Q12.2, Schweser practice exam 1 pm. I understand the solution to the original question but would be confused if I change it a little bit. “Because the beta for a firm’s pension assets will usually be higher than that of the firm’s operating assets, incorporating the firm’s pension plan into its wacc will usually result in an *** DECREASE *** in the wacc”. Is this now correct or not? - sticky
I think so
pension asset beta usually greater than firm’s operating asset beta? Why? - sticky
I think irrespective of whether pension beta is greater or lower than firm’s operating asset beta, including pension asset & liability will reduce WACC. WACC = Rf + Beta of operating asset * (Rm - Rf) Once pension asset is included, beta of operating asset will drop. This is bcoz - beta of total asset is constant (since this is equal to wt of firm’s equity*firm’s equity beta) - operating asset beta is total asset beta - pension asset beta (aft applying wts) - BN
BN Wrote: ------------------------------------------------------- > I think irrespective of whether pension beta is > greater or lower than firm’s operating asset beta, > including pension asset & liability will reduce > WACC. This is actually what I thought initially but then I find this may not be the case all the time — and that’s why I can asking this question. See arguements below. > WACC = Rf + Beta of operating asset * (Rm - Rf) > > Once pension asset is included, beta of operating > asset will drop. I can only say beta of TOTAL ASSET will drop (arguements below). Will the beta of operating asset drop as well? >This is bcoz > > - beta of total asset is constant (since this is > equal to wt of firm’s equity*firm’s equity beta) no. beta of total asset is actually reduced, since inclusion of (zero beta) pension liabilities on the right side of the balance sheet will decrease the % of the existing equity (say from 60% to 50% of total of right hand-side). Result is that total asset beta will decrease. > - operating asset beta is total asset beta - > pension asset beta (aft applying wts) Yes, but weight of operating asset has decreased as well. For example, Without pension asset: If OA beta = TA beta = 1.5 (beta of OA) x 100% (weight of $10 OA) PA $90 included: If TA beta now drops to 1 and PA beta is 0.2, then 1 = 0.1 x OA beta + 0.9 x 0.2 ==> OA beta = 8.2 which has increased from 1.5 That’s why I guess an assumption to the whole discussion is that “pension asset beta is greater than firm asset beta”. Which means the “if” in my original question must be true — a common case in practice? Not sure if I am right though. Comments on this appreciated. - sticky
I agree with you. What you’re saying is if you add on a pile of pension assets that are primarily invested in fixed income (hence low beta) then it could cause the operating asset beta and WACC to increase. How that relates to your original question, I don’t know. But your “discovery” is important – let’s say exam gives you the following: Which of the following is true? A. Not considering pension plan always overstates WACC. B. Considering pension plan assets and liabilities decreases debt/equity ratio. C. More projects get rejected when asset beta is adjusted for pension plan. D. Not adjusting for pension plan can sometimes result in accepting projects that should have been rejected.
TooOld4This Wrote: ------------------------------------------------------- > Which of the following is true? > > A. Not considering pension plan always overstates > WACC. > B. Considering pension plan assets and liabilities > decreases debt/equity ratio. > C. More projects get rejected when asset beta is > adjusted for pension plan. > D. Not adjusting for pension plan can sometimes > result in accepting projects that should have been > rejected. If pension asset has higher beta than firm assets (and this is what CFAI wants us to say), then A and B are true, C and D are false. - sticky
B. Isn’t always true… Say Debt is 100 and Equity is 200 so D/E is 0.5 Now we haev 100 in Pension Liabilities and 100 in Pension Assets So Debt is now 200 and Equity is 200 (right?) so D/E is 1.0 now… What did I miss?
A is not true, because of the word “always”. As sticky pointed out, adding low beta pension assets could actually increase the operating asset beta, thus increasing WACC. In fact B can be true in some cases and false in some cases, it depends on size and funded status of the plan. If you add an evenly or poorly funded plan, you will worsen (increase) D/E. But if you add a big enough, well funded enough (+100%) plan, you could reduce (improve) D/E. C is false. D is the only one that can be true. Again, getting back to sticky’s point, sometimes, if the conditions of the plan are right, accounting for the pension plan assets/liabs will increase the oper asset beta, raising the WACC. Before making this adjustment the WACC was too low, allowing mgnt to greenlight projects that they really shouldn’t have. The point I was trying to make is that the reading makes two really big assumptions: 1. all pension plans are unfunded 2. all pension plans are invested in equities Both are generally true, but not always true. I don’t necessarily agree with sticky that CFAI wants you to answer assuming these are absolute truths. I personally will answer knowing what I know, and if the issue comes up on the exam, I’ll make sure to point it out to CFAI as part of my answer (if in the written part) or afterwards.
I thought that the plans were fully funded. The problem is the inclusion of a higher % of equities in the plan assets, which in turns whacks the WACC out of line. If the plans are unfunded, then how will WACC account for unfunded pension liabilities?
I think that including Pension Assets will always lead to a lower WACC because now the operating beta represents a smaller % of the overall firm beta. Someone please correct me if I’m wrong.
Usually adding pension assets lowers the firm’s WACC. COuld someone provide clean definitions of: total asset beta operating asset beta Is the operating asset beta the number you typically see in the CAPM? I always fumble on the formulas in this section.
Sorry the first big assumption of the article is that all pension plans are either 100% funded or underfunded. The results are different when the pension plan is overfunded. PJ, what you’re saying isn’t true if pension plan assets have a really low beta. Play with the example (using lower equity content) and you’ll see.