This average is referred to as the weighted average

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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 pudding...
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