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The WACC Fallacy: The Real Effects of Using a Unique Discount Rate
Author(s) -
KRÜGER PHILIPP,
LANDIER AUGUSTIN,
THESMAR DAVID
Publication year - 2015
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/jofi.12250
Subject(s) - division (mathematics) , fallacy , economics , capital asset pricing model , context (archaeology) , capital budgeting , cost of capital , investment (military) , weighted average cost of capital , econometrics , value (mathematics) , business , microeconomics , actuarial science , monetary economics , financial economics , statistics , capital formation , financial capital , profit (economics) , paleontology , philosophy , arithmetic , mathematics , epistemology , project appraisal , politics , political science , law , biology
In this paper, we test whether firms properly adjust for risk in their capital budgeting decisions. If managers use a single discount rate within firms, we expect that conglomerates underinvest (overinvest) in relatively safe (risky) divisions. We measure division relative risk as the difference between the division's asset beta and a firm‐wide beta. We establish a robust and significant positive relationship between division‐level investment and division relative risk. Next, 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 significantly lower.