I tried to read some posts before posting a new topic, as clearly this is not new.
Unfortunately, after much practice I am still confused in calculating WACC.
I think I understand Total Asset Beat, and how including pension assets and liabilites decreases it. This calculation is straightforward.
However, when going into the final stage of calculating WACC… I seem to miss a step.
WACC = RF + Beta(MRP)
But way is the beta in this equation different to the Beta I calculated previously when incorporating pensionable funds, etc???
As you can tell, I’m out of WACC - - and would appreciate an example or insight.
I had trouble with this for a while too. Here’s how I finally figured it out. Create yourself a simple balance sheet with the pension assets and liabilities on their respective sides. Then calculate the L&E beta. You know that total asset beta must equal total L&E beta, so you can back the operating assets beta out with the information given. Implicit in all of this is that the market knows about the risk in the firm’s pension and prices that risk into the equity accordingly.
I’ll give it a shot looking at it this way.
Is this required - there’s no calculate LOS?
We only need to understand that failing to bring pension assets and liabilities onto the balance sheet results in an incorrect allocation of total firm risk -> Total Firm Risk = Operating Risk + Pension Fund Risk, but if you don’t include the Pension Fund then your risk budget is 100% allocated to Operating Assets which makes them look riskier than they actually are, especially if the Pension fund is highly concentrated in equities. This results in a higher discount rate (project WACC) for marginal operating investments and lower NPVs -> more likely to forego projects that actually add value.
You have to calculate too. Check out 2009 AM.
I think we should know how to do the calculations.
See Vol. 2 pg. 495 for practice questions (reading 17.
Maybe I can explain in an easy way:
Add pension liability and assets to your the balace sheet
total equity will drop since Equity is less now when adding pension liability (E/(D+E)*Bequity)
Go to calcualte operating asset beta, which is operating (asset beta*operating assets/total assets + pension assets beta * pension assets / total assets) = total assets (the one you calculated from step 2
Use operating asset beta in CAPM
The questions at the end of the book are really poorly worded. Look at question 2:
- The beta for total (operating) assets, including the pension plan assets and liabilities is closest to: - when they say total (operating) assets … what do they mean exactly? Do they want total asset beta or operating beta? -> seems they wanted total asset beta, in which case why put the operating in brackets. - when they say ‘including’ here, they mean total asset beta (operating + pension assets) Question 3, again they say ‘including’, but their definition in this case means including pension assets and liabilities on the balance sheet I really cant tell if they want us to include pension assets in the sense that we include pension assets with operating assets to get total assets (as they mean in Q2) or if they want us to include these accounts on the balance sheet and focus on just operating asset beta. If you have a way of working around the language, please help.
What’s the logic behind plugging the operating asset beta in the CAPM equation to get WACC?
Does that disregarding the cost of debt and the tax rate?
If not, how would a change in cost of debt flow through to WACC with this method?
I’m hung up on something… why are they referring to it as “operating” asset beta if it includes pension assets and liabilities? Wouldn’t that be the total asset beta?
I think I would understand this topic if I could get a clear definition of the terms. The coverage of this in the book is horrible.
I agree the book material is poor.
When they say total (operating) assets including pension assets, ignore the (operating) part. They mean total.
As for cost of debt in determining WACC, they don’t use cost of debt at all in this chapter. It’s all presented in beta terms. WACC is completely determined by weighted systematic risk and risk free rate.
Total asset beta confuses the situation
The operating asset u calc from the clustereff is the one u use in wacc
Don’t need to know how to do this IMO
You do, IMO.
Anyway, always calculate TOTAL asset beta as equity weight * equity beta; then subtract weighted pension beta (weighted by assets); then divide by weight of operating assets to get operating beta. Then calculate WACC = Rf + op ass beta * MRP.
Know that the market will implicitly increase the equity beta and hence the total asset beta when it perceives that pension assets are risky (high beta.) There is no calculation for how this happens.