Many firms use a single firm-wide discount rate to evaluate projects in spite of the projects’ different levels of risk. This strategy results in firms favoring higher-risk projects. Such behavior is referred to as the WACC (weighted average cost of capital) fallacy. In the case of mergers and acquisitions, the stock price reaction of the acquiring firm tends to be lower when the target entity has a higher beta than the acquirer.
The authors investigate whether firms properly adjust for risk in their capital-budgeting decisions. The value of riskier projects tends to be overestimated, whereas the value of safer investments tends to be underestimated. In the case of mergers and acquisitions, if the bidder’s beta is lower than the target’s beta, using the former to value the target’s cash flow will result in overvaluing the target. The authors highlight that the WACC (weighted average cost of capital) fallacy is related to managerial bounded rationality. Such behavior seems to decrease over time and is less significant in cases of larger divisions, of more diverse companies, and when the CEO holds a larger stake in the company.
How Is This Research Useful to Practitioners?
According to the authors, firms fail to properly adjust for risk in investment appraisal decisions. The WACC fallacy results in value destruction. Conglomerates tend to invest less in lower-beta divisions than in higher-beta divisions. The authors also examine the value loss caused by using a single discount rate and consider various mergers and acquisitions. When a bidder uses the firm-wide discount rate to evaluate a target company, it tends to overvalue the target. The acquirer’s stock price reaction to the announcement of the acquisition also ends up being lower when the target has a higher beta than the acquirer. Such behavior results in a relative loss of about 0.8% of the bidder’s market capitalization, which represents, on average, about 8% of deal value, or $16 million per deal.
Using the CAPM for capital budgeting can be value creating when the CAPM beta reflects information on fundamental risk. In addition, the WACC fallacy is related to managerial bounded rationality. Such behavior seems to decrease over time as chief financial officers (CFOs) become more aware of the drawbacks of using a single discount rate for project appraisal. The WACC fallacy is less pronounced in cases of larger noncore divisions, in more diverse companies, and when the CEO holds a large stake in the company.
CFOs, investment analysts, and investors in general would find the conclusions of this research useful. It seems that many firms fail to properly adjust for risk in their capital-budgeting decisions, which results in value-destroying investments.
How Did the Authors Conduct This Research?
First, the authors focus on investment in diversified conglomerates. To construct a dataset of conglomerate divisions, they examine data from the Compustat Segment files for the period 1987–2007. They then merge these data with firm-level accounting information from Compustat North America. Finally, they merge the resulting division-level dataset with firm-level information about CEO ownership from Compustat ExecuComp. This information is available only for the period 1992–2007 and only for a subset of firms.
A second series of tests is then carried out on two samples of mergers and acquisitions. The authors construct the samples by downloading all completed transactions between 1988 and 2007 from the SDC Platinum Mergers and Acquisitions database in which both the target and the bidder are US companies.
For both samples, the authors construct annual industry-level measures of the unlevered cost of capital, which they merge with the relevant datasets. They find a positive relationship between division-level investment and the spread between its industry beta and the beta of the firm’s core division. They also find that an acquirer’s stock price reaction to the announcement of an acquisition is lower when the target has a higher beta than the acquirer. The WACC fallacy among companies seems consistent with managerial bounded rationality. The authors also carry out a series of robustness tests—for example, excluding financial service firms from the sample, using equal-weighted industry betas, and using the asset-weighted average of industry betas of all divisions in the conglomerate—and they note that the conclusions remain unchanged.
The authors’ results are interesting. Although I have concerns that the data used in the tests are all US related and do not cover a very extensive period, the research supports the assertion that many companies do not always consider project-specific risk when conducting investment appraisal, potentially because project risk can be difficult to estimate, the process can be time consuming, or management is not yet convinced of the benefits of using project-specific discount rates.