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Hi John
I’m wondering if you can explain this paragraph a bit better, it’s from the AFM BPP workbook.
“Translation risk does not involve cash flows so there is doubt as to whether it matters. if write offs result in changes to gearing (using book values) that affect a borrowing covenant there may be real economic consequences from translation risk. if it affects reported profits it may affect share price, it could also signal a direction of movement in exchange rates and therefore indicate cash problems in future. Using international debt finance reduces the net assets in foreign currency resulting from an overseas investment and reduces translation risk”
I understand translation and what it does, but its the write offs and loan covenants that is confusing me.
Thanks!
ElizaI wouldn’t worry about this and I am surprised that BPP bothered writing it.
However, lenders might have insisted on something in the borrowing contract that says that if the gearing increases beyond a certain level then they can (for example) insist that the company repay the borrowing – this is what is meant by a covenant.
Given that the gearing for these purposes will be measured using book values from the SOFP, then if it is borrowing in a foreign currency changes in the exchange rate can likely result in a change in the gearing which in turn could mean that the company breaks the agreement/covenant.
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