International Business Finance

Michael Connolly

• Publisher: Routledge
• Year: 2006
• Topic: Business
• eBook ISBN:
  9781135991777
• Subtopic: Business General
• Index: Business

This textbook introduces students to the fundamental workings of business and finance in the global economy. It brings clarity and focus to the complexities of the field and demonstrates the key linkages between the foreign exchange markets and world money markets.

Core topics examined include:

• corporate aspects of international finance, with special attention given to contractual and operational hedging techniques
• the mechanics of the foreign exchange markets
• the building blocks of international finance
• the optimal portfolio in an international setting.

Michael Connolly also provides up-to-date statistics from across the globe, relevant international case studies, problem sets and solutions and links to an online PowerPoint presentation.

International Business Finance is an engaging and stimulating text for students in undergraduate and MBA courses in international finance and a key resource for lecturers.

Chapter 1

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Introduction to international finance

FEATURES OF INTERNATIONAL FINANCE

In what sense does international finance differ from finance? In fact, there are many.

Currencies

The key distinction between international finance and finance is the exchange rate issue. Issues of valuation, uncertainty about the future exchange rate, and its convertibility and transactions costs, lead to market segmentation. Consider the important decision to make a foreign acquisition. To value the foreign firm, it is customary to work up an income statement forecasting free-cash flow over the next five years, then compute a terminal resale value of the acquisition. When the forecast is in terms of a foreign currency, say the euro, the forward cash flows must then be converted to the home currency, say the dollar or the pound. This task is easy enough using forward rates for the euro up to two years and interest rate parity to forecast the exchange rate for years three to five. The corresponding conversion of free-cash flows is now in dollars for each year, ready to be discounted by the firm’s weighted average cost of capital in dollars. If the net present value is positive and higher than alternative investments, the firm may decide to undertake the acquisition. In doing so, the firm is faced with foreign exchange risk due to unexpected deviations from forecasted exchange rates. This exchange risk takes different forms: transactions risk associated with a specific transaction in foreign exchange; operational risk associated with ongoing operations in the foreign currency; and translation risk associated with the accounting requirements of FASB 52 (Financial Accounting Standards Board). In addition, reporting requirements are in local currency to the Internal Revenue Service or Inland Revenue. In order to hedge exchange risk, there are contractual, operational, and financial hedges, but these add to the costs of risk management of the firm. If done selectively, hedging incurs costs, but may increase the net present value of the firm by lowering borrowing costs and risks of financial distress.

Accounting rules

Another important consideration is the issue of different accounting rules and practices. In the United States, the generally accepted accounting practice (the GAAP) is used and sanctioned by the FASB. Overseas, the standard practice is the international accounting standard (IAS), which depends more on concept and principle than on practice. Ford Motor Co., for example, initially bid $6.9 billion for the acquisition of the insolvent and bankrupt Daewoo Motor Corp. of Korea, but withdrew its bid when its accountants and analysts converted Daewoo’s books to the GAAP. The conversion revealed larger debt and commitments made by the Korean chaebol. Among the accounting irregularities reported were:

• A shell company in London, British Finance Centre (BFC), which conducted bogus import–export transactions to transfer $2.6 billion and divert an additional $1.5 billion from car exports to the London slush fund for “lobbying” in Korea and elsewhere. According to Business Week, a former Daewoo executive is quoted as saying: “Chairman Kim carried with him bundles of money to lobby for projects in emerging markets” (February 19, 2001: 51).
• To book profits at a failed Ukrainian plant, Daewoo Motor tore down fully assembled cars, and shipped them to the Ukraine plant for reassembly and sale.
• Daewoo Heavy Industry sold assets to Daewoo Motor at inflated prices, thus booking a profit in 1997. It actually posted a loss of $670 million that year.
• Daewoo Electronics borrowed nearly $1 billion from financial institutions by concealing that losses had wiped out shareholders’ equity.

Kim Woo Choong, the founder of Korea’s Daewoo Group, was a fugitive from justice from charges of fraud and embezzlement for five years, but returned to Seoul, Korea in June 2005 to face the charges. Kim Tae Gou, former Daewoo Motor chairman, and six other top officers of the Daewoo Group are currently under arrest (Business Week, 2001).

In general, reporting and disclosure requirements are higher in the United States, England, and continental Europe than elsewhere, particularly when compared to emerging markets. European accounting traditions are solidly grounded conceptually.

