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

62 Pages Posted: 21 Feb 2011 Last revised: 18 Jul 2014

Philipp Krueger

University of Geneva; University of Geneva - Geneva Finance Research Institute; Swiss Finance Institute

Augustin Landier

Toulouse School of Economics

David Thesmar

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA)

Date Written: February 18, 2011

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

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). Journal of Finance, Forthcoming; AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1764024 or http://dx.doi.org/10.2139/ssrn.1764024

Philipp Krueger

University of Geneva ( email )

102 Bd Carl-Vogt
Genève, CH - 1205
Switzerland

University of Geneva - Geneva Finance Research Institute ( email )

Geneva
Switzerland

Swiss Finance Institute ( email )

Switzerland

Augustin Landier

Toulouse School of Economics ( email )

Place Anatole-France
Toulouse Cedex, F-31042
France

David Thesmar (Contact Author)

Massachusetts Institute of Technology (MIT) - Economics, Finance, Accounting (EFA) ( email )

77 Massachusetts Avenue
Cambridge, MA 02139-4307
United States
16172259767 (Phone)

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