The WACC Fallacy: The Real Effects of Using a Unique Discount Rate
University of Geneva - Geneva Finance Research Institute
Toulouse School of Economics
HEC Paris - Finance Department
February 18, 2011
AFA 2012 Chicago Meetings Paper
We document investment distortions induced by the use of a single discount rate within firms. According to textbook capital budgeting, firms should value any project using a discount rate determined by the risk characteristics of the project. If they use a unique company-wide discount rate, they overinvest (resp. underinvest) in divisions with a market beta higher (resp. lower) than the firm's core industry beta. We directly test this consequence of the "WACC fallacy'' and establish a robust and significant positive relationship between division-level investment and the spread between the division's market beta and the firm's core industry beta. Consistently with bounded rationality theories, this bias is stronger when the measured cost of taking the wrong discount rate is low, for instance, when the division is small. Finally, we measure the value loss due to the WACC fallacy in the context of acquisitions. Bidder abnormal returns are higher in diversifying mergers and acquisitions in which the bidder's beta exceeds that of the target. On average, the present value loss is about 0.8% of the bidder's market equity.
Number of Pages in PDF File: 54
Keywords: capital budgeting, cost of capital, behavioral finance, investment
JEL Classification: G11, G31, G34working papers series
Date posted: February 21, 2011 ; Last revised: March 13, 2013
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