Copenhagen Business School

FINANCE Corporate

Quiz 3

1)Cash holdings and cash equivalents have a required return equal to the risk free rate. This implies that:

• • Cash holdings are not placed on the security market line (SML).
  • The beta of cash holdings are equal to the beta of the risk free rate.
  • The risk free return must be 0.
  • None of the above.

2. In an investment analysis it is often preferable to use market values instead of book values. However, the company book value of debt is often used instead of the market value of total debt. Why is this?
   • Market value and book value of debt are the same.
   • Market value of total debt is not usually available.
   • You need to pay the book value of debt and not the market value in order to acquire the outstanding debt.
   • None of the above.

It is often difficult to estimate the market value of debt, but we often estimate the market value of debt by using the book value of debt.

3. You are evaluating the riskiness of a project with a high level of fixed cost relative to variable costs.
   • Projects with high fixed costs are risky but it is an idiosyncratic risk, so it does not affect project value.
   • Project costs only affect expected cash flows and does not impact the discount rate for the project.
   • A high ratio of fixed cost to variable cost implies a high level of market risk which decreases project value.
   • None of the above.

4. How can a company affect its cost of capital?
   • The company can switch costly debt for new debt with a low interest rate.
   • The company can obtain a new investment strategy.
   • The cost of capital is determined by the opportunity cost for the investors, therefore the company cannot do anything to change the cost of capital.
   • None of the above.

? New investments can increase or decrease the riskiness of future cash flows. You can most likely not just switch old debt for new debt with a lower interest rate unless something else has changed (i.e. the riskiness of your company).

If you had answered the first one, that would be true as well.

5. Financial economists prefer to use market values when measuring debt and equity ratios because:
   • Market values are a better reflection of current value than historical value.