I’ve actually got the calculation parts down pat and I understand that whenever the pension assets are heavily weighted in Equities, you need to adjust by reducing Debt in the capital structure in order to keep the overall beta the same. The question I have is how are you guys explaining the impact of including Pension Assets/LIabilities on both Total Asset Beta and Operating Asset Beta? I understand that by not including Pension Assets/Liabilities, the firm’s operating asset beta is over-stated and as a result, projects will be rejected when in fact they should be accepted. However, how does including the Pension Assets/Liabilities reduce the operating asset beta? Is it because by taking into consider the risk of the pension assets, the actual risk of the operating assets is a smaller fraction of the firm’s overall risk/beta?
Well your adding Liabilities to the balance sheet which have a Beta of 0 and on the Other side you are adding Assets which will have a Beta of <1 assuming your not 100% invested in equitites.
Beta of total asset = wt avg of operating asset beta + pension asset beta ---- (1) Beta of total asset = equity wt*equity beta (since liab beta = 0) — (2) So when pension asset & liab is included in balance sheet, from (1) —> operating asset beta will now be lower (beta of total asset = const from (2) ). This in turn leads to lower WACC. Essentially, by including pension asset & liability, the operating asset’s beta is a smaller portion of the total asset beta. - BN
BN… exactly… okay, got this down. Thanks
what is equity wt? is it equity/total assets?
It assumes there is not equity in pension plan. So the equity is still the firm’s equity (balance sheet figure), the NEW total asset is the combination of operation asset and pension asset (which is larger than operation asset only), therefore makes equity % a lower % overall.