A Rational for the Payback Criterion: An Application of Almost Stochastic Dominance to Capital Budgeting
38 Pages Posted: 11 Nov 2008
Date Written: September 28, 2008
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 this 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.
Keywords: capital budgeting, decision procedures, investment appraisal, net present value, payback method, almost stochastic dominance, risk aversion, uncertainty
JEL Classification: G31, D81, D70
Suggested Citation: Suggested Citation