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

  • Krüger, Philipp
  • Landier, Augustin
  • Thesmar, David

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 0.7% of the bidder's market equity.

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Paper provided by Toulouse School of Economics (TSE) in its series TSE Working Papers with number 11-222.

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Date of creation: Feb 2011
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Publication status: Published in The Journal of Finance, 2015.
Handle: RePEc:tse:wpaper:24151
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Web page: http://www.tse-fr.eu/

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  1. Paul A. Gompers & Joy L. Ishii & Andrew Metrick, 2001. "Corporate Governance and Equity Prices," NBER Working Papers 8449, National Bureau of Economic Research, Inc.
  2. Rajan, Raghuram G & Servaes, Henri & Zingales, Luigi, 1998. "The Cost of Diversity: The Diversification Discount and Inefficient Investment," CEPR Discussion Papers 1801, C.E.P.R. Discussion Papers.
  3. Xavier Gabaix, 2011. "A Sparsity-Based Model of Bounded Rationality," NBER Working Papers 16911, National Bureau of Economic Research, Inc.
  4. Marianne Bertrand & Antoinette Schoar, 2003. "Managing With Style: The Effect Of Managers On Firm Policies," The Quarterly Journal of Economics, MIT Press, vol. 118(4), pages 1169-1208, November.
  5. Augustin Landier & David Thesmar, 2009. "Financial Contracting with Optimistic Entrepreneurs," Review of Financial Studies, Society for Financial Studies, vol. 22(1), pages 117-150, January.
  6. Randall Morck & Andrei Shleifer & Robert W. Vishny, 1989. "Do Managerial Objectives Drive Bad Acquisitions?," NBER Working Papers 3000, National Bureau of Economic Research, Inc.
  7. Owen Lamont, 1996. "Cash Flow and Investment: Evidence from Internal Capital Markets," NBER Working Papers 5499, National Bureau of Economic Research, Inc.
  8. Oguzhan Ozbas & David S. Scharfstein, 2010. "Evidence on the Dark Side of Internal Capital Markets," Review of Financial Studies, Society for Financial Studies, vol. 23(2), pages 581-599, February.
  9. Fama, Eugene F. & French, Kenneth R., 1997. "Industry costs of equity," Journal of Financial Economics, Elsevier, vol. 43(2), pages 153-193, February.
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