Why might the cost of capital for a foreign project differ from that of an equivalent domestic project? Could it be lower?

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Why might the cost of capital for a foreign project differ from that of an equivalent domestic project? Could it be lower?

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Why might the cost of capital for a foreign project differ from that of an equivalent domestic project? Could it be lower?

Explanation & AnswerSolution by a verified expert

Explanation

Foreign cash flows are needed 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. So, an additional risk premium should be added to the actual cost of capital to determine the effective cost of capital of a foreign project. Thus, due to constant changes in the value of domestic currency in relation to the value of foreign currencies, there can be variations in the cost of capital of domestic project and foreign project.
 
However, the cost of capital of foreign project can be lower than that of a domestic project due to following reasons.

If the inflation rate in the foreign country is lower than that of the home country, the borrowing rate may also be at a lower side. As a result, a multinational corporation can borrow more funds at a cheaper cost.
If the value of home currency is stronger than the value of currency of the country in which the project is operated, then the foreign cash flows generated will be of higher amount when converted to home currency. This will lead to foreign exchange gain. Thus, such gain can be adjusted against the cost of capital, which results in lower cost of capital for foreign projects.

Verified Answer

The cost of capital of a foreign project may differ from that of a domestic project because of additional risk premium due to fluctuations in currency exchange rate.
Yes, the cost of capital of a foreign project can be lower than that of a domestic project.

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