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Unformatted text preview: s make an adjustment for
the additional risk of the foreign project, such as exchange rate risk, inflation risk, and political risk.
The cost of capital is generally based on an assessment of the company's overall cost of capital. First, the
company evaluates the cost of each source of capital -- debt, preferred stock, and common equity. Then
each cost is weighted by the proportion of each source to be raised. This average is referred to as the
weighted average cost of capital (WACC).
There are tools available to assist the decision-maker in measuring and evaluating project risk. But much
of what is actually done in practice is subjective. Judgment, with a large dose of experience is used more
often than scientific means of incorporating risk. Is this bad? Well, the scientific approaches to
measurement and evaluation of risk depend, in part, on subjective assessments of risk, the probability
distributions of future cash flows and judgments about market risk. So it is possible that by-passing the
more technical analyses in favor of completely subjective assessment of risk may result in cost of capital
estimates that better reflect the project's risk. But then again it may not. The proof may be in the
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- Spring '07