International Financial Management Chapter 1 Features of international

International Financial Management Chapter 1 Features of international finance Michael Connolly School of Business Administration, University of Miami Michael Connolly © 2007 Chapter 1 1

Introduction International finance differs from finance in several ways: n Currencies n Accounting rules n Stake-holders n Legal and institutional framework n Language n Taxation n Regulatory framework n Political risk n Intellectual property rights Chapter 1 2

Currencies n Exchange rates n Currency conversion n Spot rates – for “immediate” delivery n n n “On the spot” Or within two business days Futures and forwards – n n Futures are standardized contracts traded on exchanges, while Forwards are over-the-counter tailored contracts in terms of size, maturity and delivery Chapter 1 3

Currencies n Exchange rates n American quotations vs. European quotations n American: USD per unit of foreign currency n n Example: $1. 7778 per GBP European: Units of foreign currency per USD n Example: 8. 04 yuan (RMB) per USD Chapter 1 4

Currencies n Exchange rate risk n Transaction exposure n n Gains or losses due to unanticipated changes in the exchange rate associated with a foreign currency transaction Usually dealt with by offsetting contractual hedges Chapter 1 5

Currencies n Exchange rate risk n Operational exposure n n Unanticipated changes in the value of the cash flow from operations in foreign exchange due to unexpected changes in the exchange rate. Usually dealt with by natural hedges – matching cash flows. Chapter 1 6

Currencies n Exchange rate risk n Translation exposure n Accounting requirement: US Federal Accounting Standards Board (FASB) 52 requires conversion of most line items at the current exchange rate to the USD for reporting of income and financial statements. n Usually dealt with by matching cash flows and accounting hedges. Chapter 1 7

Accounting rules n n In the United States n Generally Accepted Accounting Practice (GAAP) based on FASB rulings and law, such as the SEC Act of 1934 and the Sarbanes-Oxley Act of 2002 Overseas n Internationally Accepted Standards (IAS) based more on concept than rules and regulations Chapter 1 8

Accounting rules n Comparison: n Reporting and disclosure requirements are higher in the U. S. , England, and continental Europe than abroad: specifically, in emerging markets n American Depositary Receipts (ADRs) are frequently listed on US exchanges in lieu of foreign shares due to disclosure and reporting requirements Chapter 1 9

Stakeholders n In the US: n n Shareholders are of utmost importance: the objective of the firm is to maximize shareholder wealth. Overseas: n Often various stakeholders: n n n The Government is often a majority, state owned enterprises (SOEs) or a minority shareholder Management holds less shares than in the US Workers and unions are often powerful and have many legal rights Chapter 1 10

Legal framework n Common laws in the US and the UK n n n Securities and Exchange Commission, 1934 US SEC Act of 1934 and SOX 2002 regulates securities offerings, disclosure and reporting US Foreign Corrupt Practices Act of 1997 (FCPA 1977) prohibits making payments to foreign officials to obtain contracts, licenses and favors n n Civil penalties of up to $100, 000 and imprisonment for not more than 5 years, or both Exception for “grease money” - to expedite or to secure the performance of a routine governmental action by a foreign official, are permitted unless prohibited by local laws Chapter 1 11

Legal framework n n Napoleonic laws n France, Spain, Italy and most Latin American countries are governed by the Napoleonic Code. Louisiana is partially so Islamic laws n Interest prohibited by the Koran, but profit sharing permitted Chapter 1 12

Legal framework n n In 1999, the Organization for Economic Cooperation and Development (OECD) established A Convention Against Bribery of Foreign Public Officials in International Business which 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 The UN Convention Against Corruption (UNCAC) was signed by 113 countries since its launching in December 2003 Chapter 1 13

Language n Language can be either an obstacle or an advantage. n Banco Santander Central Hispano of Madrid - the largest bank in Latin America in terms of assets - owes its comparative advantage over other banks in Latin America to language, Napoleonic Law, and its long history of good banking practices. Chapter 1 14

Corporate income taxes n n Statutory corporate income taxes vary: * Countries such as Ireland are now tax havens foreign direct investment and foreign sales corporations, benefiting from a 10% special tax rate, while others, such as Russia have adopted a flat tax of 15% to encourage compliance. *Source: Price Waterhouse. Chapter 1 15

