Luxor Corporation has a 100% interest in a foreign subsidiary known as Luminaire. The foreign subsidiary was created for the primary purpose of distributing electronic components throughout a number of foreign countries. The parent initially invested 3,000,000 FC to finance equipment purchases, and it is anticipated that a dividend equivalent to $1,110,000 will be paid to the parent company at the end of each year. Luxor is trying to determine whether to structure the subsidiary with the foreign currency (FC) or the U.S. dollar ($) as Luminaire’s functional currency.
Projections for the subsidiary’s first year of operations are as follows: sales of 10,000,000 FC; cost of sales (excluding depreciation) of 3,700,000 FC; and selling, general, and administrative expenses (excluding depreciation) of 1,200,000 FC. It is anticipated that the company will purchase 2,000,000 FC of equipment at the beginning of the year and another 1,000,000 FC of equipment at midyear. All equipment is depreciated over 10 years using the straight-line method.
It is anticipated that the exchange rate between the FC and the U.S. dollar are as follows:
Beginning of year ........ 1 FC = $1.00
Average for year ........ 1 FC = 1.06
Midyear ............ 1 FC = 1.05
End of year .......... 1 FC = 1.11
For the first year, prepare a schedule to determine the effect on the parent company’s translated net income, balance sheet, and cash flows assuming the functional currency is:
(a) The dollar and
(b) The FC.