whos afraid of WACC?? standard, corporate, including, allocation, only

Zesty

General idea: Risk which comes from the pension plans asset allocation should be included in the balance sheet in order to truly reflect the risk of the company (pension assets are shareholders assets and pension risks are corporate risks so they should be clearly shown)

By not including them we are:

1. Assigning the firm’s total risk to its business operations only, when a potentially significant part of that risk comes from the pension fund assets

2. Because the standard analysis does not take account of the pension liabilities, it understates the firm’s leverage ratio

So our problem is:
To make capital budgeting decision we need to estimate expected cash flows and discount those at firm’s WACC, so we understand that if that number (WACC) is distorted then decisions will also be distorted!

Typical effect is: WACC is overstated and we apply a high hurdle rate to projects so we may miss projects that will increase our company’s value!

Its calculation:

WACC is equal to : Rf + β of operating assets(ERP)

So our only problem is finding this β as other two should be given so we have to remember this formula:

Operating asset beta = TWO (just remember the number!)

Operating asset beta = (Total asset beta – Weighted pension beta)/Operating assets weight

And then apply the operating asset beta in WACC = Rf + β of operating assets(ERP)

And finally two classic cases:

1. Equities beta in pension assets is higher than firm’s balance sheet assets so total asset beta should be higher in evaluating projects and in order to keep the same equity beta as before we have to decrease debt so D/E ratio will decrease

2. Equities beta in pension assets is lower than firm’s balance sheet assets so total asset beta should be lower in evaluating projects and in order to keep the same equity beta as before we have to increase debt so D/E will increase

zwjy

yeah this is a beast. run through the EOC problems though a few times and build up your confidence (then get ready to forget that in two weeks)

Analyze_This

this and VWAP calcs are something i am still struggling to master.........hopefully this weekend

cityboy

Does anybody else's screen display: β in the first post?

liangfeng

yup.

can u help me explain asset beta ??how is it the weighted avg of equity and debt beta?? what i understand of asset beta is-- it is the beta of company with no debt . so why its supposed to be the weighted avg equity and debt beta than..... i have reached an impasse... sitting on this small chapter for 3 days now.

Windjammer

@ demmel , yes i seee the same screen display

@superstar , can u explain me the WACC calculation u doing in terms of the capm formula , i see the same being done in the illustration on pg 477 chapter 22 , vol2 of cfa books.

My mind understands: the capm formula , return = rf+ beta( market risk prm) is to take out required returns or cost of equity . the latter is then used in wacc formula... weighted avg of cost of debt and equity. so what's with this wacc and capm formula??

please do reply!

thanks

strikethree

I think it was bonecrusher who once said "I aint never scared of being wack."

jmh530

wake2000 Wrote:
-------------------------------------------------------
> I think it was bonecrusher who once said "I aint
> never scared of being wack."


uhm yah thanks for that one

justin88

rish regarding the formulas

you use the formula to find the operating assets beta which is op assets beta = TWO the one i described above and then you apply this to the CAPM formula to find the WACC....i understand there is some confusion regarding why using this but personally i wont go deeper into this,i think just know these two and the idea of total asset beta which is increased when equities increase in pension assets and decreases when equities decrease in pension assets and it shall be enough....

and asset bet is the weighted avg of the two but debt is always a beta of zero so its the equity beta you are measuring