Morning 2009 Question 4

Anyone felt helpless when tryin to solve this part a? I still read the solution and I cant get what theyre taking about… :frowning: depressing.

yes…i think CFAI has no such detailed example?

Not much, i think there’s only 1 vignette.

Guys there is absolutely nothing to be scared about here .

The topic is about leverages you can apply when your pension fund is fully funded.

1.A pension fund fully invsted in fixed income is considered zero systematic risk ( i.e. beta is zero )

  1. For a general pension fund with some amount investe in equities the beta is considered the proportion of equities invested.

  2. The beta of the operating assets used when pension assets are not considered is simply the weighted betas of equity and debt ( usually beta of debt is given as zero , so beta of operating assets without pension assets is simply the equity beta times the weight of equities in the assets ).

  3. Now include pension assets in the total assets . Always draw up the two sides of the balance sheet :

i. Assets ( including assets of the pension fund ) and their betas

ii Liabilities ( including liability of the pension fund ) and Equity and their betas.

Total assets risk is nothing but the sum of weighted betas of each liability and equity component ( right hand side of the balance sheet ) . Calculate this weighted average beta from right hand side and write it down on the bottom line ( Total Assets beta ).

Write the pension assets betas with the assumption that pension beta is nothing but the proportion of the pension fund in equities.

Next re-calculate the operating assets beta by backing out . Operating assets is a term denoting all the assets except pension assets . It is the same component whose realistic beta has been miscalculated when using a standard balance sheet which does not account for pension assets . It is nothing but the balance sheet assets ( liabilities and shareholder equity ) .

The backing out recalculates a realistic beta . It does this more sensibly by allowing leverage in the beta using pension fund assets as a “virtual” lever.Depending on the proportion of the pension fund in equities ( and of course the weight of the pension assets and the weight of operating assets ) you can get a lower , but sometimes a higher beta than indicated in the standard un-economic measurement,

Wt of operating assets * economic beta of operating assets + Wt of pension asstes * beta of pension assets = Beta of total assets * 1

now back out the economic beta bit and calculate the WACC using this.

The theory continues im he CFA text by considering what happens when the pension fund allocates more to equities . Naturally the backout calculation would decrease the operating asset beta and thus the economic WACC would have to be lowered. i.e. if you take more risks in the pension fund , you would have to lower the risks in the operating side by deleveraging ( i.e. reducing the proportion of debt in the balance sheet ).

On the other hand if you lowered the prportion of equities in the pension fund , i.e, swtiched more weight to less risky fixed income in the pension assets , and if you want to maintain the WACC at its present level, welll the beta of operating side of the firm must rise , you can leverage up with debt on the balance sheet and pursue more risky projects or fringe given the same WACC.

Just remember to write the two sides of the balance sheet the assets side and the liabilities+equity side with the right numbers and it is the easiest thing in the world.

^ wow, Jana!

Ok also tell whether the following statement is right…In general after including pension assets toghether with operating asset, the asset beta & WACC are decreased?

I think it totally depends on whether the BETA a,p > BETA a,o or its BETA a,p < BETA a,o…

(BETA a,p = assest beta of pension plan & BETA a,o = asset beta of operating asset)

But IN GENERAL it lower both the WACC & Total Asset beta after inclusion, rt?

yes , since most pension funds are conservatively allocated , the systematic riskiness of pension assets is low ( exam had 0.6 beta which is typical and quite low compared to almost any firm eta which is usually close to or higher than 1 )

The chapter inn the text makes it a point to show that firms are routinely overestimating WACC by ignoring their conservative pension allocations.