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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.