Explanation

Effect on cost of capital due to exchange rate risk: Foreign cash flows need to be converted in home currency, in order to be considered as revenues. Fluctuations in the currency exchange rates may create variances in the actual and the budgeted foreign cash flows. As a result, an additional risk premium should be added to the actual cost of capital to determine the effective cost of capital of a foreign project. However, if there is a fall in the value of foreign currency with respect to domestic currency, it will lead to exchange gain on cash flows. If such exchange gain is adjusted against the cost of capital, it will lower the overall cost of capital effectively.
 
Effect on cost of capital due to political risks: Political risks mainly arise in form of restrictions on repatriation of earnings or for expropriation of assets by the host government. Repatriation restrictions though affect the cash flows, but it will not affect the cost of capital directly. However, to protect the business from the risk of expropriation, the company usually insures all the assets in the foreign country. This creates additional cost in the form of insurance premium. Thus, the effective rate of cost of capital increases.

Verified Answer

The domestic rate of cost of capital gets indirectly affected by exchange rate risk and political risk. Additional risk premium needs to be added to cost of capital due to fluctuations in exchange rates. Political risks require business to bear additional insurance costs, which indirectly increase the cost of capital.