Why does having a Pension Plan lower the WACC

CFA Level III
#1

Is it because the pension plan holds assets with betas less than one?

Page 62 - 68 of Schweser book 2

#2

Total asset beta (after incorporating Pension assets ) = wt avg of pension plan’s asset & operating asset

If Pension plan asset contains majorly debt so lower weight of equity in portfolio.

Since Asset beta of pension asset = Weight of equity * Equity beta. So lower asset beta

also if asset beta of pension asset is less than the operating asset so after incorporating both (operating & pension assets), they should have used lower WACC than only considering operating assets. So they need to lower WACC.

#3

Yep, so more debt in the cap structure lowers the overall WACC. Thanks for the reply.

#4

wouldn’t it also be because often pension plans are tax exempt?

#5

i guess not as tax doesn’t come into play in beta calculation.

#6

Do we need to do these calculations? If i remember correctly, the los does not mention this…but i may be wrong

ty

#7

I don’t know. The CFAI EOC on page 525 tests the calculations.

Even if you don’t have to do the calculations, you sort of have to know the formulas to ‘explain’ what is asked in LOS 17b&c.

#8

it was in one of the morning tests a few years back… not sure if the LoS “command” word has changed or not. I would not risk it, know the math. I had tons of trouble with this topic because of the terrible wording, making a table with assets on one and and liabilities/equity on the other is key.

#9

We can easily get the following two equations from the text book:

1, (Operating Asset)*(beta of OA) = E*(beta of equity) 2, (Operating Asset)*(beta of OA with Pension plan) + (Pension Asset)*(beta of pension asset) = E*(beta of equity)

From the above two equations, and considering beta here is postive, we can have:

(Operating Asset)*(beta of OA) > (Operating Asset)*(beta of OA with Pension plan)

Then,

(beta of OA) > (beta of OA with Pension plan)

So WACC=Rf+(beta of OA)*(market premium) is overestimated, no matter how large the beta of pension plan is, as long as the beta is a positive number.

#10

My reasoning is abnormal and it only helps me to understand the concepts.

rahuls’ answer is the answer CFAI would expect, and I would use it in the exam – using (weight of OA) instead of (OA).

#11

LOS is not changed, its does not ask calculate. I tell you many of LOS does not ask to calculate yet question ask us to calculate in the exam.

Like this pension plan’s asset case, Two bond duration hedge, Multi period attribution analysis etc.

Simply neglecting these may cost us a lot.