What is WACC Fallacy?

As to Hargraves (2020), the weighted average cost of capital (WACC) is a calculation of

a firm's cost of capital in which each category of capital is proportionately weighted. All sources
of capital, including common stock, preferred stock, bonds, and any other long-term debt, are
included in a WACC calculation. On the other hand, the WACC fallacy refers to behaviors such
as firms favoring higher risk projects because debt is better for the reason that debt is cheaper
than equity.
WACC fallacy: “Debt is Better because it is Cheaper than Equity”. In this investors
demand a lower return for holding debt than for holding equity. Raising more debt has two
effects: increase the cost of borrowing and makes existing equity riskier which increases the
cost of equity. Financial leverage is the use of debt to buy more assets and is employed to
increase the return on equity. However, an excessive amount of financial leverage increases the
risk of failure, since it becomes more difficult to repay debt. As financial leverage increases, the
expected rate of return on equity increases and by issuing debt, the company has created
financial leverage for the investor and this creates more volatility in return.
Additionally, in a research entitled, “The WACC Fallacy: The Real Effects of Using a
Unique Discount Rate”, the prevalence of the “WACC fallacy” among corporations seems
consistent with managerial bounded rationality. Also, the prevalence of this “WACC fallacy”
implies that firms tend to bias investment upward for divisions that have a higher industry beta
than the firm’s core division.

Hargrave, M. (2020). Weighted Average Cost of Capital – WACC. Retrieved on July 7, 2020 from
https://www.investopedia.com/terms/w/wacc.asp#:~:text=The%20weighted%20average%20cost
%20of,of%20capital%20is%20proportionately%20weighted.&text=A%20firm's%20WACC%20increases
%20as,and%20an%20increase%20in%20risk.

Lewellen, K. (2003). Capital Structure - PowerPoint PPT Presentation. Retrieved on July 7, 2020 from

https://www.slideserve.com/brier/capital-structure

Financial leverage. Retrieved on July 7, 2020 from

https://www.accountingtools.com/articles/2017/5/14/financial-leverage#:~:text=Financial%20leverage
%20is%20the%20use,more%20difficult%20to%20repay%20debt.

The WACC Fallacy: The Real Effects of Using a Unique Discount Rate. Retrieved on July 7, 2020 from
https://pdfs.semanticscholar.org/5754/8c346c6155a4caccfab43f61889148d5b13c.pdf