When pension asset/ liabilities are included into the operating balance sheet, the WACC of the firm drops. I can understand this mathematically (as detailed in Schweser), but is there a simple qualitative explanation on why inclusion of pension risk would reduce the WACC of the firm? - BN
Its a good question, I was wondering too and still am… But, looking at the material once again I think using WACC is probably a misnomer. They should call it hurdle rate based on beta. If anything WACC should increase upon including the pension liabilities but 'cos the “debt” beta is zero it brings down the “WACC”. I don’t know the answer, but include pension assets/liabilities and I know now WACC goes down…
Look, if treat pension liabiliy as liability. Then the firm equity(as a percentage) will decline. The book use a CAPM approach, they will calculate the beta of the firm, interestly, they assume the debt beta is 0. Only consider equity beta. Helps?
…if I remember right on the material (need to go back and check), they also assume that assets=liabilities in the pension plan. The picture would change if the plan was massively under or over funded.
The material assumes 0 equity in the pension plan==> pension asset = peisnion liabilityl.
There are two points to note to answer your question: First, the mechanics of how WACC is being calculated. Basically, corporate managers look at equity prices to calculate equity beta and then WACC. Implicit in this is the assumption that calculated beta reflects operational risk and only that. Second, it seems markets are smarter and they factor in pension risk in addition to the operational risk in the equity prices. So the beta calculated using equity prices incorporates both the pension risk as well as operational risk ==> we must back out the contribution of pension risk to beta calculated from equity prices. The result is that we are left with lower value for beta that corresponds only to operational risk (i.e. the asset beta) ==> lower WACC.
On the same note, i dont get this: ifi increase my equity in pension plan, to keep same beta overall, why do i need to reduce debt? if anything, i should be reducing equity at the company level to keep same beta.
You are best off setting up an economic balance sheet and playing around with the numbers to see what happens.
needhelp Wrote: ------------------------------------------------------- > On the same note, i dont get this: > > ifi increase my equity in pension plan, to keep > same beta overall, why do i need to reduce debt? > if anything, i should be reducing equity at the > company level to keep same beta. Good question! Schweser and CFAI has some “unreasonable” assumptions. Here are the underlying assumption: 1) In pension asset, use of equity(stock) is MORE riskier than bonds 2) In operational asset, use of equity is safer than use of debt. So. If you use stock in your pension asset, you increased the risk in your overall firm, so you need to balance out your operational asset with less risky financing===>more equity or less debt. Make sense??
Ahaaaa…. Ws thank you for this wonderful insight. Did I miss this because I didn’t read the relevant CFAI text? Anyway this makes more sense now. They already said that there are many companies for which the pension asset is greater than market cap of company. At company level, it is better to raise capital through equity rather than through debt. So if I increase equity in pensions, I need to also increase equity in my total company portfolio. Otherwise, I will be heavily invested in other companies, and also will be indebted to others, while raising little capital based on my own company prospects.
^Actually, Schweser did a decent job of explaing this section.