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Incorporating pension liabilities in DCF valuation

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Defined benefit pension schemes create leverage effects. Firstly, if pension liabilities exceed pension assets, t
deficit is comparable to a debt claim. Secondly, further leverage usually arises because of the mismatch betw
liabilities which are debt like in nature, and pension assets, that are generally not fully invested in matching b
leverage effects increase the cost of equity. The question is which, if any, should be considered when calculati
rate for a DCF valuation. The answer is that it depends on how the pension cash flow is measured – as ever, c
applying DCF matters.

This model illustrates the alternative methods to correctly include pensions in a DCF valuation. The differenc
pension asset allocation risk and reward are both excluded from (approach 1) or included in (approach 2) cas
of capital. This is demonstrated for both a discounted enterprise cash flow and discounted equity cashflow b
four models in total, all of which produce the same equity value.

In our view, you should only be using one of these approaches, read our article DCF and pensions: Enterprise
cash flow? to find out which. Whatever you do, don't make the mistake of combining Approach 1 Cash Flow
Cost of Capital; if pension liabilities are material then you could get very distorted results.

This is an interactive model: All blue cells can be modified

Inputs - Cost of capital

Cost of capital Beta factors and CAPM returns

Risk free rate 2.0%
Equity risk premium 6.0% Asset beta and WACC

Values (at valuation date - t0) Pension liability

Equity (model output) 1,253 Pension assets

Pension liability 800 Implied equity beta

Pension assets 400 and cost of equity (at t0)
Pension deficit / (surplus) 400 (Derived from asset beta and leverage effe
Pension deficit / (surplus) - after tax 320

Enterprise value 1,573

Inputs - Profit and cash flows

 1
Operating profit (after pension service cost) 100
Additional investment in operating assets 22
Pension service cost included in operating profit 20
Company contributions to the pension fund 5
Pension and other payments from the pension fund 30
Long-term growth 2.0%
Long-term iROIC 12.0% Corporate tax rate

Discounted enterprise free cash flow valuation

Approach 1 - Exclude asset allocation risk 1 2

Operating profit before pension expense 120 130
Pension cash flow - service cost only -20 -20
Taxation -20 -22
Additional investment -22 -25
Enterprise free cash flow 58 63
Asset beta - operating risk only 0.80 0.80
WACC 6.80% 6.80%
PV enterprise free cash flow 1,573 54 55
Pension deficit (after tax) -320
Equity value 1,253

Approach 2 - Include asset allocation risk 1 2

Operating profit before pension expense 120 130
Service cost -20 -20
Expected asset allocation gain 12 12
Pension cash flow -8 -8
Taxation -22 -24
Additional investment -22 -25
Enterprise free cash flow 68 73
Asset beta - operating risk plus asset allocation risk 0.90 0.90
WACC 7.41% 7.39%
PV enterprise free cash flow 1,573 63 63
Pension deficit (after tax) -320
Equity value 1,253

Discounted equity free cash flow valuation

Approach 1 - Exclude asset allocation risk 1 2

Operating profit before pension expense 120 130
 Service cost -20 -20
Interest accretion on pension (deficit) / surplus -13 -13
Change in pension deficit / surplus 16 -229
Pension cash flow (contribution excl. asset allocation gain) -17 -262
Additional investment -22 -25
Taxation -21 26
Equity free cash flow 60 -131
Equity beta - operating risk and financial risk only 0.95 0.95
Cost of equity 7.72% 7.73%
PV equity free cash flow 1,253 56 -113

Approach 2 - Include asset allocation risk 1 2

Operating profit before pension expense 120 130
Service cost -20 -20
Expected asset allocation gain 12 12
Interest accretion on pension (deficit) / surplus -13 -13
Change in pension deficit / surplus 16 -229
Pension cash flow (actual company contribution ) -5 -250
Additional investment -22 -25
Taxation -23 24
Equity free cash flow 70 -121
Equity beta - observed equity beta incl. all risk factors 1.08 1.08
Cost of equity 8.48% 8.47%
PV equity free cash flow 1,253 65 -103

