Ok, just getting to the end of SS# 5 and I can't for the life of me figure this out. First real point of frustration so far so I guess thats good.
When you calculate operating asset beta before pension assets, why would it change later?
I understand total asset beta will change because you are bringing in the pension assets, but I don't understand how operating assets change when their value doesn't change. To me it seems that the only thing that should change is their weighting in calculating total asset beta.
Any help with this?作者: susana 时间: 2011-7-13 16:32
traditional balance sheet - use Debt (with a beta of 0), Equities with the Equity Beta
and calculates the Asset Beta (Assets are only the Operating Assets).
Since the assets only have operating assets - asset beta = operating asset beta.
With the Economic Balance sheet: (assuming Pension Assets = Pension Liabs -- fully funded pension plan).
when you introduce the pension assets - total assets increase, and total balance sheet beta changes since
Operating Asset * Op Asset beta + Pension assets * Pension assets beta = Total Assets * Total Asset beta.
As a result of introduction of the pension asset beta and as a result of the above equality - operating assets beta changes.
CP作者: mik82 时间: 2011-7-13 16:32
Very much appreciate the explanation CP.
You don't have to continue with this, but I'm still stuck on this point. The beta of the operating assets doesn't seem like it should change as long as pension assets are broken out (which they are in most examples). This would lead me to conclude that the operating assets (not total assets) haven't changed, and therefore why should their beta.
I understand the formulas above, it just seems like in your last one formula, the op asset beta shouldn't change from when you calc'd it before adding pension assets. Pension assets is separate when computing total asset beta. I agree that the total asset beta changes, but I think it should be because of the weight. You aren't actually adding anything different to op assets other than their effect on total asset beta. Those same assets' beta doesn't magically change. Its effect does though.
Does that even make sense?作者: nannan66 时间: 2011-7-13 16:32
I think this can seem to be confusing because we were taught in level 2 that the risk level of assets are not affected by the capital structure (i.e. the asset beta remains the same no matter how much debt is used in the capital structure).
The point of this exercise is that we can calculate the beta of total assets. First, we find the beta of total assets with pension assets and liabilities included. Because we know the beta of the total assets and the beta of the pension assets, we can then back into the implied beta of the operating assets.
This formula directly relates to the risk budget. Point being that a firm can assume more risk in its core business depending upon the how the pension portfolio is constructed. This would implie more risk in operating assets, but the same overall level of risk for the firm.
This did not click for me at first, but then I had an "ah ha" moment. Just have to step back and think of the big picture here.作者: bkballa 时间: 2011-7-13 16:32
pension assets are not included at all. so based on that aspect - the operating assets that were calculated would by nature have a higher beta. Additionally what Mr. Merton is trying to say is - all of this risk (beta) is being assigned to the operating assets - hence to the WACC.
when pension assets (which are part equity and part fixed income) is included - the total beta of the firm's assets reduces (since the equity beta is spread out over a larger base (now including pension liabs)).
pension assets beta is known. total asset beta now gets apportioned between the pension and op assets - so op assets beta will change.
weight is one aspect of it all. but the other bigger part is a new component being included in the calculations (which affects the weight as well).
since the total asset beta changed, the operating asset beta will also change.
it is not a weight thingie alone. (take it for what its worth).
CP作者: mar350 时间: 2011-7-13 16:32
I'll let this one be. Thanks for the input fellas (assuming), my mental block is still somewhat hung up on the point WorldsGreatest made about betas not changing despite capital structure. I see what both of you are saying and it makes sense that equity beta is spread over a larger asset base with pensions included.
I don't like the fact that "pension asset beta is known." Just a minute ago before we added pension assets, operating asset beta was known. Now suddenly we are recalculating it. ARGH!!!!
I can follow the steps and even see the big picture of why it makes sense that WACC goes down. But this little step in the calculations is just not getting me to "ah ha" land. Ah well, sometimes you have to muscle through without 100% understanding.
Thanks for your time, now get back to studying. I already feel bad taking the amount of time I have! Best of luck.作者: cityboy 时间: 2011-7-13 16:32
this also relates to the fact that once the operating asset's true risk level is known - in order to implement - either leverage would need to be reduced or increased depending upon how the firm wants to move (100% equity on Pension assets or 100% bonds on Fixed Assets). When 100% Equity is pushed on the Pension assets - they become more risky. In order to keep the Equity Beta of the firm the same as before - you would now need to reduce the total risk of the firm - which would only be possible by reducing Debt - so your leverage needs to go down.
Risk Budget is what it is in the final analysis.
CP作者: former 时间: 2011-7-13 16:32
CP and WorldGreatst have given an elaborate explanation, which is already complete. I will just attempt to get you your 'ah ha' feeling. I got mine the next day after doing the reading
As WorldGreatest said, Risk of Project is independent of Capital Structure it is funded with. The catch is, risk of Project may be independent of Capital Structure, but risk to Shareholder's Equity is NOT. Risk to shareholder's Equity comes from Risk of Project PLUS the risk added by Financial Leverage.
Now, in this case, we can take that firm has 2 Projects:
1. Shareholder's Equity is UNCHANGED, whether we use Traditional B/S or the Modified B/S including Pension Assets and Pension Liabilities.
2. Market has already priced the stock based on Risks from both the Projects A and B. meaning, Equity Beta (Risk to Shareholder's Equity), already includes risk of Project B as well. (Market is smart and it already looks beyond your traditional B/S)
Next,
Case 1: Traditional B/S
We unlever Equity Beta to get Intrinsic Risk of Project A. Since, Equity Beta is already having risks from both Projects, if after unlevering, we put all that risk on Project A, it will be more than what the Project A actually has. Thus, in this case, Project A's Beta is overestimated and hence its WACC is overestimated.
Case 2: Modified B/S
We unlever Equity Beta to get Risks from Both Projects. Then we weight it accordingly between Project A and Project B. In this case, we get true intrinsic Risk of Project A, which is lower than as calculated in Case 1. Hence, WACC for Project A is also lower.
That is how and why Beta of Operating Assets (project A) changes.
Hope this helps.作者: Darien 时间: 2011-7-13 16:32
But, why not keep Op Asset beta constant? Then Equity beta will increase.
Sponsoring a pension plan is like adding a risk for shareholders to me. It benefits plan participants, not shareholders...I get confused again.作者: Unforseen 时间: 2011-7-13 16:32
equity beta is constant.. it is the other way around.
now with equity beta constant - because of the pension plan assets - your operating assets beta (risk) reduces.
so now with that - you are better positioned to give the risk its due. without that - your operating assets are too risky, higher beta, higher WACC... (traditional without pension assets).
with inclusion of pension assets - operating assets beta is lower - so WACC is more reasonable for all your projects evaluation...
pension plan risk needs to be included appropriately to the pension assets - not to the operating assets .
