This freakin session takes me hours to understand 1 page. It’s probably due to my mix up of concepts ( i.e mixing up Equities in plan assets with shareholder equity etc…) In any case, here is straight from schweser: “When a firm’s PENSION ASSETS are weighted more towards EquitIES, the result will be increased risk in its pension assets with an accompanying increased asset beta” -Ok this is pretty clear to me; so if they are invested more in equities, the beta is higher which means higher risk in the Pension Plan Assets overall. “This will case the total ( i.e Overall) asset beta to increase and the risk of the firms equity capital to increase” - Ok, it starts getting just a little bit murky for here. When they say overall, I am assuming they mean FIRMS assets + PENSION assets together, total asset beta will increase, which makes sense since you are adding higher beta pension assets to the Firms assets which equals a total overall higher asset beta. But the 2nd part about the equity capital risk to increase? “To keep this from happening, management will need to decrease the amount of DEBT in the FIRMS CAPITAL STRUCTURE” -OK Here I am throwing in the towel. I assume when they say to keep this from happening, they are referring to the equity capital risk of increasing. BUT what really confuses me from all this is ( HIGH BETA PENSION ASSETS ( DUE to higher allocation to equities in plan assets) when added to FIRMS assets will be a higher equity/asset beta. So to REDUCE this, the SS# is telling us to reduce DEBT, but why? Why dont we reduce the FIRMS equity holdings??
Capital structure(operating) is considered more risky when a firm has high debt / equity ratio. So if pension fund increases firm overall risk … to counterbalance it, operating side should use less debt to reduce the risk, to keep over all risk constant. Hope it makes sense. Cheers
BUT what really confuses me from all this is ( HIGH BETA PENSION ASSETS ( DUE to higher allocation to equities in plan assets) when added to FIRMS assets will be a higher equity/asset beta. Hope my explanation helps. Higher allocation to equities in plan assets ----> increase risk of these ASSETS ----->these ASSETS when added to firms assets ----> increases the overall risk (as risky assets were added) ------> thus increasing the risk of the firms equity capital ----> to neutralize this effect the firm should reduce its debt levels I think you are incorrect in assuming that the pension assets invested in equity increase the firms equity. Disclaimer: I might be totally wrong as i did this quite sometime ago. don’t mean to add to you confusion. Heeral
GetSetGo Wrote: ------------------------------------------------------- > Capital structure(operating) is considered more > risky when a firm has high debt / equity ratio. > So if pension fund increases firm overall risk … > to counterbalance it, operating side should use > less debt to reduce the risk, to keep over all > risk constant. > > Hope it makes sense. > > Cheers GETSET, So your saying from a PENSION PLAN PERSPECTIVE ( Equities - More Risk, DEBT Less Risk) and from a OPERATIONS Perspective ( “ASSETS” ( Debt meaning fixed income investments and Equities) the more the better and “DEBT” here meaning actual external financing such as loans etc… So this make sense then… So if we add more risk to the pension plan by adding more equities, we can counter balance this by reducing risk on the operational side which would mean for example reducing our loans etc. Wow, thanks GETSET !!!
Exactly. Debt is less risky in a pension and more risky in an operating standpoint. If you think about it it makes sense- From an operations standpoint, when viewing debt, you are a BORROWER and more debt is more leverage and more leverage means bigger chance of going bust. In the case of the pension, you are the LENDER of the debt in question. You are getting a return for lending your capital to someone else. As we know, bonds are less risky then stocks. You are on opposite sides of the transaction, so you have opposing views on the risk.
bump… another sorta related question… why is it that the typical effect of excluding the risks from pension assets and liabilities tends to overstate the WACC for operational purposes? Wouldn’t incorporating pension assets/liabilities risk lead to either a higher/lower WACC based on the weights of the equity vs debt on the balance sheets…and how much of an effect the risks from the pension assets/liabilities have on the overall original wacc? or is it always the case that the increased risk from the equity securities ( in the pension assets) has a smaller effect in increasing the overall WACC, than the decreased risk from the debt holdings (in the pension asset)
“or is it always the case that the increased risk from the equity securities ( in the pension assets) has a smaller effect in increasing the overall WACC, than the decreased risk from the debt holdings (in the pension asset)” The above is true most of the time. (I can easily think of exceptions like hitech companies with no debt, whoose wacc goes up by adding pensions assets / liabilities…but this is immaterial to the CFAI exam). So the statement you mentioned is true most of the time.