Any Finance 101 course of instruction volition emphasize that the appropriate discount charge per unit of measurement for a projection depends on the project’s ain characteristics, non the job solid equally a whole. If a utilities job solid moves into media (e.g. Vivendi), it should role a media beta - non a utilities beta - to calculate the discount rate . However, a survey flora that 58% of firms role a unmarried company-wide discount rate for all projects, rather than a discount rate specific to the project’s characteristics. Indeed, when I was inwards investment banking, several clients would role their ain toll of upper-case missive of the alphabet to discount a potential M&A target's cash flows.
But the of import query is – does this actually matter? Perhaps an ivory-tower academic volition tell yous the right weighted average toll of upper-case missive of the alphabet (WACC) is 11.524% only if yous role 10%, is that practiced enough? Given the cash flows of a projection are thus hard to approximate to commence with, it seems pointless to “fine-tune” the WACC calculation.
An interesting paper, entitled “The WACC Fallacy: The Real Effects of Using a Unique Discount Rate”, addresses the question. The newspaper is forthcoming inwards the Journal of Finance and co-authored by Philipp Krueger of Geneva, Augustin Landier of Toulouse too David Thesmar of HEC Paris.
This newspaper shows that it matters. The authors commencement looked at organic investment (capital expenditure, or "capex"). If your inwardness concern is utilities too the non-core sectionalisation is media, yous should live on using a media discount charge per unit of measurement for non-core capex. But, if yous incorrectly role a utilities discount rate, the discount charge per unit of measurement is likewise depression too you'll live on taking likewise many projects. The authors indeed detect that capex inwards a non-core sectionalisation is greater if the non-core sectionalisation has a higher beta than the inwardness division. Moreover, they detect the number is smaller (a) inwards recent years, consistent amongst the growth inwards finance instruction (e.g. MBAs), (b) for larger divisions – if the non-core sectionalisation is large, too thus management puts the endeavour into getting it right, (c) when management has high equity incentives, equally these also laissez passer on them incentives to piece of work it right.
The authors too thus plough to M&A. They detect that conglomerates tend to purchase high-WACC targets rather than low-WACC targets, i time to a greater extent than consistent amongst them erroneously using their ain WACC to value a target, when they should live on using the target’s ain high WACC. Moreover, the attraction of studying M&A is the authors tin mensurate the stock market’s reaction to the deal, to quantify how much value is destroyed. They detect that shareholder returns are 0.8% lower when the target’s WACC is higher than the acquirer’s WACC. They written report 6,115 deals too the average acquirer size is $2bn. Thus, the value devastation is 0.8% * $2bn * 6,115 = $98bn lost to acquirers inwards aggregate because they don’t apply a uncomplicated regulation taught inwards Finance 101!
We oftentimes wonder whether textbook finance theory is relevant inwards the existent globe – mayhap yous don’t ask the “academically” right response too it's sufficient to live on unopen enough. But this newspaper shows that “getting it right” does brand a large difference.
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