Stakeholders

A related issue is more philosophical; the US firm typically owes its allegiance to its owners, the shareholders. In Europe and elsewhere the firm may have different constituents or stakeholders: the shareholders, management, the government, its unions, and its customers. In the case of Daewoo Motor, militant unions were seeking back pay with no layoffs, making its acquisition by Ford more troublesome. Airbus is a majority government consortium that has not needed to rely upon shareholder monitoring and financing, although it issued an IPO in 2002 under the name EADS for financing the 600-passenger jumbo jet A380, which flew in prototype in the summer of 2005. It is not clear that EADS would be able to finance the jumbo jet without implicit guarantees by the governments and research and development subsidies.

Legal framework

A number of countries observe Napoleonic rather than Common Law, deriving from the Napoleonic codes that govern business law there. Spain also implanted the Napoleonic codes in most of Latin America. In Islamic countries, interest is prohibited by the Koran, so financial institutions must arrange for profit-sharing with its depositors-owners. As an amendment to the US Securities Act of 1934, the Foreign Corrupt Practices Act of 1977 (FCPA 1977) prohibits making payments to foreign officials for the purpose of securing contracts or licenses, influencing decisions, evading regulations and law, and obtaining business, retaining business, or directing business to any person. If a director, officer, or shareholder of the firm either knows or should know that a payment is being made as a bribe or kickback to favorably influence a decision, it is illegal and subject to civil penalties up to $100,000 and imprisonment for not more than five years, or both. There is an exception for routine governmental action “to expedite or to secure the performance of a routine governmental action by a foreign official.” This is known as “grease money,” which is not prohibited unless it is so by the local laws. If a grease payment is not large and is made to expedite governmental action to grant a license to operate a bank that is granted to everyone qualifying for a bank license, there may be no problem. If the payments are made simply to expedite the request, they are not illegal under FCPA 1977. If the official has some discretion, and few applicants are approved, the payment would be illegal. The Organization for Economic Cooperation and Development (OECD) established in February 1999 a Convention Against Bribery of Foreign Public Officials in International Business. The Convention makes it a crime to offer, promise, or give a bribe to a foreign public official in order to obtain or retain international business deals. In addition, The UN Convention Against Corruption (UNCAC) is an international treaty that has been signed by 113 countries since its launching in December 2003.

In Paraguay, there is a professional known as a “dispachador de aduana” (customs dispatcher), who is hired to make grease payments to customs inspectors on a routine basis. The use of a customs dispatcher to clear goods through customs would be permitted, but not to secure a unique license to import a certain good. In an anonymous interview, a customs dispatcher is quoted as saying: “To clear a shipment through Paraguayan customs, there are 15 hands in the customs office stretched out for money to facilitate the clearance procedures.”

Institutional framework

There is no question that corruption exists everywhere to some degree. Kleptocracies misappropriate profits and wealth, thereby discouraging enterprise and thrift. Instead, bribery and malfeasance are rewarded. It matters little to have laws against corruption, when it is institutionalized in practice. To combat bribery, on November 21, 1997, OECD member countries and five non-member countries, Argentina, Brazil, Bulgaria, Chile, and the Slovak Republic, adopted a Convention on Combating Bribery of Foreign Public Officials in International Business Transactions. The Convention was signed in Paris on December 17, 1997. However, Peter Eigen, Chairman of Transparency International, puts it this way:

The scale of bribe-paying by international corporations in the developing countries of the world is massive. Actions by the majority of governments of the leading industrial countries to curb international corruption are modest. The results include growing poverty in poor countries, persistent undermining of the institutions of democracy, and mounting distortions in fair international commerce.

(www.transparency.org, January 20, 2001)

The current rage at the International Monetary Fund (IMF), if one is to believe their publication Finance & Development: “Taking the offensive against corruption” (IMF, 2000), is the fight against governmental and state enterprise corruption. The IMF’s “crusade” is not credible as their history has been one of lending to corrupt governments worldwide, provided they qualify for a loan and agree to IMF conditionality. For example, much of the last standby loan to Russia before their sovereign default is rumored to have been deposited by Russian officials in an offshore bank in Jersey, the Channel Island, which honors banking secrecy and has no income taxes.

