Schweser Exam 1, Afternoon, #12.3

Paraphrasing: If pension plan allocation to equity increased, what should management of the firm do to maintain its current equity beta? Answer: Decrease the D/E ratio, Increase the Amount of Equity Capital, and Total Assets Beta will increase. This is because since equity allocation has increased, we need to reduce risk to the firm by decreasing the debt allocation, which decreases the D/E ratio. I do not understand this answer. Isn’t it true that more equity in the pension–meaning a lower D/E ratio-- means a higher beta? (Because high D/E=more risk for the firm assets, but high D/E=low risk for the pension assets) So since pension beta has increased due to decreased D/E ratio (and thus the total asset beta has increased), don’t we want to increase the D/E ratio to maintain the current equity beta?

I think you confused yourseof rellison. the question says allocation to equity increased in pension plan, which means firm is facing more risk than before. In order to curb this risk we have to make adj to firm cap structure by reducing its capital and thereby naturally increase in equity. your last para should be other way round, pension beta increased due to fall in D/E.

If you invest more of pension assets in equities (read as higher beta) then to maintain a constant WACC we would need to take the leverage down (i.e. reduce the amount of Debt in the capital deployed).