Defined benefit pension schemes create two leverage effects – financial leverage due to the debt-like nature of pension deficits, and asset allocation leverage if pension assets are not matched with pension liabilities. In DCF valuation these effects must be correctly, and consistently, included in both the discount rate and free cash flow.
We use an interactive model to demonstrate four possible DCF approaches based on enterprise and equity cash flows. Our preferred approach uses enterprise free cash flow with the effects of asset allocation leverage excluded from the discount rate.
Continue reading “DCF and pensions: Enterprise or equity cash flow?”