The effect of defined benefit pension plans on corporate valuation : an empirical investigation

Abstract

This study examines the relationship between defined benefit pension plan data and the market value of the firm's common equity. An equity valuation model is developed which relates the firm's equity value to (1) the expected after tax earnings before interest and pension expenses, (2) the after tax book value of debt, (3) the market value of preferred stock, (4) the growth in total assets, (5) the firm's asset beta, and (6) the unfunded or overfunded pension obligation. This study provides evidence that equity value decreases with unfunded pension benefits and increases with overfunded pension benefits. It seems that the under and overfunded vested pension benefits and the under and overfunded total pension benefits both provide good indicators of equity value when used in conjunction with expected earnings, debt, preferred stock, growth and asset beta. The pension expense did not provide a significant relationship with firm equity value. This was contrary to the results of an earlier study which found pension expense to be more clearly reflected in firm equity value than unfunded vested pension benefits or unfunded prior service costs. The current findings may be attributable to the disclosure requirements of Statement of Financial Accounting Standards No. 36 which set more stringent rules on the appropriate determination of accumulated vested and nonvested pension benefits. However, with the new regulations set forth in Statement of Financial Accounting Standards No. 87 for determining pension expense, this pension expense may yet prove to be a better indicator of firm value. Using the net unfunded or overfunded benefits or using the pension benefits and the pension plan assets both provided good indicators of firm common equity value. Finally there is some limited evidence that the overfunded pension benefits may be valued differently from the underfunded pension benefits.