Jack Rose and Ryan Boatman are analysts with Quincy Consultants. Quincy provides advice on risk management and performance presentation to pension plans, insurance firms, and other institutional portfolio managers throughout the United States and Canada.
Rose and Boatman are preparing an analysis of the defined benefit pension plans for four mature corporations in the United States. In an effort to ascertain the risk to the firm's shareholders from the plans. Rose and Boatman gather the information in Figure 1:
Figure 1: Pension Plan Data
While discussing how the weighted average cost of capital (WACC) for a corporation can be adjusted to incorporate pension asset risk. Rose and Boatman make the following comments:
• Rose: "From what I understand, in order to calculate a true weighted average cost of capital, management should consider the assets held in their pension plan. Because pension plans hold equity securities as assets, the plan assets usually have a higher weighted average beta than the sponsoring firm's operating assets. This means the typical firm's weighted average asset beta and cost of capital are higher than when calculated using only the operating assets. If management bases their accept/reject decisions on a weighted average cost of capital that considers only operating assets, they might accept projects that really should have been rejected."
• Boatman: "I'm not sure I agree with you. To match the maturity of their liabilities, pension plans like to hold at least half their assets in long maturity bonds. Then, since the bonds have a long weighted average duration, they have considerable interest rate sensitivity. This is really what makes the pension assets riskier than the firm's operating assets. However, since debt securities have zero betas, they have a low weighted average asset beta and the firm has a lower weighted average cost of capital when pension assets are considered than when they are not considered. The result of considering only the operating assets is that the weighted average cost of capital is inflated and management tends to incorrectly reject projects that could have been accepted." In a visit to the headquarters of Beeman Enterprises, Rose and Boatman explain how in an expanded balance sheet format, a change in a pension plan's asset allocation can result in a change in the firm's financial ratios. To illustrate the concept to the firm's chief financial officer, they provide three different scenarios (shown in Figure 2) indicating necessary changes in the firm's capital structure under the assumption that the firm's pension plan increases its allocation to equity and management wants to keep the sponsoring firm's cost of equity capital constant (i.e., constant equity beta).
Figure 2: Cost of Capital Scenarios
Quincy Consultants has also provided advice to Monroe Portfolio Managers. Among its investments, Monroe has a real estate portfolio that invests in shopping centers and office buildings throughout the southern United States. The firm has provided the following data to calculate and report quarterly returns to current and prospective investors. Additionally, the capital contribution came on day 47 (0.52 into the quarter) and the capital disbursement came on day 67 (0.74 into the quarter).
After calculating the capital return and income return for the portfolio, Rose and Boatman discuss the performance presentation standards for real estate and private equity portfolios. Discussing the differences between the general provisions of the GIPS standards and those for real estate and private equity portfolios, Rose states the following:
1. "The general provisions require that valuations take place monthly until 2010. For real estate, valuations could be done annually until 2008, but starting in 2008 quarterly valuations are required. For private equity, valuations should be performed annually."
2. "The performance standards in the general provisions for real estate and for private equity require that both gross-of-fees and net-of-fees returns are presented."
Also commenting on the differences between the various GIPS requirements, Boatman states the following:
1. "Although the general provisions for GIPS make the verification of GIPS compliance by an outside third party voluntary, the valuation of real estate and private equity by an outside third party is required by GIPS."
2. "The GIPS general provisions for real estate and for private equity require that both income and capital gains are included in the calculation and presentation of returns."
Of the three scenarios (see Figure 2) presented to the Beeman Enterprises executives, which would represent the appropriate reaction to increasing the pension plan allocation to equity, if management wishes to maintain its current equity beta?
Answer(s): B
Explanation:
Scenario B is the most likely scenario. Using an expanded balance sheer format, it can be seen that as pension plan risk increases, so does the total asset beta.
Under the assumption that the firm would like to keep its cost of equity capital constant, the firm must make changes in its capital structure on the right hand side of the balance sheet to accommodate the pension plan's increased allocation to equity. More specifically, to keep the equity beta constant, the firm must reduce its risk to its shareholders by reducing its financial leverage (debt). Thus it must use more equity capital, thereby decreasing its debt-to-equity ratio. (Study Session 5, LOS 22.c)