ADVERSE SELECTION IN CAPITAL BUDGETING DECISION MAKING

Arditti (1973) was the first article to discuss the weighted average cost of capital (WACC). Since then, numerous papers have fine tuned the exact definition and interpretation of the WACC and how it can be used in capital budgeting as a cutoff rate [Ang (1973), Babcock (1985), Ben‐Horin (1979), and Miles and Ezzell (1980)]. To date, however, no article has quantified the magnitude and frequency of capital budgeting errors. The purpose of the article is to show the significance and frequency of errors that will occur when the WACC is even slightly miscalculated.