Strategic Corporate Finance: Applications in Valuation and Capital Structure

THE PROBLEMS WITH EQUITY

The 25-year-old case against equity remains controversial and largely ignored in practice.4 It is diminished by the practical limitations of the rating agencies and obfuscation created by generally accepted pension accounting methods; admittedly, this complex issue holds limited appeal for many equity investors. Nonetheless, the weight of evidence suggests that equity allocations should be reduced.

Pension Cost

Many practitioners believe they serve shareholder interests with equity-oriented investment strategies that earn higher returns, thus saving on the cost of pension benefits. But there is no free lunch: The higher return is the corollary to higher risk, leading to higher capital costs, and lower multiples. And equities face an opportunity cost in failing to make use of the favorable tax status of many pensions. Furthermore, though the higher risk may reduce the cost of the benefits, the risk also reduces the value of the benefits. Finally, equity returns are more likely to introduce pressure for increased benefits in times when equity returns are good.

A switch from equity to debt can be done without affecting EPS. The sale of equities and purchase of bonds in the fund can be accompanied by an offsetting increase in financial leverage in the company and share repurchases (issuance of debt and purchase of stock) to maintain EPS and create value through significant tax benefits.5

Equity Risk

If a large part of the pension portfolio is invested in equities, ...