Payback criterion, hurdle rates and the gain of waiting

Abstract In the standard literature on investment decisions, commonly observed instruments, namely the payback criterion and the use of hurdle rates, are criticised as they do not lead to a maximization of expected profits. By using the real option approach to investment under uncertainty, we show that it can be rational for the investor to use the payback criterion as a rule of thumb, because a shorter payback period indicates lower gains of waiting. In addition, we claim that the use of hurdle rates can serve a similar purpose: It allows to distinguish between projects with different values of waiting. An explicit expression for the optimal payback period and the optimal hurdle rate is given.