Discount rate on Pension cost

CFA Level II FRA
#1

Reading 23, Q14.

I am sure you can answer this question without looking at the book.

When the discount rate is increased, the pension expense is also reduced. Why wouldn’t the cash flow from operating activity

is also reduced, becoz it is non-cash expense and added back?

Thanks in advance.

#2

Well the reason is,

Increased discount rate will have 2 impacts on 2 components of pension expense:

It will 1/ decrease service cost ( due to higher discount rate, thus lower PV)

2/ increase interest cost

Normally this will apply to non mature fund, that is the increase is smaller than the decrease (above), therefore net effect is the decrease in pension expense. It’s the other case for mature plan: interest cost’s effect will be dominant .

Hope this helps/

#3

Understood that maxmeomeo. Thanks for that explanation.

I am asking why the Cash flow from Operations is low, when the discount rate is increased? I think the cash flow should reduce.

#4

Why wouldn’t the cash flow from operating activity

is also reduced.

For this question im not sure, essentially pension expense in non cash charge and thus should be added back to calculate CFO. THerefore logically speaking, it will reduce the CFO (compare to higher expense)

Any same thought on this?

#5

It should increase CFO if take tax into consideration, just like depreciation. It will increase CFO by (Tax X Depreciation)

#6

The net increase to CFO = t* Pension expense. Because pension expense is lower in this case, the net increase is lower. Thus that makes the CFO lower than the case of higher pension expense ( if low discount rater)