Foreign Subsidiary: Transactional and Economic Risks
Mishrad PLC is a major exporter of agricultural equipment to Australia, New Zealand, and throughout Europe. All production facilities are in the United Kingdom. The majority of raw materials and tools are also sourced in the United Kingdom, with few imports from Canada, priced in pound sterling. Major competitors are based in the United States and Germany. There are plans to set up a manufacturing subsidiary in Australia, funded in part by an Australian dollar loan to be taken out by Mishrad PLC. The new manufacturing facility would be used to source the Australian and New Zealand markets.
While the manufacturing subsidiary is being established, Mishrad PLC will be exposed to transactional and economic risks. The company will require purchasing land to build the facility on, construct the factory, warehousing facilities, and other related structures. Other related expenses would involve purchasing any necessary tools and equipment, hiring workers, etc. All of these actions would require Australian dollars. While the Australian dollar loan would cover some of these expenses, it would likely not be enough to cover all costs, which means Mishrad PLC would need to exchange some of its pounds sterling for Australian dollars, which would expose it to transactional risks. Economic risks, while present, would not be so prevalent at this point, as the venture would not yet start, meaning there won’t be any long-term expenses and contracts to consider.
However, once the manufacturing subsidiary starts working, the company will be exposed to other risks. Aside from transactional risks that every company that does business abroad is exposed to, there will be prominent economic and translational risks as well. Translational risks are risks associated with accounting systems. The accounting system at the company HQ will have to translate the accounting reports from its Australian branch, done in Australian dollars. This could potentially create complications as well as gains or losses based on the reporting requirements in different countries.
Lastly, there is economic exposure. The Australian branch would need to purchase production materials domestically, sell products to the Australian and New Zealand markets, pay the workers, and pay local taxes. All of these operations would require Australian dollars on a daily basis. Naturally, most of their income would also come in Australian dollars. At the same time, Mishrad PLC operates in pounds sterling as their home currency, meaning that the company could face losses from an unfavorable exchange rate when transferring money to and from the manufacturing subsidiary.
In order to reduce some of these risks, the company should negotiate with future customers about their paying currency. For example, goods sold on the domestic market could be sold for Australian dollars, which would then be used to purchase materials and pay the workers. At the same time, any exports to New Zealand markets could be paid for in pounds sterling, to be sent to the UK later. This would limit the number of monetary exchanges necessary for continuing operations, thus reducing transactional and economic exposure. However, this measure has the potential of complicating the accounting process, as it would have to deal with two cash flows in different currencies instead of one.