Should firms require higher rates of return on foreign projects than on identical projects located at home? Explain.

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Should firms require higher rates of return on foreign projects than on identical projects located at home? Explain.

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Should firms require higher rates of return on foreign projects than on identical projects located at home? Explain.

Explanation & AnswerSolution by a verified expert

Explanation

A foreign project of a multinational corporation is exposed to many risks. While comparing the returns from a foreign project with the returns from a similar domestic project, the cash flows from the foreign projects are subject to currency conversion risk.
 
A US multinational corporation, whose majority of the shareholders are U.S. residents, will be interested in determining its cash flows in dollars. Foreign cash flows are subject to exchange rate risks and U.S. currency is one of the strongest currencies. Thus, a foreign investment needs to earn more to match up with the cash flows of similar domestic projects. However, exchange rate is not the only factor that affects the foreign income, political risks and taxation risks also add up to the burden on cash flows Thus, considering the overall risk return profile, a foreign project has to earn an additional risk premium.
 
However, the main motive of entering the foreign markets is the expansion and diversification of the business. A foreign market provides larger business opportunities which do not prevail in domestic markets. Thus there is a substantial difference in the quantum of foreign and domestic cash flows. A foreign project generates higher cash flows, which may nullify or even override the exposure to risks.
 
Thus, whether a foreign project should earn a higher return as compared to identical domestic projects, also depends on the balance between the risks and opportunities in the foreign market. If risks in foreign markets are higher  in comparison to the opportunities, then it should definitely earn a higher return.

Verified Answer

No, there is no definite rule that a multinational corporation should earn a higher rate of return on foreign projects, than on identical domestic projects.

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