This is very conflicting, maintain optimal WACC by adjusting D/E (How come?)

CFA Level III
#1

This is really confusing and conflicting.

Let say we increase equity investing in pension asset. This will lead to increasing Pension asset beta and also the Total asset beta and the firm overall equity risk.

Here they say we can avoid this from happening by decrease D/E ratio, this means increase Equity weight.

According to the 2 below fomular, this is not true

  1. Beta(equity) = Beta (operating asset) ( 1+ D/E) . This means hold Beta equity constant, decrease D/E will increase operating asset beta -->increase firm risk --> Increase WACC

  2. Total asset beta = Weight Equity * Beta equity (because beta of debt = 0)

So Decrease D/E means Increase in Equity weight --> Increase total asset beta --> Increase firm risk

I dont see how decrease D/E ratio can help to offset the effect from increase equity investing in Pension asset??

Anyone can explain this, please?

#2

Think it alternatively.

In general, a company with a lower D/E ratio is considered more financially strong/safe. Overleveraged companies are perceived as more risky.

By decreasing D/E ratio through the issue of equity, you effectively lower the risk of company (i.e., you have a lower equity beta).

In sum, when you assume a higher risk on the asset side (by equity investing in pension assets) you can offset it by decreasing risk on the liability side (by issuing equity and decreasing D/E ratio and subsequently lower equity beta).

#3

Well, it is nothing to question about if think of it that way. The thing is the fomular doesnt prove the conclusion. If the question ask you about effect on WACC instead, you will see that decrease D/E increase operating asset beta --> Increase WACC . No way a reducing in firm risk will increase WACC right ? That’s why i got confused.

#4

Think about it this way instead,

Your leveraged equity beta is equal to your total asset beta, correct?

If you increase the equity in your pension assets, then your total asset beta will increase. This will increase your equity beta, holding debt constant.

To reduce the equity beta to what it was before, you’ll need to deleverage so the risk is spread out over a larger equity pie.