The Sports Exports Company continues to focus on producing footballs in the U.S.

Question

The Sports Exports Company continues to focus on producing footballs in the U.S. and exporting them to the United Kingdom. The exports are denominated in pounds, which has continually exposed the firm to exchange rate risk. It is now considering a new form of expansion where it would sell specialty sporting goods in the U.S. If it pursues this U.S. project, it would need to borrow long-term funds. The dollar-denominated debt has an interest rate that is slightly lower than the pound-denominated debt. What is an advantage of using equity to support the subsidiary? What is a disadvantage? If Jim decided to use long-term debt as its primary form of capital to support this subsidiary, should he use dollar-denominated debt or pound-denominated debt?

Explanation / Answer

Advantage of using equity to support the subsidiary are:

1) It provides a parent company with a more accurate income balance. It shows the investment income from all its

sources and not just the parent company.

2) Parent company can use the equity method to hide unfavorable numbers from investors. If a parent company has

numbers showing a low profit, then adding the numbers from its subsidiaries can reflect a higher profit for the

company.
Disadvantage are:

1) The equity method is difficult to use and understand. This method takes a lot of time to obtain, compare and

review numbers between the principal company and its subsidiaries.

2)The equity method fails to show dividends as revenue and instead shows these as deductions.

If Jim decided to use long-term debt as its primary form of capital to support this subsidiary, should he use dollar-denominated debt because dollar-denominated debt has an interest rate that is slightly lower than the pound-denominated debt.

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