pressure in the marketplace. source: https://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf
The most likely impact of currency fluctuations on IBM’s 2011 pre tax earnings net of hedging activities is that pre-tax earnings were:
A. lower by $600 million
B. lower by $100 million
C. higher by $600 million
Pre-tax earnings offset by the net impact of hedging activities decreased approximately $100 million in 2012 and increased by approximately $600 million due to currency translation effects.
Thanks