Abstract

http://ssrn.com/abstract=1764024
 
 

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The WACC Fallacy: The Real Effects of Using a Unique Discount Rate


Philipp Krueger


University of Geneva - Geneva Finance Research Institute

Augustin Landier


Toulouse School of Economics

David Thesmar


HEC Paris - Finance Department

February 18, 2011

AFA 2012 Chicago Meetings Paper

Abstract:     
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, G34

working papers series


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Date posted: February 21, 2011 ; Last revised: March 13, 2013

Suggested Citation

Krueger, Philipp and Landier, Augustin and Thesmar, David, The WACC Fallacy: The Real Effects of Using a Unique Discount Rate (February 18, 2011). AFA 2012 Chicago Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1764024 or http://dx.doi.org/10.2139/ssrn.1764024

Contact Information

Philipp Krueger
University of Geneva - Geneva Finance Research Institute ( email )
Geneva
Switzerland
HOME PAGE: http://www.gfri.ch/index.php?dispatch=staff.view&member_id=49
Augustin Landier
Toulouse School of Economics ( email )
Place Anatole-France
Toulouse Cedex, F-31042
France
David Thesmar (Contact Author)
HEC Paris (Groupe HEC) - Finance Department ( email )
1 rue de la Liberation
Jouy-en-Josas Cedex, 78351
France
+33 1 39 67 94 12 (Phone)
HOME PAGE: http://www.hec.fr/hec/eng/professeurs_recherche/p_liste/p_fiche.php?num=135

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