Question

Because of the low labor costs in Thailand, Melnick Co. (based in the United States) recently established a major research and development subsidiary there that it owns. The subsidiary was created to improve new products that the parent of Melnick can sell in the United States (denominated in dollars) to U.S. customers. The subsidiary pays its local employees in baht (the Thai currency). The subsidiary has a small amount of sales denominated in baht, but its expenses are much larger than its revenue. It has just obtained a large loan denominated in baht that will be used to expand its subsidiary. The business that the parent of Melnick Co. conducts in the United States is not exposed to exchange rate risk. If the Thai baht strengthens over the next three years, will the value of Melnick Co. be favorably affected, unfavorably affected, or not affected? Briefly explain.

Answer 1

Answer:

The subsidiary operates in Thailand simply because its labor costs are much lower. The vast majority of their operations is financed by US dollars that are sent there by the parent company. If the Thai strengthens, then it is more expensive to operate there. I.e. the cheaper a country, the better for the parent company.

In this particular case, the company just obtained a large loan in bahts that it can use to finance its expansion. The thing is that the loan is going to be repaid using US dollars, not Thai bahts. The subsidiary doesn't generate enough bahts to even cover its own expenses, so it will not be able to repay the loan by itself.

If the baht's value increases, then the subsidiary will be hit hard since it will need more US dollars to finance its normal operations and to repay the loan. That will hurt Meinick's value since their cash outflows will increase, reducing its net cash flows.