R22 Question 6 only, someone, because, overall

DoubleDip

Can someone explain why the answer to Reading 22 Question 6 is C? I thought the answer was A because shifting some pension assets from equity to fixed income would mean less overall shareholder equity risk. Less shareholder equity risk leads to higher market value of equity and thus a lower D/E. You debt doesn't change if you move pension assets from equity to FI, so I thought only the E in D/E would change.

Thanks.

liangfeng

lower the equity allocation of pension plan ,the overall operating asset risk will decrease.
but the CFO want to maintain the risk, so it should use leverage by issuing more debt,
so the D/E will increase.

see TABLE 5 P480 V2

Darien

As I understand, if the plan is fully funded, then increasing pension plan investment in debt results in pension equity investment getting reduced because there is no pension shareholder equity (surplus).


Accordingly, the company's total (operation + pension) debt will increase and equity will decrease. Does this seem right?

oneboy

You seem to be confused about several concepts.

>Less shareholder equity risk leads to higher market value of equity and thus a lower D/E

No, it does not lead to higher value. It leads to a lower beta but same value.

-------------------------------------------------------
> As I understand, if the plan is fully funded, then
> increasing pension plan investment in debt results
> in pension equity investment getting reduced
> because there is no pension shareholder equity
> (surplus).

The above sentence mixes several things together. Pension surplus has nothing to do with whether the plan invests in equity or debt.


> Accordingly, the company's total (operation +
> pension) debt will increase and equity will
> decrease. Does this seem right?

Again, confusion here. Pension plan investing in debt (ie. bonds) is on the asset side of the balance sheet. Pension DEBT is the company's OBLIGATION to its employees.

To answer your question: if the company chooses to invest more in debts (bonds) in its pension plan, its own equity's beta decreases but the size stays the same. If the company want to keep the same equity beta, it can borrow more money.

Important to remember: the TOTAL asset size (operation+pension assets) = TOTAL liabilities (pension obligations + operational debt+ equity)