Session 5, reading 22- Page 199. I understand that Pension Plan Assets are less risky then Firm Assets therefore if you exclude them from a Wacc calculation, you are overestimating Wacc, which could lead to rejection of possible profitable opportunites. What I don’t understand is WHY Pension Assets are less risky than firm assets, and WHY for : “ PLAN: As D/E Increase, Risk Decreases” This doesn’t make sense to me.
when D/E for a plan increases you’re investing in more fixed income and less equity. fixed income (DEBT in this context) is less risky and therefore reduces the risk of the total assets held by the entity. Also, if you’re properly using debt to match your pension liabilities through an ALM approach you’re pension plan is less risky. If i finance my entire pension plan with equity i’m going to have shortfall risk and furthermore, there will be higher volatility of the assets i hold (equities) and as a result the risk of my firm increases. Does that make sense?
Purelife… very much appreciated. I was getting confused with “debt” as in company issuing debt. Thank you
Good explanation and very enlightening. My reply is that due to the higher cost of equity and lower cost of debt (and also helped by the tax shield for borrowing), the initial effect of leveraging will acutally reduces WACC but beyond a point, the higher gearing will actually increases financial risk and hence WACC will rise.