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http://ssrn.com/abstract=565261
 
 

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Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan?


Zvi Bodie


Boston University - Department of Finance & Economics

Robert C. Merton


MIT Sloan School of Management; National Bureau of Economic Research (NBER); Harvard Business School - Finance Unit

Li Jin


Harvard Business School - Finance Unit

December 2005

HBS Finance Working Paper No. 05-011

Abstract:     
This paper examines the empirical question of whether systematic equity risk of US firms as measured by beta from the capital asset pricing model reflects the risk of their pension plans. There are a number of reasons to suspect that it might not. Chief among them is the opaque set of accounting rules used to report pension assets, liabilities, and expenses. Pension plan assets and liabilities are off-balance sheet and are often viewed as segregated from the rest of the firm, with its own trustees. Pension accounting rules are complicated. Furthermore, the role of the Pension Benefit Guaranty Corporation clouds the real relation between pension plan risk and firm equity risk. The empirical findings in this paper are consistent with the hypothesis that equity risk does reflect the risk of the firm's pension plan despite arcane accounting rules for pensions. This finding is consistent with informational efficiency of the capital markets. It also has implications for corporate finance practice in the determination of the cost of capital for capital budgeting. Standard procedure uses de-leveraged equity return betas to infer the cost of capital for operating assets. But the de-leveraged betas are not adjusted for the risk of the pension assets and liabilities. Failure to make this adjustment typically biases upward estimates of the discount rate for capital budgeting. The magnitude of the bias is shown here to be large for a number of well-known US companies. This bias can result in positive net present value projects being rejected.

Number of Pages in PDF File: 43

Keywords: Defined Benefit Pension Plan, Market Efficiency, Cost of Capital, Capital Budgeting

JEL Classification: G14, G23, G31

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Date posted: July 19, 2004  

Suggested Citation

Bodie, Zvi and Merton, Robert C. and Jin, Li, Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan? (December 2005). HBS Finance Working Paper No. 05-011. Available at SSRN: http://ssrn.com/abstract=565261 or http://dx.doi.org/10.2139/ssrn.565261

Contact Information

Zvi Bodie
Boston University - Department of Finance & Economics ( email )
595 Commonwealth Avenue
Boston, MA 02215
United States
617-353-4160 (Phone)
617-353 6667 (Fax)
HOME PAGE: http://smgnet.bu.edu/mgmt/profiles/BodieZvi.html
Robert C. Merton (Contact Author)
MIT Sloan School of Management ( email )
77 Massachusetts Avenue
E62-634
Cambridge, MA 02139-4307
United States
617 715 4866 (Phone)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Harvard Business School - Finance Unit ( email )
Boston, MA 02163
United States
617-495-6678 (Phone)
Li Jin
Harvard Business School - Finance Unit ( email )
Boston, MA 02163
United States
617-495-5590 (Phone)
617-496-5271 (Fax)
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