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Firm A is a diversified firm with two main divisions, division 1 and division 2. Firm's...

Firm A is a diversified firm with two main divisions, division 1 and division 2. Firm's WACC is 15%. What discount rate shall we use for a new proposed project from division 1?

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Answer #1

If we use a unique company-wide discount rate, we overinvest (resp. underinvest) in divisions with a market beta higher (resp. lower) than the firm’s core industry beta.This is known as WACC fallacy.

The WACC fallacy results in value destruction. Conglomerates tend to invest less in lower-beta divisions than in higher-beta divisions.

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.

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