Management Compensation and Payback Method in Capital Budgeting: A Path Analysis

Abstract While discounted cash flow techniques, such as net present value, are the primary normative models of capital budgeting recommended by finance theory, our survey suggests that one of the so-called ‘naive methods’, the payback (PB) criterion, is widely used in practice. About 85% of the responding firms make some use of the payback criterion. Almost 50% of the responding firms indicate that the payback method plays a relatively important role in capital budgeting decisions, and the degree of the importance varies among firms. This study uses path analysis to empirically identify links between the use of payback and management compensation contracts. Controlling for uncertainty in estimating future cash flows and firm size, we find that the use of the payback method is positively related to the degree to which management compensation depends on accounting earnings. Furthermore, this study finds two indirect links between management compensation and the use of payback. The more management compensation depends on accounting earnings: the more important management perceives the earnings objective and, consequently, the greater the use of the payback method; and the less important management perceives the shareholder wealth objective and, consequently, the greater the use of the payback method. We conclude that owner-management conflict and management's self-interest behaviour induced by employment contracts are factors that promote the use of payback method.