Question Completion:
What is the net impact on Black Lion Company's Year 2 net income as a result of this hedge of a forecasted foreign currency purchase? Assume that the raw materials are consumed and become a part of cost of goods sold in Year 2.
a. A $70,000 decrease in net income.
b. A $70,900 decrease in net income.
c. A $71,100 decrease in net income.
d. A $72,900 decrease in net income.
On November 1, Year 1, Black Lion Company forecasts the purchase of raw materials from an Argentinian supplier on February 1, Year 2, at a price of 200,000 Argentine pesos. On November 1, Year 1, Black Lion pays $1,200 for a three-month call option on 200,000 Argentinian pesos with a strike price of $0.35 per peso. The option is properly designated as a cash flow hedge of a forecasted foreign currency transaction. On December 31, Year 1, the option has a fair value of $900. The following spot exchange rates apply:
Date Spot Rates
Nov. 1, Year 1 $0.35
Dec. 1, Year 1 0.30
Feb. 1, Year 2 0.36
Answer:
Black Lion Company
The net impact on Black Lion Company's Year 2 net income as a result of this hedge of a forecasted foreign currency purchase is:
b. A $70,900 decrease in net income
Step-by-step explanation:
Black Lion Company will pay Argentine peso 200,000 * $0.35, the spot rate when the forward contract was concluded = $70,000 and also the options fair value of $900. This reduces the net income by a total of $70,900 ($70,000 + $900). The reduction does not take place in Year 1 when the transaction is initiated, but when the raw materials are consumed and become a part of the cost of goods. This is Year 2. We are aware that Cost of goods reduces the net income.