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Dear tutor, may I know why below statements are wrong?
1) Assume the beta of debt is zero will understate financial risk when ungearing an equity
2) Operational efficiency means that efficient capital markets direct funds to their most productive use
Financial risk is due to the fixed interest being paid – the more fixed interest, the more the risk (as explained in my free lectures).
The amount of the interest depends on the amount of debt borrowing and the rate of interest being paid on it.
Assuming a debt beta of zero assumes that the interest is at the risk free rate. In ‘real life’ debt is not completely risk free and the rate of interest on it will be higher than the risk free rate – so more financial risk. So assuming the beta is zero is understating the level of financial risk.
Operational efficiency can in fact mean several things, but it is never used to mean that capital markets direct funds to their most productive use.
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