Corporate income tax n n Corporate income tax collections are a small percentage of GDP in general. However, the data do not reflect marginal effective tax rates since countries like Ireland with low effective tax rates have greater compliance and attract FDI, thus collecting a high percentage of GDP. The US, on the other hand, has depreciation and interest expenses as tax shields, so despite a high marginal statutory rate, collections are low as a percentage of GDP, as seen in the OECD countries Chapter 1 16

Corporate income tax Chapter 1 17

Capital gains taxation n Capital gains taxes vary and depend on the length the investment is held. The US reformed it’s rates in 2003, but these expire in 2009, unless re-voted. • A principal residence in the U. S. has a capital gains exempt amount of US$250, 000 (US$500, 000 for married persons filing jointly) for gains on the principal residence if owned and occupied by the taxpayer as the principal residence for greater than two years over prior five years. Chapter 1 18

Capital gains taxation n n In the United Kingdom, capital gains are taxed at top marginal personal rate on savings income. These are respectively: 10 per cent/20 per cent/40 per cent Chapter 1 19

Transfer pricing n Transfer pricing involves the price one branch of a company charges the other for the transfer of intermediate goods n n It can be used to transfer profits from a high tax jurisdiction to a low tax jurisdiction Foreign Sales Corporations (FSC) n Under US laws, a FSC may incorporate in a tax haven to promote exports. If it does not repatriate profits, they go untaxed Chapter 1 20

Transfer pricing n n Under WTO regulations, a Foreign Sales Corporation violates Article VI Anti. Dumping and Countervailing Duties since U. S. corporations’ export earnings are exempted from corporate taxes, constituting an export subsidy. Indeed, the European Union won its anti -dumping case against the Foreign Sales Corporation which is being phased out. Chapter 1 21

The regulatory framework n The U. S. Securities and Exchange Commission (SEC) regulates major exchanges and securities dealers based on a simple concept: all investors should have access to certain basic facts about an investment prior to buying it n n n The SEC requires public companies to disclose meaningful information to the public to judge for themselves if a company's securities are a good investment SEC-governed typical infractions include insider trading, accounting fraud, providing false or misleading information about securities and issuing companies, and backdating of options grants. The SEC offers the public the EDGAR database of required disclosure documents from public companies Chapter 1 22

Political risk n Political risk: economic exposure to unanticipated changes in governmental policy that affect the earnings and value of your affiliate or subsidiary, the most serious being nationalization. Chapter 1 23

Political risk n Political risk falls with WTO’s growing membership n n n The GATT/WTO’S Article III National Treatment on Internal Taxation and Regulation requires equal treatment for both domestic and foreign firms. Despite national treatment requirements, discrimination against foreign firms may still take place Nationalization with a populist government coming to power n The foreign oil companies in Venezuela are facing implicit nationalization through governmental decrees, as was the case under Alan García in Perú from 198590 where they were explicitly nationalized Possible solutions n World Bank Multilateral Investment Guarantee Association (MIGA) provides insurance against investment risk in emerging markets Chapter 1 24

Intellectual property rights n Pirated and counterfeit products are commonplace worldwide n Software code, Madonna’s songs, Microsoft’s latest Windows operating system and its Office Suite, Rolex watches, Lacoste shirts and so on n n In some countries, the copying and manufacture of patented pharmaceuticals is perfectly legal Brazil seems to be the greatest culprit in Latin America. Chapter 1 25

Intellectual property rights n Possible deterrents? n WTO member countries are to respect international patents, trademarks and brands (TRIPS –Trade related intellectual property rights are to be implemented according to the Uruguay Round 1994) n As a WTO member, China is taking steps to enforce intellectual property rights Chapter 1 26

Conclusion n n International finance has an additional layer of complication that involves currency risk and conversion, different laws, regulations, languages, and business practices Today, however, world production and trade are global in nature Therefore, financing is also global This leads to less market segmentation, more liquidity, and greater efficiency in world capital markets Chapter 1 27