Question

Saller Co. has a subsidiary in Mexico. The expected cash flows in pesos to be received in the future from this subsidiary have not changed since last month, but the valuation of Saller Co. has declined since last month. What could have caused this decline in value?

1) a weaker Mexican economy
2) lower Mexican interest rates
3) depreciation of the Mexican peso
4) appreciation of the Mexican peso

Answer 1

The decline in Saller Co.'s valuation, despite stable cash flows from its Mexican subsidiary, is likely due to the depreciation of the Mexican peso. The future cash flows are worth less when converted to Saller Co.'s functional currency because of the decrease in exchange rate value.

Step-by-step explanation:

Given the scenario where Saller Co. has a subsidiary in Mexico with unchanged expected cash flows in pesos, but where Saller Co.'s valuation has declined, it can be linked to the currency exchange rate movements. The depreciation of the Mexican peso against Saller Co.'s functional currency can cause such a decline in valuation. If investors expect the peso to depreciate, they would be more eager to sell it, leading to an increase in the supply of pesos. This causes the exchange rate to drop, reducing the value of the future cash flows when converted to Saller Co.'s functional currency.

On the other hand, an appreciation of the Mexican peso would normally be beneficial for the company's valuation when the subsidiary's earnings are repatriated. Increased demand for the peso, along with decreased supply in anticipation of appreciation, will raise the equilibrium exchange rate, translating into more functional currency per peso. This situation does not match the given decline in valuation and hence is not the cause.