Foreign projects are subjected to unique risks that are not present in domestic projects. Two different methods have been suggested in the literature to allow explicitly for these additional risks. Which of the following statements is most correct when describing how to adjust for foreign risks?
A) When foreign risks are present in a project, an additional risk premium can be included in the denominator of the valuation equation. That is, the WACC can be increased to compensate for the additional project risk.
B) When foreign risks are present in a project, the cash flows in the numerator of the valuation equation can be reduced by including as expenses the cost of neutralizing the foreign risks, and then discounting the remaining net cash flows at a rate appropriate for an equivalent domestic project.
C) When foreign risks are present in a project, the cash flows in the numerator can be reduced by including as expenses the cost of forward cover to neutralize foreign exchange risks and the premium for OPIC insurance that protects against all other risks. The remaining risk-free cash flows are then discounted at the risk-free rate.
D) When foreign risks are present in a project, the beta for the project can be adjusted upward by the ratio of the standard deviation of the project cash flows to the standard deviation of the market, multiplied by 0.6, or
E) Only statements a and b above are feasible, and b is preferred on theoretical grounds if it can be done.

Question

Foreign projects are subjected to unique risks that are not present in domestic projects. Two different methods have been suggested in the literature to allow explicitly for these additional risks. Which of the following statements is most correct when describing how to adjust for foreign risks?
A) When foreign risks are present in a project, an additional risk premium can be included in the denominator of the valuation equation. That is, the WACC can be increased to compensate for the additional project risk. 
B) When foreign risks are present in a project, the cash flows in the numerator of the valuation equation can be reduced by including as expenses the cost of neutralizing the foreign risks, and then discounting the remaining net cash flows at a rate appropriate for an equivalent domestic project. 
C) When foreign risks are present in a project, the cash flows in the numerator can be reduced by including as expenses the cost of forward cover to neutralize foreign exchange risks and the premium for OPIC insurance that protects against all other risks. The remaining risk-free cash flows are then discounted at the risk-free rate. 
D) When foreign risks are present in a project, the beta for the project can be adjusted upward by the ratio of the standard deviation of the project cash flows to the standard deviation of the market, multiplied by 0.6, or 
E) Only statements a and b above are feasible, and b is preferred on theoretical grounds if it can be done.

Quizplus · Accepted Answer

The Answer of Foreign projects are subjected to unique risks that are not present in domestic projects. Two different methods have been suggested in the literature to allow explicitly for these additional risks. Which of the following statements is most correct when describing how to adjust for foreign risks?
A) When foreign risks are present in a project, an additional risk premium can be included in the denominator of the valuation equation. That is, the WACC can be increased to compensate for the additional project risk. 
B) When foreign risks are present in a project, the cash flows in the numerator of the valuation equation can be reduced by including as expenses the cost of neutralizing the foreign risks, and then discounting the remaining net cash flows at a rate appropriate for an equivalent domestic project. 
C) When foreign risks are present in a project, the cash flows in the numerator can be reduced by including as expenses the cost of forward cover to neutralize foreign exchange risks and the premium for OPIC insurance that protects against all other risks. The remaining risk-free cash flows are then discounted at the risk-free rate. 
D) When foreign risks are present in a project, the beta for the project can be adjusted upward by the ratio of the standard deviation of the project cash flows to the standard deviation of the market, multiplied by 0.6, or 
E) Only statements a and b above are feasible, and b is preferred on theoretical grounds if it can be done.

Foreign Projects Are Subjected to Unique Risks That Are Not