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A rationale for the payback criterion

Hermann Jahnke () and Dirk Simons ()
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Hermann Jahnke: University of Bielefeld, Postal: Department of Business Administration and Economics, University of Bielefeld, 33501 Bielefeld, Germany
Dirk Simons: University of Mannheim, Postal: Departement of Accounting, Mannheim Business School, University of Mannheim, D-68131 Mannheim

No 08-15, Sonderforschungsbereich 504 Publications from Sonderforschungsbereich 504, Universität Mannheim, Sonderforschungsbereich 504, University of Mannheim

Abstract: Textbooks on financial management have emphasized the shortcomings of the payback criterion for decades. However, empirical evidence suggests that in actual capital budgeting procedures the payback method is used quite regularly. Mostly, it is implemented supplementary to net present value or internal rate of return, but small companies tend to rely on payback times as single criterion. A convincing theoretical foundation for the observed use of the payback criterion is lacking. Consequently, our goal is to provide such an explanation for the payback criterion’s popularity. We demonstrate from a decision theoretical perspective how relying on payback times simplifies investment decisions in modern organizations. Gathering information from different management levels and ensuring the utilization of individual skills requires a multi-stage capital budgeting process. Accordingly, we consider fundamental organizational features of this process with respect to their impact on the payback method’s use. For this purpose, we built upon almost stochastic dominance (ASD) as modeling device. Firstly, we show that applying his concept allows to include the risk preferences of all relevant decision makers into the analysis. Secondly, we illustrate that the criteria derived from this model help conveying these preferences to those who do the preparatory work preceding the final decision. To some extent, these new criteria are generalizations of payback times. This finding provides a potential explanation for the payback’s persisting prominence.

Pages: 38 pages
Date: 2008-09-28
New Economics Papers: this item is included in nep-ppm
Note: Financial support from the Deutsche Forschungsgemeinschaft, SFB 504, at the University of Mannheim, is gratefully acknowledged.
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