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In: Business and Management

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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 assistance. Thesmar e thanks the HEC Foundation for financial support. Corresponding Author: Philipp Kr¨ger. Email: u philipp.krueger@unige.ch, Telephone: +41 (0)22 379 85 69. Augustin Landier, augustin.landier@tsefr.eu, Telephone: +33 (0)5 61 12 86 88. David Thesmar, thesmar@hec.fr, Telephone: +33 (0)1 39 67 94 12.

1

Electronic copy available at: http://ssrn.com/abstract=1764024

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

Abstract 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...

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