Portfolio Management and Wealth Planning【Reading 17】 following, statements, regarding

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Which of the following statements regarding a funding shortfall is most accurate? A funding shortfall is when the:

A) market value of pension assets is less than the market value of pension liabilities.

B) present value of pension assets is less than the present value of pension liabilities.

C) pension assets on the balance sheet are less than the pension liabilities on the balance sheet.

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Funding shortfall means the market value of pension assets is less than the market value of pension liabilities.

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Which of the following statements is least accurate regarding the problems associated with an asset/liability mismatch and funding shortfall?

A) Asset/liability mismatch is a bigger problem than funding shortfall because the risk due to the pension assets being invested in equities does not appear on the balance sheet.

B) Funding shortfall is a bigger problem than an asset/liability mismatch because most firm's pension plans are underfunded.

C) The asset/liability mismatch is a bigger problem because the size of many firm’s pension assets is larger than the overall market capitalization of the firm.

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Asset/liability mismatch is thought to be a bigger problem because of the risk associated with the pension assets being invested in equities; this risk does not show up on the balance sheet. Also there are a significant number of firms whose pension assets are larger than the overall market capitalization of the firm in which case the pension assets add a significant amount of risk to the firm. Most firms are eliminating their defined benefit plans in favor of defined contribution plans.

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Which of the following statements regarding sources of risk to the firm is most accurate?

A) Both asset liability mismatches and funding shortfalls are equal sources of risk for firms.

B) An asset liability mismatch is considered to be a bigger source of risk to the firm than a funding shortfall.

C) A funding shortfall is considered to be a bigger source of risk to the firm than an asset liability mismatch.

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A funding shortfall is when the market value of pension assets is less than the market value of pension liabilities. Although this is a concern to sponsors of pension plans a bigger problem is thought to occur due to the asset liability mismatch which is when the pension assets are invested in equities while the pension liabilities have fixed income debt like characteristics. Asset liability mismatch is a bigger risk for several reasons: 1) the balance sheet does not reflect the asset allocation of the pension assets whereas the balance sheet would indicate whether or not the pension plan was underfunded, 2) if the equity markets decrease in value while interest rates decrease the pension assets will also decrease while the pension liabilities will increase in value, 3) it’s not uncommon for a company’s pension assets to be larger in value than the overall market value of equity of the firm and if those assets are invested in equities this will contribute a significant amount of risk to the firm.

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When the pension assets are included in the weighted average cost of capital (WACC) which of the following statements is most accurate?

A) The WACC will decrease and the firm will be able to accept more projects, increasing the overall value of the firm.

B) The WACC will increase and the firm will accept projects with a higher rate of return, increasing the overall value of the firm.

C) The firm’s debt-to-equity ratio will fall.

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When the pension assets and liabilities are included in the overall WACC the WACC will fall because the total liability and equity beta will be reduced since the pension liabilities have a risk beta of zero. The total assets beta equals the total liabilities and equity beta so when the total liabilities and equity beta decreases this will also decrease the total assets beta with an associated decrease in the operating assets beta. The lower operating assets WACC will reduce the firm’s hurdle rate allowing it to accept more projects thus increasing the overall value of the firm. The increased pension liabilities increases the firm’s debt-to-equity ratio since the pension liabilities are viewed as debt.

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A firm increases the risk of its pension assets by investing those assets in a higher percentage of equities. The amount of equity capital needed to maintain the same equity beta and the resulting debt/equity ratio respectively would:

Equity Capital

Debt/Equity

A) Increase Decrease

B) Decrease Increase

C) Decrease Decrease

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A higher percentage of the pension assets invested in equities will increase the risk of the pension assets resulting in a higher total asset beta. To maintain the same equity beta there must be a decrease in risk in the capital structure of the firm. To accomplish this the amount of equity issued must increase along with a decrease in debt financing thus the debt/equity ratio will decrease.

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To maintain the same equity beta after decreasing the percentage of pension assets invested in equities a firm would need to:

A) increase the amount of risk in its capital structure by using more debt financing.

B) increase the amount of risk in its capital structure by using more equity capital.

C) decrease the amount of risk in its capital structure by using less equity capital.

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Decreasing the percentage of pension assets invested in equities will decrease the risk of the pension assets decreasing the overall total asset beta. To maintain the same equity beta there must be an increase in risk in the overall capital structure of the firm which would be accomplished by using more debt financing and decreasing the amount of equity capital.

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If a company changes its allocation of pension assets to be invested more heavily in bonds while maintaining the same equity beta, what is the likely effect on the:

Total asset beta?

Debt/equity ratio?

A) Decrease Decrease

B) Increase Decrease

C) Decrease Increase

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As the pension assets are invested more heavily in bonds the pension asset risk will decrease causing the total asset beta to decrease. To keep the equity holders and creditors satisfied that the overall risk of the firm has not changed there must be a corresponding increase in debt financing thus the debt/equity ratio will increase.

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When the pension asset allocation changes which of the following is least likely to occur?

A) The higher the investment in bonds in the pension assets the more debt the firm will need to issue to maintain the same overall level of risk in the firm’s capital structure.

B) The total value of liabilities and equity stays the same even though the amount of equity capital changes.

C) The equity beta will change while the total value of firm assets remains constant.

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The firm’s equity beta remains the same as the asset allocation in the pension assets changes but the total asset beta, equity capital, debt financing, and debt-to-equity ratio will all change. As the percentage of pension assets invested in equities increases the total asset beta will increase and to maintain the same equity beta the level of risk in the firm’s capital structure must decrease, thus the firm must issue more equity and reduce the amount of debt financing hence the debt-to-equity ratio will decrease.