The Wacc Fallacy: the Real Effects of Using a Unique Discount Rate

18805 WordsOct 22, 201176 Pages
The WACC Fallacy: The Real Effects of Using a Unique Discount Rate 1 Philipp Kr¨ ger u Geneva Finance Research Institute - Universit´ de Gen`ve e e Augustin Landier Toulouse School of Economics David Thesmar HEC Paris and CEPR First Version: February 2011 This Version: September 2011 We greatly appreciate comments and suggestions by Malcolm Baker, Andor Gy¨rgy, Owen Lamont, o Masahiro Watanabe, Jeff Wurgler and seminar participants at the NBER Behavioral Finance Spring Meeting, the University of Mannheim, the 2011 European Financial Management Association meetings, the 2011 European Finance Association meetings, the CEPR European Summer Symposium on Financial Markets and HEC Lausanne. Boris Vall´e provided excellent research…show more content…
The economic magnitude of the bias is potentially large. For example, suppose that a firm invests in a project that pays a dollar in perpetuity. If it takes a discount rate of 10%, the present value of the project is $10. By contrast, a hurdle rate of 8% would imply a present value of $12.5. Hence, underestimating the WACC by only 2 percentage points leads to overestimating the present value by 25%. This paper is an attempt to document and measure such distortions using field data. First, we use business segment data to investigate if diversified firms rely on a firm wide WACC. To do so, we examine whether diversified companies are inclined to overinvest in 1 Electronic copy available at: http://ssrn.com/abstract=1764024 their high-beta divisions and underinvest in their low-beta divisions. The intuition is the following: A company using a single firm-wide WACC would tend to overestimate the NPV of a project whenever the project is riskier than the typical project of the company. If companies apply the NPV principle to allocate capital across different divisions2 , they must have a tendency to overestimate the NPV 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 firm-wide beta. Let us illustrate our empirical strategy

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