chapter  1
10 Pages

Introduction to international finance

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

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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).