Reading 22: Allocating Shareholder Capital to Pension Plans capital, average, adjusted, potential, class

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

B) The total assets beta will increase with an associated increase in the operating assets beta.

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

D) The firms debt-to-equity ratio will fall.

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Answer and Explanation

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 firms hurdle rate allowing it to accept more projects thus increasing the overall value of the firm. The increased pension liabilities increases the firms debt-to-equity ratio since the pension liabilities are viewed as debt.

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CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 5: Portfolio Management for Institutional Investors
Reading 22: Allocating Shareholder Capital to Pension Plans
LOS b: Explain how the weighted average cost of capital (WACC) for a corporation can be adjusted to incorporate pension risk and discuss the potential consequences of not making this adjustment.

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The following information is regarding the Plexi Corporation.

• Plexis equity beta = 2.5
• Risk free rate = 3%
• Market risk premium = 5%
• Debt = $19 million
• Equity = $21 million
• Pension assets beta = .70
• Pension assets = $15 million

The firms total liabilities and equities beta before including the pension liabilities into the balance sheet and the operating assets beta after incorporating the pension assets into the balance sheet would be:

Total L&E beta

Operating assets beta

A) 0.95 1.04

B) 0.95 0.95

C) 1.31 1.04

D) 1.31 0.95

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Answer and Explanation

Balance sheet not incorporating the pension plan into the WACC

	Value ($million)	Risk(Beta)		Value ($million)	Risk (Beta)
Operating assets	$40	1.31	Debt	$19	0.00
			Equity	$21	2.5
Total Assets	$40	1.31	Total L&E	$40	1.31

The total L&E beta = 21/40 ×2.5 = 1.31. The beta of the operating assets is found by using the Total L&E beta.

Balance sheet incorporating the pension plan into the WACC

	Value ($million)	Risk(Beta)		Value ($million)	Risk (Beta)
Operating assets	$40	1.04	Debt	$19	0.00
Pension assets	$15	0.70	Pension Liabilities	$15	0.00
			Equity	$21	2.5
Total Assets	$55	0.95	Total L&E	$55	0.95

New total L&E beta = 21/55 × 2.5 = 0.95.
Since the beta for the total assets = 40/55 (Operating Asset Beta) + 15/55 (.7) = 0.95
Solving for the Operating Asset Beta = 1.04

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After incorporating the risk of the pension assets into the overall capital structure, the weighted average cost of capital (WACC) for capital budgeting purposes is closest to:

A) 8.2.

B) 7.8.

C) 6.5.

D) 8.7.

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Answer and Explanation

After incorporating the pension assets and liabilities into the capital structure the new operating assets beta becomes 1.04 as shown in the previous question. Thus for capital budgeting purposes the WACC is: 3 + 1.04(5) = 8.2