operating asset beta

BMiller12 wrote:
a.) Pension Risk (beta) increases –> Total equity beta stays the same (bc of altered cap structure) –> then optg beta must decrease because the sum of a higher pension + lower optg beta = same total eequity beta
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Total Equity beta is KEPT [not stays the same] the same - that is the management decision. Under this circumstance the Operating Asset beta MUST now decrease => since equity beta * weight of equity = weighted average of asset betas.[both pension and operating. combined].
BMiller12 wrote:
b.) By chaning the capital structure to have more equity & less debt, the risk of the operating assets all decreases bc more is back by equity
Is this logic and correct? Thanks
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Since the risk of operating assets have now decreased (due to the reduction in beta) and there is an overarching concept of risk budget for the firm - the overall Risk on the RHS of the balance sheet must now increase - and this can only happen by increasing (issuing more equity) - so Leverage decreases.
 
THink we’re on the same page. Your second point though, shouldn’t total risk on the RHS be the same (since it;s kept the same). Decreasing debt dereases risk, no?
 
but debt has no risk (0 beta) - so to equate the risk the equity weight should increase - since equity beta is also being kept the same. Merton also talks about using the extra equity issued to reduce the debt ….
 
Thanks CPK, very much
One final question: Why do they say that pension liabilities behave like debt / have same interest rate sensitivities that fixed income does?
I get that pension payments will be made in the future akin to making debt payments and that the obligation to make those payments is essentially a liability to the firm. Is that simply it? Becuase its not like the actual pension payments are interest payments or are truly debt?
 
it is a liability - and affected by inflation (wage inflation) and interest rates (term structure) due to the PV nature of it. And if you look back at the Level II pension material in FRA - the benefits for each individual participant are like a monthly coupon payment.
 
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