Any Finance 101 class will emphasize that the appropriate discount rate for a project depends on the project’s own
characteristics, not the firm as a whole. If a utilities firm moves into media
(e.g. Vivendi), it should use a media beta - not a utilities beta - to
calculate the discount rate . However, a survey found that 58% of firms use a single
company-wide discount rate for all projects, rather than a discount rate specific to the
project’s characteristics. Indeed, when I was in investment banking, several clients would use their own cost of capital to discount a potential M&A target's cash flows.
But the
important question is – does this really matter? Perhaps an ivory-tower
academic will tell you the correct weighted average cost of capital (WACC) is 11.524% but if you use 10%, is that
good enough? Given the cash flows of a project are so difficult to estimate to
begin 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 paper is forthcoming in the Journal of Finance and co-authored by Philipp Krueger of
Geneva, Augustin Landier of Toulouse and David Thesmar of HEC Paris.
This paper
shows that it matters. The authors first looked at organic investment (capital expenditure, or "capex"). If your
core business is utilities and the non-core division is media, you should be
using a media discount rate for non-core capex. But, if you incorrectly use a
utilities discount rate, the discount rate is too low and you'll be taking too
many projects. The authors indeed find that capex in a non-core division is
greater if the non-core division has a higher beta than the core division.
Moreover, they find the effect is smaller (a) in recent years, consistent with
the increase in finance education (e.g. MBAs), (b) for larger
divisions – if the non-core division is large, then management puts the effort
into getting it right, (c) when management has high equity incentives, as these also give them incentives to get it right.
The authors then turn
to M&A. They find that conglomerates tend to buy high-WACC targets rather
than low-WACC targets, again consistent with them erroneously using their own
WACC to value a target, when they should be using the target’s own high WACC.
Moreover, the attraction of studying M&A is the authors can measure the stock
market’s reaction to the deal, to quantify how much value is destroyed. They find
that shareholder returns are 0.8% lower when the target’s WACC is higher than
the acquirer’s WACC. They study 6,115 deals and the average acquirer size is
$2bn. Thus, the value destruction is 0.8% * $2bn * 6,115 = $98bn lost to
acquirers in aggregate because they don’t apply a simple principle taught in Finance 101!
We often wonder whether textbook finance theory is relevant in the real world – perhaps you don’t need the “academically” right answer and it's sufficient to be close enough. But this paper shows that “getting it right” does make a big difference.
