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?

“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?

A. Scenario A.

B. Scenario B.

C. Scenario C.

View Answer

Answer: 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)