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

Philipp Krueger, Augustin Landier, David Thesmar
2011 Social Science Research Network  
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
more » ... ignificant 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 0.7% of the bidder's market equity. JEL-Classification: G11, G31, G34
doi:10.2139/ssrn.1764024 fatcat:2unwqz74cffndeppexwcugdbgy