Why ?
let’s say the plan is funded suplus 0 that means that on the balance sheet you have a 0 net equity created by the fund. but because leverage is assets/equity and assets operational+assets pension> assets operational then the leverage is bigger if you take into account all assets this is USUALLY the case. you would have to have an equity proportion(surplus) equal in % to the equity/assets operational for your leverage to be the same or lower. hope you get it
to try to make it shorter and simpler the proportion of equity in pension plans is rarely as big as the equity proportion in a company on the operational side
Financial Leverage = Debt/Equity Assets - Liabilities = Equity If you add in pension assets and liabilities (lets assume they are the same so equity remains constant) then Debt increases while equity is the same. Thus, higher leverage. If pension assets < pension liabilities, then equity will actually decrease by whatever that difference is. Debt is still higher, and now equity is smaller. Still higher leverage. If pension assets > pension liabilities, then equity will increase by that difference. However, debt increases by the amount of the pension liabilities while equity only increases by the difference. Still higher leverage. Any way you look at it, financial leverage is understated if you exclude pension stuff. Well, I think that is right…
of course this is wrong. pension liab is typically close to pension asset, but lehman brothers can leverage their common equity up by 30 times. what is the consequence of combining them for lehman, suppose it has one?
This is going to get messy but here’s my take: For a pension, what’s riskier?.. equity (owning stock, more volatile, etc), what’s safer? Debt. Ie the more bonds the pension holds relative to equities (think of stocks not equity for the pension), the safer it is. For the firm’s bs, debt increases leverage, cause it’s issuing debt, increasing the d/e ratio. If the firm issues equity, that reduces the d/e, equity reduces the risk of the firm’s balance sheet. Look at the relative compositions of the balance sheet and the pension plan. If the pension plan has a greater composition of bonds than the balance sheet, it’s less risky (lower beta). If the pension plan has more “stocks” (equity!) it’s more volatile and risky, a greater beta. For the pension plan to reduce risk - buy bonds For the balance sheet to reduce risk - issue equity. Please tell me I’m completely wrong if that’s the case, but my reasoning seems to get me to the right answers, which is all I can ask.
it does not need to be so completed here. the definition in CFAI and Schweser is always TA/EQ. The answer is going to be “it depends”.
lol, on what?
delete.
Financial Leverage = Debt/Equity so by NOT including pension liabilities on numerator, and pension assets in denominator we are understating this ratio>??? How about if pension assets/liabilities were equal? then the ratio would be the same ? which would mean the financial levergae ratio would still be understated??? HELP
Think about it. If Pension assets = pension liabilities, then equity remains the same according to (Assets-Liabilities = Equity). But, Debt (or Liabilities) are now higher since we are adding in the pension liabilities but remember equity is the same. So Debt/Equity is now higher (larger numerator, same denominator).
wanderingcfa Wrote: ------------------------------------------------------- > > If pension assets > pension liabilities, then > equity will increase by that difference. However, > debt increases by the amount of the pension > liabilities while equity only increases by the > difference. Still higher leverage. > > Any way you look at it, financial leverage is > understated if you exclude pension stuff. Well, I > think that is right… This statement assumes that the financial leverage ratio of the pension plan > than that of the firm doesn’t it? Say the firm has: A: 10000 L: 9000 E: 1000 Financial Leverage = 9/1 = 9 Now the pension plan has A: 100 PBO: 85 E: 15 Financial Leverage = 9085 / 1015 = 8.95 So, I don’t think you can make that blanket statement unless I am missing something (which has been known to happen).
Bankin’ Wrote: ------------------------------------------------------- > This statement assumes that the financial leverage > ratio of the pension plan > than that of the firm > doesn’t it? > > So, I don’t think you can make that blanket > statement unless I am missing something (which has > been known to happen). Oh yea, that’s right. My mistake. Thanks Bankin. I suppose the CFAI makes that statement because rarely do pension plans have leverage less than their operating assets???