“The IMF should learn a lesson from the past five years,” the former official, Boris Fyodor, said, referring to the IMF. “The IMF was pretending that it was seeing a lot of reforms in Russia. Russia was pretending to conduct reforms. The Western taxpayer was paying for it” (Gordon, 1998). However:

The IMF was surprised by last year’s discovery that the central bank was linked to an offshore investment company in the Channel Island of Jersey and that the [Russian central] bank had misreported its asset levels to the fund. The offshore company, Fimaco, was acquired by a subsidiary of the central bank during Gerashchenko’s previous tenure as central bank chief, although the Fimaco operations that have drawn the most attention to date fell during the 1994–98 period when he did not head the central bank. [Then US Secretary of the Treasury, Larry] Summers continued his public warnings to Russia on Sunday, repeating the line he took at the opening of a congressional inquiry last week into corruption, money-laundering and the still-unsubstantiated charges that IMF funds had been illegally diverted.

(Sanger, 1999)

Language

Language can be an important obstacle or, alternatively, an advantage in conducting business abroad. Banco Santander Central Hispano of Madrid is now the largest bank in Latin America. It is closely followed by Bilbao Viscaya of Barcelona in size of assets. No doubt the language, cultural similarities, and the use of Napoleonic Law explain in part the comparative advantage of Spanish banks in Latin America. Also, their long banking tradition serves them well in emerging markets.

Taxation

International taxation varies from country to country, ranging from zero corporate income taxes and zero personal income tax in some tax havens to 35 percent in the United States, 36.6 percent in France, 37.5 percent in Japan, and up to 45 percent in Germany. The highest corporate income tax reported by Pricewaterhouse in Corporate taxes: a worldwide summary (1999) is Kuwait at 55 percent of taxable income. In the United States, long term capital gains may be taxed at 15 percent, but in France they are taxed at a 26 percent rate. When profits of a US company are repatriated, they are converted into dollars and the US corporate tax rate of up to 35 percent is applied. If the foreign tax rate is lower, say 20 percent, the company receives a tax credit of 20 percent paid to the foreign government, and then pays the remaining 15 percent to the US Treasury. If it pays 55 percent corporate taxes, it will get a full offset up to 35 percent—its marginal tax rate on US earnings—as well as tax credits, possibly deferred or for other branches, on the additional 20 percent.

In some cases, companies are able to transfer profits out of the United States to shell corporations in tax havens to escape taxes by transfer pricing. This is not in principle a legal practice if done solely for the purpose of evading taxes. In other instances, such as with a Foreign Sales Corporation, companies may legally do so under US law. The portion of income exempted varies from 34 percent with arm’s length pricing to 74 percent with an advanced pricing agreement. However, tax rates are not applied if the earnings are not repatriated, in which case they remain untaxed. The World Trade Organization (WTO) has ruled that the foreign sales corporation (FSC) law of the United States violates Article VI, Anti-dumping and countervailing duties, since the law exempts export earnings of US corporations from corporate taxes, thereby constituting an export subsidy.

Regulatory framework

In the United States, the US Securities and Exchange Commission (SEC) regulates the major exchanges and securities dealers:

The primary mission of the US Securities and Exchange Commission is to protect investors and maintain the integrity of the securities markets . . . The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company’s securities are a good investment. The SEC also oversees other key participants in the securities world . . . Typical infractions include insider trading, accounting fraud, and providing false or misleading information about securities and the companies that issue them . . . The SEC offers the public . . . the EDGAR database of disclosure documents that public companies are required to file with the Commission.

(www.sec.gov, April 30, 2001)

While overseas exchanges, firms, and securities dealers are also subject to scrutiny, in emerging markets many of these are recent and the same disclosure and transparency requirements do not apply. Interestingly, the SEC was created during the great depression (1929–37), precipitated by the October 1929 stock market crash, in which half of the $50 billion in new securities offered during the 1920s became worthless. Purchases on margin represented over 10 percent of the market.

The main purposes of the security and exchange law of 1933 can be reduced to two common-sense notions:

• Companies publicly offering securities for investment dollars must tell the public the truth about their businesses, the securities they are selling, and the risks involved in investing.

• People who sell and trade securities—brokers, dealers, and exchanges— must treat investors fairly and honestly, putting investors’ interests first.

(www.sec.gov, April 30, 2001)

Here is a lexicon for some of the common filings by publicly traded companies. These are some of the more common entries from the EDGAR (Electronic Data Gathering and Retrieval) database of corporate filings:

10K The official version of a company’s annual report, with a comprehensive overview of the business.

10Q An abridged version of the 10K, filed quarterly for the first three quarters of a company’s fiscal year.

8K If anything significant happens that should be reported before the next 10K or 10Q rolls around, the company files one of these.

12B–25 Requ...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Preface
• Abbreviations
• Chapter 1
• Chapter 2
• Chapter 3
• Chapter 4
• Chapter 5
• Chapter 6
• Solutions to Problems