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

Abstract

We provide evidence that firms fail to properly adjust for risk in their valuation of investment projects, and that this behavior leads to value-destroying investment decisions. If managers tend to use a single discount rate within firms, we expect conglomerates to underinvest in relatively safe divisions, and to overinvest in risky ones. We measure division relative risk as the difference between the division market beta and a firm-wide beta. We establish a robust and significant positive relationship between division-level investment and division relative risk. Then, we measure the value loss due to this behavior in the context of acquisitions. When the bidder's beta is lower than that of the target, announcement returns are lower by 0.8% of the bidder's equity value.

Keywords: capital budgeting, cost of capital, behavioral finance, investment

JEL Classification: G11, G31, G34