“pension assets can be a large part of the overall assets of the firm and by not including these assets in the WACC, the overall risk of the asset side of the balance sheet my be understated. Likewise, by not incorporating the pension liabilities into the WACC, the level of the firm’s debt is understated and the leverage ratio is also understated. When the WACC is adjusted to reflect the level of pension assets and liabilities, it will DECREASE???” can’t seem to wrap my head around this. I get that debt has a lower cost of capital than equity, but increasing leverage and increasing risk of the asset side of balance sheet…you would think should INCREASE the WACC rather than reduce it Also seems somewhat contradicting with another part of the readings where if the pension beta is high, the firm needs to reduce D/E to reduce the operating beta to balance the two. Likewise, if pension beta is low, company needs to increase D/E to increase operating beta to balance the two. everything above is straight from the book…cant figure out how WACC decreases
I think this is a new reading and agree it was very wiered. Thus the prep book is not covering it well either.
I believe the reason why WACC decreases after taking into consideration pension assets/liabilities is that when determining which projects to accept/reject, we are only considered with the “operating asset beta”. This measure is overstated when excluded the firm’s pension assets/liabilities. By including them, the operating asset beta is lower, thereby resulting in a reduced WACC. At least that’s my understanding. PJStyles