Article
Reference
The WACC Fallacy: The Real Effects of Using a Unique Discount
Rate
KRUEGER, Philipp, LANDIER, Augustin, THESMAR, David
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.
KRUEGER, Philipp, LANDIER, Augustin, THESMAR, David. The WACC Fallacy: The Real
Effects of Using a Unique Discount Rate. The Journal of finance, 2011, vol. 70(3), p.
1253-1285
Available at:
http://archive-ouverte.unige.ch/unige:85443
Disclaimer: layout of this document may differ from the published version.
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Electronic copy available at: http://ssrn.com/abstract=1764024
The WACC Fallacy: The Real Effects of Using a
Unique Discount Rate
PHILIPP KR
¨
UGER, AUGUSTIN LANDIER, and DAVID THESMAR
∗
Journal of Finance forthcoming
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 ex-
pect 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.
∗
Kr¨uger is with the Universit´e de Gen`eve and the Geneva Finance Research Institute, Landier is with
the Toulouse School of Economics, and Thesmar is with HEC Paris and CEPR. The authors greatly
appreciate comments and suggestions from Malcolm Baker, Andor Gy¨orgy, Owen Lamont, Oliver Spalt,
Masahiro Watanabe, Jeff Wurgler and seminar participants at AFA, CEPR, EFA, EFMA and NBER
meetings, HBS, Mannheim University, Geneva University, and HEC Lausanne. The authors also thank
three referees, the Editor (Cambell Harvey), and an Associate Editor for their constructive suggestions.
Kr¨uger thanks Gen`eve Place Financi`ere for financial support. Landier aknowledges financial support
from a Scor Chair at the JJ Laffont foundation and from the European Research Council under the
European Communitys Seventh Framework Programme (FP7/2007-2013) Grant Agreement no. 312503
SolSys. Thesmar thanks the HEC Foundation for financial support.
Electronic copy available at: http://ssrn.com/abstract=1764024
In this paper, we provide evidence that firms fail to properly adjust for risk in their
valuation of investment projects, and that such behavior leads to value-destroying invest-
ment decisions. According to the standard textbook formula, the value of an investment
project depends on both its expected cash flows and its discount rate, which is a measure
of risk. In practice, however, survey evidence shows that most firms use only one single
discount rate to value all of their projects (Bierman (1993), Graham and Harvey (2001)),
a behavior that we label the “WACC fallacy”. The WACC fallacy is a failure to account
for project-specific risk, which is particularly damaging when the firm has to decide be-
tween heterogeneous projects. The value of riskier projects will be overestimated, while
that of safer ones will be underestimated.
Thus, we expect the WACC fallacy to have real effects: in relatively complex firms,
investment will be biased against safe projects, and this should lead to the destruction of
value as capital is not optimally used. The economic magnitude of this bias is potentially
large. For example, suppose that a firm invests in a project that pays a dollar in perpetu-
ity. If it takes a discount rate of 10%, the present value of the project is $10. By contrast,
a rate of 8% would imply a present value of $12.5. Hence, underestimating the discount
rate by only 2 percentage points leads to overestimating its present value by 25%. The
present paper is a first attempt to document and measure the distortions induced by
the WACC fallacy by relying entirely on field data. To implement our empirical tests,
we focus on two types of projects: Investment within conglomerates and Mergers and
Acquisitions.
First, we use business segment data to investigate if diversified firms rely on a firm-
wide discount rate. To do so, we examine whether diversified companies are inclined
to invest less in their low beta division than in their high-beta divisions, controlling for
standard determinants of investment, such as growth opportunities. The intuition is the
following: A company using a single firm-wide discount rate would tend to overestimate
the value of a project whenever the project is riskier than the typical project of the com-
pany. If companies apply the NPV principle to allocate capital across different divisions
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Electronic copy available at: http://ssrn.com/abstract=1764024
they must have a tendency to overestimate the value of projects that are riskier than the
firm’s typical project and vice versa. This, in turn, should lead to overinvestment (resp.
underinvestment) in divisions that have a beta above (resp. below) the beta of the firm’s
representative project.
Using a large sample of divisions in diversified firms, we show in the first part of the
present paper that investment in non-core divisions is robustly positively related to the
difference between the cost of capital of the division and that of the most important
division in the conglomerate (the core-division). We interpret this finding as evidence
that some firms do in fact discount investment projects from non-core divisions by relying
on a discount rate closer to the core division’s cost of capital. We then discuss the cross-
sectional determinants of this relationship and find evidence consistent with models of
bounded rationality: Whenever making a WACC mistake is more costly (e.g., the non-
core division is large, the CEO has sizable ownership, the within-conglomerate diversity
of costs of capital is high), the measured behavior is less prevalent.
In the second part of this paper, we document the present value loss induced by the
fallacy of evaluating projects using a unique company-wide discount rate. To do this,
we focus on diversifying acquisitions, a particular class of investment projects which are
large, can be observed accurately, and whose value impact can be assessed through event
study methodology. We look at the market reaction to the acquisition announcement of
a bidder whose cost of capital is lower than that of the target. If this bidder uses its own
WACC to value the target, it tends to overvalue it, thus announcement returns should be
relatively poorer, reflecting relatively lower shareholder value creation. We find that such
behavior leads to a relative loss of about 0.8% of the bidder’s market capitalization. On
average, this corresponds to about 8% of the deal value, or $16m per deal. This finding
is robust to the inclusion of different control variables and to different specifications.
Following Stein (1996), our approach is connected with the idea that CAPM betas
capture some dimension of fundamental risk. On the positive side, our investment re-
gressions show that, irrespective of whether the CAPM holds or not, managers do use
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CAPM betas but fail to adjust them across projects. Most corporate finance textbooks
recommend the use of CAPM betas to compute discount rates, but require that managers
use the project’s beta. Our investment regressions show that investment in non-core di-
visions depends strongly on core betas. Hence, managers do use a CAPM beta to make
capital budgeting decisions, even if it is the wrong one (core instead of non-core). On
the normative side, our M&A results suggest that using the wrong beta to value the
NPV of an acquisition is actually value-destroying. This may come as a surprise given
that the CAPM fails at predicting stock returns. As shown in Stein (1996), however,
this empirical failure is not inconsistent with the normative prescriptions of textbooks.
Indeed, CAPM based capital budgeting is value-creating if CAPM betas contain at least
some information on fundamental risk relevant for long-term investors. Our M&A results
suggest that they do.
Our paper is related to several streams of research in corporate finance. First, it con-
tributes to the literature concerned with the theory and practice of capital budgeting and
mergers and acquisitions. Graham and Harvey (2001) provide survey evidence regard-
ing firms’ capital budgeting, capital structure and cost of capital choices. Most relevant
to our study, they show that firms tend to use a firm-wide risk premium instead of a
project specific one when evaluating new investment projects. Relying entirely on ob-
served firm-level investment behavior, our study is the first to test the real consequences
of the finding in Graham and Harvey (2001) that few firms use project specific discount
rates. More precisely, we provide evidence that the use of a single firm-wide discount rate
(the WACC fallacy) does in fact have statistically and economically significant effects
on capital allocation and firm value. Since we make the assumption that managers do
rely on the NPV criterion, the present paper is also related to Graham, Harvey, and
Puri (2013). This more recent contribution shows that the net present value rule is the
dominant way for allocating capital across different divisions. The same reasoning does,
however, also apply to firms using an IRR criterion: if the minimum IRR required for
projects is similar across all the firm’s projects, there will be overinvestment in risky
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