NakedPuts2011

I'll have to check the book (at home).... but my point is independent of the pension's funded status.

Do you agree that a plan's higher equity allocation decreases the firm's D/E ratio? That's point I was making... is straight from LOS 5(c)

Also, can you clarify why would the firm's increased borrowing increase the pension liability? I don't completely follow



Edited 1 time(s). Last edit at Sunday, May 30, 2010 at 02:55PM by Neveruse_95%_everagain.

canadiananalyst

NeverUse, I am not sure you are correct with respect to the levering up the balance sheet based on the asset allocation of the pension plan.

The firm "levers up" the balance sheet if the pension is running at a deficit (underfunded), which increases pension liability, while maintaining pension assets the same (so firm equity decreases).

The difference in debt vs equity used in the pension assets only affects the pension asset beta.

mcmc

Irishgyy Wrote:
-------------------------------------------------------
> Remember these principles, it works for me, you
> can figure out the rest
>
> 1, the equity beta NEVER changes, the one changes
> is asset beta.
> 2. equity in balance sheet changes same direction
> as equity in pension
> 3. WACC uses operating assets beta


Be careful. The equity beta changes if they reallocate the pension. Ie they change from 50% equity to 60% equity.

former

Remember these principles, it works for me, you can figure out the rest

1, the equity beta NEVER changes, the one changes is asset beta.
2. equity in balance sheet changes same direction as equity in pension
3. WACC uses operating assets beta

pennyless

p.s. this is only my opinion, but I don't see the CFAI asking us to do all the calculations 2 years in a row..... I'll be crying next week if I'm wrong.

zwjy

Here is the big take-away from the reading... from my notes (* thanks for asking because I haven't reviewed recently... hope they don't pick on us, since was on the 2009 exam)


- Firm risk is higher, all things equal, as its pension asset allocation approaches 100%
(from a practical standpoint, this makes sense because the firm's matching a fixed liability with a contingent claim... this isn't in the readings, just my interpretation)
- therefore, firm's beta is higher (because the market recognizes this fact)
- firm's WACC should account for off-balance sheet obligations, like pensions (again, this makes sense from a practical standpoint)
- WACC calculations that don't account for off-balance-sheet obligations typically OVERSTATE the WACC... this isn't intuitive, until you look at the firm's behavior in response to an increase to the firm's equity portion of its pension plan assets (below).

*** Here's the meat of the chapter.:

Firm either increases its DB pension asset allocation to (1) equities or (2) fixed income

If (1), leads to
- higher pension asset beta (because of point above)
- higher total asset beta
- higher risk to the firm's equity capital
- lower debt-to-equity ratio for the firm... because the firm de-levers its balance sheet (in response to higher equity allocation) to maintain its previous asset beta.

Looking at (1), the firm is replacing cheaper debt with higher-cost equity capital...therefore, WACC is higher

(2) Leads to:
- lower pension asset beta
- lower total asset beta;
- lower risk to the firm's equity capital
- higher D/E ratio for the firm... because it levers up, to maintain its previous asset beta



Edited 3 time(s). Last edit at Sunday, May 30, 2010 at 02:28PM by Neveruse_95%_everagain.

aidebaobao

Set up two columns, one for assets, one for liabilities.

In each, setup the item, its weight, its beta, and its weighted beta. That helps keep things straight. The company is going to have 3 inputs, operating assets, liabilities and equity. Equity beta is the beta of the stock. Liabilities have no beta. Then you solve for operating asset beta.

To find WACC ignoring pension assets, use the operating asset beta in CAPM. This is different that the WACC calc you may know so just memorize that.

Now reconstruct your columns, but add in pension stuff. You have 3, pension equity, pension debt assets and pension liabilities. The beta of your pension equity is observable. The beta of the other two is 0. Fill in for your weights, and solve again for the operating asset beta.

Now re-do the WACC with the new operating asset beta to find the true WACC.

Now sort of memorize the structure of the full, filled out chart you built to find the effects of company actions or pension actions.

What if they rebalance to more equity? Well, that means a higher weighting to your pension equity beta on the left side. The right side must move up to balance also. That means equity beta must increase. What if they want to maintain the equity beta? Well, then you need to increase equity weight in the capital structure to make your grid balance again.

Basically, to solve these make a really good balance sheet and then playing with the numbers inside you should be able to solve for any effects.

bkballa

Most important thing to remember at the start is they are defining WACC = Rf + Beta of Operating Assets (Market Risk Premium)

For the rest:
Rf = Risk Free
Boa = Beta Operating Assets
Bta = Beta Total Assets
Bp = Beta Pension
Be = Beta Equity
OA = Operating Assets
PA = Pension Assets
MRP = Market Risk Premium
E = Equity
L = Liability

Ok, sorry about that long list but it can be hard to post clear equations on AF.

So Wacc w/no Pension:
1. Solve for Boa = E/(L+E) x Be
2. Wacc = Rf + Boa(MRP)

Now bring Pension into the mix.
1.Add Pensions Assets and Liabilities (add to both sides of the balance sheet)
2. Solve for Bta = E/(L+E) x Be (remember the L should have increased in all of the below)
3. Solve for Boa (I back into it...thus the *Boa* is what you solving for), yes you could rearrange, but I just find it easier to remember this way.

Bta(we just calculated in #2) = OA/(L+E) x *Boa* + PA/(L+E) x Bp
Thus the Bta is just a weighted average of OA times its Beta and Pension Assets times its Beta (Bp will be given). It is this new Boa that you've been working towards.

4. Once you have that Boa from step 3:
Wacc = Rf + Boa(MRP).

Analyze_This

you mean, for the pensions?