Beta factors and costs of capital

Analysis of components of equity risk 0 1
Asset beta - operating asset risk only 0.80 0.80
Leverage effect of pension fund asset allocation 0.10 0.10
Asset beta - including asset allocation leverage 0.90 0.90
Financial leverage effect 0.18 0.18
Equity beta including all risks 1.08 1.08
Equity beta excl. asset allocation leverage 0.95 0.95

Enterprise value
Equity 1,253 1,290
Pension liability (after tax) 640 652
Pension assets (after tax) 320 320
Pension deficit (after tax) 320 333
1,573 1,622
Profit, pension cash flow and pension fund analysis
Statement of comprehensive income (IFRS) 1
Operating profit before pension service cost 120
Pension service cost -20
Operating profit 100
Interest expense - net interest on pension deficit -13
Profit before tax 87
Taxation -23
Net profit 64
OCI - Expected gain / (loss) due to pension asset allocation 12
Comprehensive income 76

Analysis of pension cash flow

Service cost (enterprise cash flow before all financing effects) 20
(Gain) or loss from asset allocation -12
Enterprise cash flow after allowing for expected fund return 8
Interest accretion on pension deficit / (surplus) 13
Expected change in net funding position -16
Actual contributions to pension fund 5

Pension roll-forward
Opening pension assets 400
Expected asset return 25
Contribution 5
Pensions paid -30
Closing pension assets 400

Opening pension liability 800

Interest accretion 26
Service cost 20
Pensions paid -30
Closing pension liability 816
Pension fund deficit / (surplus) 416

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© The Footnotes Analyst, 2024

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s in DCF valuation
n liabilities exceed pension assets, the resulting
rises because of the mismatch between pension
rally not fully invested in matching bonds. These two
should be considered when calculating a discount
n cash flow is measured – as ever, consistency when

ns in a DCF valuation. The difference is whether the

ch 1) or included in (approach 2) cash flows and cost
w and discounted equity cashflow based analysis; so

article DCF and pensions: Enterprise or equity free

f combining Approach 1 Cash Flow with Approach 2
distorted results.

can be modified

ta factors and CAPM returns

Beta Cost / return
et beta and WACC 0.80 6.80%

nsion liability 0.20 3.20%

nsion assets 0.70 6.20%

plied equity beta

d cost of equity (at t0) 1.08 8.48%
erived from asset beta and leverage effects)
 2 3 4
110 120 130
25 28 22
20 20 20
250 5 2
30 30 30

porate tax rate 20.0%

3 4 TV
140 150
-20 -20
-24 -26
-28 -22
68 82 1,750
0.80 0.80 0.80
6.80% 6.80% 6.80%
56 63 1,345

3 4 TV
140 150
-20 -20
19 20
-1 0
-28 -30
-28 -22
83 98 1,750
0.95 0.95 0.95
7.73% 7.72% 7.72%
67 73 1,307

3 4 TV
140 150
 -20 -20
-6 -6
2 4
-24 -22
-28 -22
-23 -26
65 81 1,596
0.86 0.86 0.86 ###
7.15% 7.15% 7.15%
52 60 1,198

3 4 TV
140 150
-20 -20
19 20
-6 -6
2 4
-5 -2
-28 -22
-27 -30
80 96 1,596
1.03 1.03 1.03
8.17% 8.16% 8.16% ###
63 70 1,159

2 3 4
0.80 0.80 0.80
0.15 0.15 0.15
0.95 0.95 0.95
0.07 0.07 0.07
1.03 1.03 1.03
0.86 0.86 0.86

1,520 1,564 1,596

665 679 692
516 528 538
150 151 154
1,670 1,715 1,750
 2 3 4
130 140 150
-20 -20 -20
110 120 130
-13 -6 -6
97 114 124
24 -27 -30
121 87 94
12 19 20
133 106 114

20 20 20
-12 -19 -20
8 1 0
13 6 6
229 -2 -4
250 5 2.5

400 645 660

25 40 41
250 5 2
-30 -30 -30
645 660 673

816 832 848

26 27 27
20 20 20
-30 -30 -30
832 848 865
187 189 193

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