Before you invest, your (simplified) balance sheet might look like Exhibit 7.7.
We pick a date of October 23, 1995, for the investment, and your balance sheet looks like Exhibit 7.8 at the end of October:192 193
Exhibit 7.7 Small Co. balance sheet, September 30, 1995 (in millions).
Exhibit 7.8 Small Co. balance sheet, October 31, 1995 (in millions).
Actually, the value of the investment will be in Chinese yuan renminbi (CNY), the currency of China. The accountants will convert that investment to dollars at the prevailing exchange rate at the end of each accounting period. If the $100 million were invested in China on October 31, 1995, it would buy CNY 831.490 million, and that would become the value of the plant. The exchange rate was CNY 8.31490 to one U.S. dollar on October 31, 1995. The balance sheet is important because public companies will report any gains or losses on investments on their income statements. So both the balance sheet and the income statement will change as a result of exchange rate movements. Of course, the major reason for this investment is to obtain goods for sale in the United States and in other countries at lower prices. Unlike Rodney's investment in England, the government of China had a policy to hold the exchange rate constant with the dollar. This effectively created one currency for China and the United States for 10 years. This was a huge advantage to companies doing business with China.
Look at the exchange rate of the yuan to the dollar in Exhibit 7.9.
As you can see, there has been a 10-year period of very stable exchange rates. Let's value your $100 million plant on December 31, 2004. Recall that the plant was actually valued at CNY 831.490 million on October 31, 1995. Assume no depreciation and no plant additions to allow us to see what happened because of exchange rates. We see that CNY 831.490 million divided by the December 31, 2004, exchange rate of 8.28650 converts to $100.34 million (Exhibit 7.10).
The change since 1995 is so small as to be insignificant. I'm sure Rodney wishes that his investment in England had had this stability. However, from 2005 onward, the yuan has strengthened against the dollar. The effect from a change in the rate from 8.3 to 6.9 has been to raise prices of Chinese goods by 20%, assuming that all else is equal. By now you should be able to tell what happened to the value of the investment. Since the yuan increased in value, the investment translated to dollars increased in value. Now let's convert the value of CNY 831.490 million as of December 31, 2008. The dollar amount becomes $121 million (Exhibit 7.11). Now we are seeing significant change, although it is helpful to the accounting statements.193 194
Exhibit 7.9 Exchange rate: Number of Chinese yuan renminbi per U.S. dollar.
Exhibit 7.10 Small Co. balance sheet, December 31, 2004 (in millions).
Exhibit 7.11 Small Co. balance sheet, December 31, 2008 (in millions).
The negative side is that this same movement increased the cost of the engines that Small Co. was exporting from China and importing into the United States. Just as the assets rose in value by 21%, the cost of the engines also rose by this same 21%. If we look at a five-year history in January 2001 at OANDA.com, we would see the summary shown in Exhibit 7.12.
This table shows the success of the government of China in keeping the exchange rate stable. Of course, history can be a guide but not a guarantee of future events.194 195
Exhibit 7.12 Summary of exchange rates: Chinese yuan per dollar.
We could do a time line of cash flows if we had more information. For now let's make some points that do not require us to make a time line.
If Small Co. were importing the engines into the United States and buying them for $25 each, they would have been free of exchange rate risk for 10 of the past 13 years. The price of manufacturing the engines would still be subject to inflation in China. The cost of raw materials, parts, and labor might have risen, but there was no cost escalation from the exchange rate until relatively recently. By 2008, the price would have increased to $30 each even if there was zero inflation in China.