Observability and the Payback Criterion

Among the enigmas of corporate finance theory that have received little attention is the puzzling use of the payback method as a capital budgeting tool. Although the payback method has many drawbacks, it is widely used in industry (see Klammer 1972; Fremgren 1973; Schall, Sundem, and Geijsback 1978).1 Gordon (1955) attempted to explain this anomaly by observing that the inverse of the payback period is an approximation for the internal rate of return. But as Sarnat and Levy (1969) point out, the accuracy of the approximation depends on the life of the project and its IRR. For low values of IRR the inverse of payback is a very poor approximation. Moreover, it is difficult to believe that corporations that use complex and sophisticated technologies need a rule of thumb to approximate something as simple to compute as the IRR. In fact, empirical evidence shows that most firms compute both the IRR and the payback period (see Schall The payback criterion continues to be widely used in industry, although there is little support for it among the academicians. This paper attempts to find an economic rationale for it by using an incentive model with asymmetric information. It argues that when the managers possess private information regarding projects selected for implementation, it is in their interest to choose, ceteris paribus, projects that pay back faster. Since manager's wages depend on output (because their productivity is unknown), by choosing projects that pay back fast they hope to improve their reputations. * I wish to thank Milton Harris and an anonymous referee for their helpful suggestions, while I retain the responsibility for any remaining errors. 1. It has been found that payback is rarely used as a primary capital budgeting method. It is used as a secondary criterion to a discounted cash-flow method such as NPV (net present value) or IRR (internal rate of return).